Microsoft has delivered strong and consistent returns to investors over the past decade and has become a core holding for many quality growth portfolios.
The US technology giant has grown to become one of the largest companies in the world, and at its current market capitalisation of $2.4trn (£1.8trn), it makes up about 4% of the entire MSCI World index.
Microsoft’s share price is up 1,129% over the past 10 years. After such a long period of strong growth, the question is whether the company can continue to deliver good returns for investors.
Reasons to be bullish
Baillie Gifford’s Spencer Adair, manager of the Monks Investment Trust said that Microsoft still has the potential to double over the next five years.
“They've got an interesting lead in use of technology in the home with the Xbox and what that can do with smart TVs in the future,” he said. “They've got this glimpse into how technology is going to be far more than just sitting at home at a work screen. And then they've got one of the top three positions in the enterprise cloud.”
Microsoft’s cloud business is what really drives the value growth over the next five years, according to the Baillie Gifford manager.
He said: “That's where scale really matters where trust really matters, where you cannot lose your data. And because of its enterprise sales force on the software side, it has already built the relationships.
“If I started a software company tomorrow selling word processing, I could probably make some inroads. If I tried to set up a company tomorrow that would convince governments and organisations to give me all their data to the cloud, it would not happen.
“So the heritage of Microsoft, bizarrely, forms part of its advantage. It's large and profitable, but using that heritage in a positive way to grow.”
Microsoft’s cloud business Azure is one of the three leading cloud companies in the world, alongside Amazon Web Services and Google Cloud.
However, Amazon’s e-commerce business and Google’s advertising business have fallen under regulatory scrutiny recently for anti-competitive behaviour.
Microsoft has already been through similar regulatory issues when it faced anti-trust scrutiny a decade ago.
Since then, Microsoft has navigated past its regulatory issues with a chief executive officer (CEO) in place that Adair praised as someone who is “listening to society and making sure that the company is responding in the right way”.
Microsoft’s current CEO Satya Nadella replaced former CEO Steve Ballmer in 2014 after he faced criticism for focusing on sales and not taking advantage of the rise of smartphones.
Adair said: “Steve Ballmer was one of the one of the co-founders of Microsoft in a first-generation aggressive way. He wasn't listening. He didn't understand how important Microsoft would become, and today it's much more important.”
Previously, another criticism of Microsoft was that it wouldn't experiment, or that it acquired and killed off businesses.
“It had Skype 15 years ago,” Adair recalled. “That should have stopped Zoom, but it didn’t. Others were allowed to innovate around it.
“What I like about LinkedIn and some of the other things it has bought is that it has been trying to leave that alone,” he said. “So Microsoft’s management has learned something from putting a lot of Microsoft people into run and control these things. It's more a loose confederation of businesses rather than all being very controlled.”
Reasons to be bearish
Not all investors are as optimistic about Microsoft’s future. Nick Clay, manager of the TM RWC Global Equity Income fund, is sceptical about the US tech giant’s market valuation.
“When the best companies become too expensive they become the most risky,” he explained. “We have been taught these lessons many times before, and yet we either want to forget or believe it will be different this time.
“Let’s look at Microsoft – an amazing company. But again, priced for perfection. In 1999, at the peak of the tech bubble, Microsoft traded at 26x sales (trailing 12m revenue of c.$20bn) and a free cash flow yield of 2.7% (free cash flow of c.$13bn) according to Bloomberg. Perfection is demanded.”
When the technology bubble burst in 2000, shares in Microsoft fell 63% and took more than a decade to recover to its previous levels.
Clay said: “Despite going on to grow its sales over threefold and its free cash flow by over twofold over the next 13 years, it failed to respond in share price terms – simply de-rating the stock to 3x sales and 11% FCF. Even delivering almost perfection it still lost 50% absolute.
“Here we are again, in 2021. Back to 13x sales and again a 2.7% FCF yield. Again, perfection is being demanded, and yet this time from a far higher base level – sales are now c.$168bn and FCF c.$56bn.”
The manager explained that in order for Microsoft to stay at its current price, but return to its 20-year average multiples, it needs to grow its sales and cash by more than twofold.
“That is asking Microsoft to grow (say over the next five years – a reasonable investment horizon) by the size of Apple, or Alphabet, or to create another 1.5x itself” he said.
“How probable is that in an uncertain future? Already there is evidence of competition in the cloud market beginning to escalate – even amongst the market leaders.”
As Microsoft continues to fight for market share with its major rivals – Amazon and Google – a growing number of competitors are emerging – such as cloud computing data warehousing firm Snowflake, and cloud monitoring firm Datadog. In China, Alibaba and Tencent have also been competing for market share.
Clay continued: “Even if Microsoft could grow 1.5x itself, that would simply give you a return of ZERO to allow it to return to average valuations. To make more from here, it has to do even more.
“Perfection may not be enough…when expectations placed upon even the best companies become too extreme investors risk reward is all skewed against them.”