Summary
- In this article, I start by making the case for low-volatility dividend growth stocks as a way to achieve long-term outperformance.
- Microsoft doesn't have a high yield, but high and consistent dividend growth is backed by impressive financials.
- MSFT stock's valuation is a bit of an issue, but with the right strategy, investors can play it safe.
David Ramos/Getty Images News
The key to successful long-term investing is buying quality. Dividend growth and low volatility - a perfect mix is where you ideally want to be.
In a 2013 article published in The Journal Of Investment Consulting, Geoffrey Gerber explains why dividend growth is such a good defensive equity strategy.
He concludes that:
Reduced-volatility equity strategies utilizing dividend growth in the stock selection process are shown to have historically provided a boost to risk-adjusted-performance.
One piece of evidence he uses is the table below, which shows three different investments. Investment A has an 8% average annual return and a 10% standard deviation. Investment B also has an 8% average annual return but a 20.1% standard deviation. Investment C has a lower average annual return of 7.0% and a 10.1% standard deviation.
The Journal Of Investment Consulting (Raw Data: Twin Capital)
As a result, investment A has the highest return, turning $1 million into $4.3 million during 20 years. Investment C did better than investment B even though investment B has a higher average return.
Nasdaq (NDAQ)looked intothis issue as well.
Aside from the 1-year data, the low volatility strategy has had superior risk-adjusted returns on a 3, 5, 10-year, and since inception basis. This shows that low volatility is better at providing long-term capital appreciation compared to high volatility strategies, which makes low volatility a critical investment factor to consider.
Nasdaq Inc.
Normally, it wouldn't make sense. Higher volatility could mean higher risk. This means investors need a higher compensation to take that risk.
The reason why low volatility is able to outperform the market is that it does relatively well during bull markets while outperforming volatile stocks during bear markets. Downside protection is the key to long-term success.
Dutch investment company ROBECO put this into perspective in a recent article. The higher the volatility, the lower the long-term compounded return.
ROBECO
While it is harder for low volatility to outperform in bull markets, they outperformed in almost all bear markets as the graphs below show (my apologies for the bad quality).
ROBECO
The best thing about dividend growth in addition to low volatility is that it allows investors to receive a payout that often not only offsets inflation but beats inflation by a rather big margin. It also proves that the underlying company is able to generate value - it has proven to be able to go with time and exploit the market it operates in. That beats a lot of companies that are unable to distribute cash for whatever reason.
Especially now, dividend growth is very important.
Why *High* Dividend Growth Is Important
I already answered this question as dividend growth is a great way to outperform the market. However, right now, the emphasis is on high dividend growth. I've highlighted this issue in a number of articles so far because we're dealing with a somewhat toxic mix of slower economic growth expectations and high inflation expectations. While inflation will without a doubt come down significantly from its current readings above 8%, it's unlikely that inflation will come close to 2% over the next 2-3 years. We're dealing with global supply chain reconfigurations after the pandemic and a severe energy supply/demand imbalance that won't be solved anytime soon, making both natural gas and crude oil much more expensive prior to the pandemic. We're dealing with labor shortages and other issues that will result in the "re-pricing" of goods and services.
When it comes to dividends, it is expected that growth will slow significantly. According to CME Group(CME):
Indeed, there are many reasons to be skeptical of the idea that dividend payments will continue to grow rapidly in the 2020s, including the fact that corporate profits are near a record as a percentage of GDP, which might not bode well as input costs soar and as economic activity potentially slows amid tighter fiscal and monetary policy.
In order to visualize that statement, CME uses its S&P 500 Annual Dividend Futures that show us expected dividends in the years ahead. In other words, based on market expectations. The graph below shows that nominal dividend expectations indicate very slow dividend growth until at least 2030. In this case, it's not set in stone and expectations will rebound when economic growth strengthens again.
Combining everything said so far, we're looking for a stock with low volatility, dividend growth (preferably high growth), and obviously, a business model that supports this on a long-term basis.
That's where Microsoft comes in.
What Makes Microsoft So Special
Without turning this into a direct comparison, one of the things that I like about Microsoft is its well-diversified business model. Unlike Apple (AAPL), which generates half of its money from iPhones, we see that Microsoft is more service-based. In 2021, the company generated 36% of its sales from cloud services, 32% from personal computing, and 32% from productivity and business processes.
In the quarter ending March 31, the company did $19.1 billion in Intelligent Cloud revenue. Thanks to Azure, growth in this segment increased by 32% on a constant currency base. Azure alone reported 46% revenue growth. Even the Office products are still seeing double-digit revenue growth numbers.
Microsoft Corp.
What makes this $2.02 trillion company so special is its huge installed base. It operates in a competitive industry with most "big-tech" companies offering cloud and related services. However, it is Microsoft that has the installed base. Windows 10 alone had an installed base of 1.3 billion users in 2021.
Morgan Stanley maintains a $372 (+38%) per share base case for this Redmond, Washington-based company driven by Azure winning in the public cloud space, sustainable growth in Office and LinkedIn, as well as a steady operating margin improvement to 44%. Its bull case is $482 (+79%) per share in a situation where cloud adoption is even higher than expected with operating margins reaching 46% in 2023.
