Are there times when a great company does not make for a great stock? The answer is a definite “yes.”
I would also say that such companies can eventually come around to once again being an attractive stock to own. I have two examples to share: Cisco Systems (ticker: CSCO) and Microsoft Corp. (MSFT).
Cisco had annual sales of $19 billion in 2000 and net income of $2.7 billion. For 2015, annual sales were in the range of $49 billion and net income in the range of $9 billion. Sales went up 250 percent and net income increased 333 percent. Don’t you think you would have liked owning the stock over this 15-year period?
Microsoft is another interesting case. For its fiscal year ending in 1999, annual sales were approximately $19.7 billion and net income was approximately $7.7 billion. In 2015, sales had increased to $93.5 billion and net income, before restructuring charges, was approximately $22 billion. Sales went up 470 percent and net income went up 285 percent. This seems like another stock that it would have been worth owning over the last 15 years.
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Companies that have grown at the rate of Cisco and Microsoft certainly qualify as great companies. The shocking thing to learn is that both stocks currently trade below their prices of late 1999 and early 2000. On a split adjusted basis, Cisco traded for approximately $77 in March 2000 and Microsoft traded for approximately $58 in December 1999. Today, Cisco trades for about $28 per share and Microsoft in the range of $54 per share.
A buy-and-hold Microsoft shareholder could make the case that after 16 years they are close to breaking even and would have collected some relatively minor dividends. Microsoft’s dividends didn’t start until 2003. In Cisco’s case a similar buy-and-hold investor is still down over 60 percent on the price of the stock and would not have started collecting a dividend until 2012. The maximum decline in stock price for both companies during those years was substantially higher.
So we have two companies that are now, respectively, more than 2.5 times and 4.5 times larger in terms of sales and substantially more profitable than they were around the year 2000. Still, an investor would have lost money owning them over this time frame. Granted, I have chosen what may be viewed as two extreme examples, but they do an outstanding job of pointing out the valuation conundrum that goes with making any buying decision and that valuations eventually matter.
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What is really interesting is where both companies stand today as major cash flow-producing machines. They both currently trade at reasonable valuations, are growing and pay a nice dividend. Cisco’s current dividend yield is around 3.7 percent and Microsoft’s is around 2.7 percent. Those yields compare very favorably to a 10-year Treasury bond yield of 1.9 percent.
What is more compelling is that unlike a bond, the yield on the right stock has the ability to grow. I believe we are in a prolonged period of unnaturally low interest rates due to central bank policies around the world. In this environment, many investors are forced to seek cash flow from companies that pay dividends. As the dividends increase over time, the stock price will likely follow.
While I like both stocks at today’s prices, I believe Cisco is a more compelling value than Microsoft. Cisco currently trades at 12.3 times expected 2016 operating earnings, whereas Microsoft is around 19.5 times. Cisco is aggressively buying back stock at these reasonable valuations, which I believe to be a good use of capital.
For future sales growth, the rapid development of the Internet of Things is a trend that Cisco will directly benefit from, given its broad product lineup. In addition, Cisco had $60 billion in cash and equivalents at the end of the second quarter of its fiscal year 2016. This cash provides it with great financial flexibility to pursue acquisitions and/or significantly increase the dividend.
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Management at both companies appear committed to returning free cash flow to shareholders through stock buybacks and, more importantly, dividend increases. I believe both companies have the ability to add to their dividends at close to double-digit rates over the next few years.
This should bode well for an investor’s cash flow, as well as the price of the stocks.
Disclosure: Bob Phillips and clients of Spectrum Management Group own MSFT and CSCO stock.
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Is a Great Company Always a Great Stock? originally appeared on usnews.com
