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Thesis
Microsoft (NASDAQ:MSFT) is one of the best businesses in the world, and that won’t change even if the Fed tightens or inflation remains hot. History shows that deflationary technologies can be an investment that generates alpha in this macro-environment. The marketThis is evident considering the recent tech disaster, which creates an opportunity for contrarian buying.
History’s Lessons
Inflation was not a problem until the 1970s. Particularly, the period 1975-1982 had extremely high inflation. It was between 6% to 14%. During this period, rates were raised rapidly by the Fed from 5.82% – 11.2% and peaked at a staggering 22.36%1981
We can expect inflation to begin to slow down and rates to decline in the future. Investors need to be prepared and have stocks that can perform in any environment.
If the recent price action is any indication energy and materials will be the best sectors to invest in when rates and inflation are rising. The argument makes sense: inflation causes energy/material prices and material prices to go up, which increases the profits of these companies. Stocks in these sectors are often considered value stocks. Inflationary environments can cause stocks to lose value, which is why value has historically outperformed growth.
However, results for the period 1975-1982 contradict this thesis. Below is a chart comparing the returns of the largest energy and materials companies with the leading “techno” companies of the day. Since Microsoft wasn’t publicly traded until 1986, I used some other companies with similar characteristics, namely low input cost, as proxy companies. ADP (NASDAQ :ADP) was a predecessor to modern SaaS businesses like Paycom (NYSE :PAYC). It focuses primarily on payroll services. It has an asset-light business, which allows its customers to make cost savings by automating back-office processes. Equifax (NYSE EFX) is a credit bureau. IBM (NYSE.IBM) was a major technology company of the time.
Source: The Author
Although this is a scientific method, it’s not very scientific. I only selected companies that I knew were publicly available at the time. The results don’t reflect all sectors. We’ll have to accept that sectors aren’t as defined today as they were in 1970s.
The three “tech” companies ADP and EFX outperformed the market. However, the results among materials stocks and energy were mixed. Steel (NUE), meanwhile Air Products and Chemicals and Exxon(XOM) outperformed the market. Chevron and gold (NEM), however, did not outperform the “tech-company” companies. The energy/materials companies averaged 21% per annum, while the “tech” companies returned 23%
This is contrary to the panicked “sell tech, buy real assets” narrative that is prevalent today. These results show that different types of businesses can achieve strong returns even under high inflation and rising rates. It is clear that energy/materials are able to benefit from higher spot prices during inflation. However, it is also true that deflationary technology may be more in demand during high inflation. Inflation can be offset by strong pricing power at the top technology companies.
Why Microsoft?
What I have learned from past challenges, macro and micro, is that I don’t hear of businesses cutting IT budgets or digital transformation projects. These projects can actually help them accelerate their transformation, or even automation. I haven’t seen such a demand for automation technology to increase productivity. In an inflationary environment, software is the only deflationary force. -Satya Nadella
There are many reasons Microsoft is better than other companies that produce deflationary technology. It has high profit margins and market leadership. It also has strong pricing power and a strong balance sheet. It is one of the few companies in the world that has a higher credit rating then the U.S. government. It’s also one of the most powerful brands in the world and one of the best places to work according To Glassdoor.
One reason why the current environment is so unique is how defensive Microsoft is with its revenue. People won’t be leaving Azure or cancelling Office subscriptions to save money. There are better alternatives, but they’re either not available or more expensive (e.g. Hire developers to build your network infrastructure. As Microsoft’s CEO pointed out, the demand for Microsoft’s services could increase in current economic conditions.
Consumer-facing brands, which make up a large portion of the tech sector, might be more at risk. People might put off buying a new phone or running digital ads if they have to cut back on their budgets because of inflation.
When looking back at the 1975-1982 period there is not much evidence that more consumer brands were affected by cyclical events, even though there have been multiple recessions from 1982 to 1980.
| Company | Average Return ’75- ’82 |
| LOW | 24% |
| TGT | 56% |
| MCD | 19% |
Source: The Author
However, it is clear that these companies had many years with poor performance but were compensated by those with great years after the recessions of 1982 and 1975. Lowe’s, for example, had a return on average of -7%, compared to ADP’s 16%.
The best way to invest is to buy great companies and keep them throughout the economic cycle. For those who are concerned about the possibility that a recession could result from Fed tightening amid high levels of inflation, it is sensible to hold more defensive stocks. Microsoft is the best defensive tech stock I know.
MSFT Stock Valuation & Factor Grades
Seeking Alpha
Seeking Alpha’s factor grades are very good for Microsoft. These include profitability, momentum and revisions. This is not surprising considering Microsoft’s 38.5% profit margins and its historical returns. Although they receive a D on their growth score this is the case for large cap blue chips and Microsoft is growing much faster than other companies of similar size with a very respectable 18% rate of revenue growth.
However, the company’s valuation score is not very good. Microsoft’s 30 P/E is not cheap. This is the main risk. Despite growing faster than these defensive megacaps, Microsoft is still fairly valued.
Seeking Alpha
A PEG ratio of 1.5 is reasonable for one of the most high-quality companies in the world, according to me. Analysts agree. They’ve maintained their $366.23 median target price (implying 29% upside), despite Microsoft’s recent sale. This is a significant price vs. target price divergence for Microsoft over the past few years. Analysts don’t tend lower their target prices for Microsoft when it sells.
There are risks
Microsoft’s biggest risk is its valuation. Even though I believe it is reasonably valued in relation to its growth and quality (30 P/E) isn’t cheap. A high P/E can leave more downside risk because the market can be irrational in short-term.
Other minor risks are also worth considering. Microsoft could be under scrutiny for antitrust violations due to their recent Activision acquisition. Hackers could also target them, especially given their support for Ukraine. With enough time, competition could pose a greater risk.
Conclusion
History has shown that rising rates and inflation don’t necessarily spell doom for stocks, even tech stocks that have been under fire recently. Microsoft is one the most reliable and defensive tech stocks. Despite this, it has been selling off with all other stocks, giving investors rare opportunity to purchase the company at a lower price than analysts target. Microsoft remains one of the largest positions in my portfolio.