In general, all eyes are on the company's ability to further achieve economies of scale with strong cloud adoption - led by Azure. It's also important that the company's pending acquisition of Activision Blizzard results in strong earnings accretion from the very beginning.
With that said, all of these qualities bring one important thing to the table: a lot of cash.
Microsoft is an incredible cash machine. In its 2021 fiscal year, the company did $56.1 billion in free cash flow. That's up more than 100% since 2013. In its 2022 fiscal year, ending on June 30, we can expect $66.6 billion in free cash flow. In 2024, this could end up close to $90 billion. The implied growth rates of the next three years (2022 included) are 18.7%, 15.1%, and 16.3%, which is truly remarkable.
Free cash flow, or FCF, is operating cash minus capital expenditures. It is cash a company can distribute to its shareholders via direct dividends or indirect buybacks without having to use external funding or existing cash. The graph below not only shows free cash flow (expectations) but also total shareholder distributions.
Author (Raw Data: TIKR.com)
In general, these distributions have followed the free cash flow trend quite well. However, the fact that there's a gap in most years means that net debt has been in a freefall. In 2012, the company had close to $50.3 billion in net cash (negative net debt, implying more cash than gross debt).
This year, net cash is expected to be higher than $63 billion. This number could rise to $150 billion in the 2024 fiscal year without buybacks.
As a result, the company is using both dividends and buybacks to get rid of cash. In 2021, the company distributed close to $44 billion through buybacks ($27 billion) and dividends ($17 billion). Regarding buybacks, the company bought back 2.7% of its shares outstanding between 2017 and 2021, which shows that dilution through stock-based compensation and related offsets a big part of buybacks.
Author (Raw Data: TIKR.com)
If we use FY2023 FCF expectations of $76.7 billion and the company's $2.0 trillion market cap, the company can distribute 3.9% of its market cap in dividends and buybacks.
With that said, the focus is clearly on dividend growth here - instead of the company's yield. Microsoft pays a $0.62 dividend per quarter per share. This translates to a 0.9% dividend yield. In other words, investing $10,000 in MSFT gets you $100 per year. It's understandable that high-yield investors will ignore MSFT.
Author
However, my point is that dividend growth is key here. Using the Seeking Alpha dividend score card, we see that MSFT scores very high on dividend safety, growth, and consistency versus its information technology peers. Its yield is a big fat D, which is understandable.
Seeking Alpha
As the dividend history chart above shows, dividend growth has improved a bit. Over the past three years, dividend growth has averaged 10.4%. The 10-year average is 12.3%.
With that said, Microsoft does not only check all boxes, it also proves that it has the qualities to outperform. Since 1986, MSFT has returned 24.8% per year, turning $10,000 into $25.8 million - the S&P 500 returned 15.1% per year. That's the biggest return I've ever seen when backtesting a stock. Despite its standard deviation of 32.5% during this period (versus 15.1% for the S&P 500), it has a 0.76Sharpe Ratio(volatility adjusted performance). The S&P 500 scored a 0.55 during this period.
Going back to 2010, MSFT is still growing by 21.8% per year as the table below shows. However, as we exclude the wild years in the early 2000s, the standard deviation has come down to 21.5%, which is roughly 600 basis points above the S&P 500's standard deviation. The worst year and the biggest drawdown are similar, resulting in a higher Sharpe Ratio for MSFT.
Portfolio Visualizer
I expect MSFT to continue delivering outperforming total returns. The problem is finding an entry.
MSFT Stock Valuation
Microsoft has a $2.02 trillion market cap. The company is expected to end up with $93 billion in net cash next year. This gives us an enterprise value of $1.93 trillion. That's roughly 16.8x next year's EBITDA estimate of $114.4 billion. The stock is down 19.7% year-to-date and 21.3% below its all-time high.
Data by YCharts
Although this is one of the biggest drawdowns of the past 10 years, MSFT still isn't cheap. This valuation is still one of the highest since the pandemic. The same goes for the implied free cash flow yield of less than 4%, which I calculated in this article.
Data by YCharts
The "problem" is that MSFT benefited from a steady increase in its valuation multiple. While the stock was way too cheap prior to 2017, the valuation has gotten a bit out of hand as the pandemic pushed demand toward cloud services and personal computing fueled by a steady increase in global liquidity as the chart below shows.
Bank of America (Via Seeking Alpha)
Bank of America believes that the Fed won't stop raising rates until a major shift in the labor market occurs. The problem is that it will have a hard time fighting inflation as the Fed cannot solve supply chain issues, nor can it end the war in Ukraine to somewhat ease food inflation.
While it's hard to tell how this will end, central banks are determined to fight inflation. Even the extremely dovish European Central bank is expected to end QE in July, to start hiking rates somewhat aggressively going into 2023.
Keep in mind that this is happening while economic growth is slowing. It's a truly tricky situation that has prevented tech stocks from rebounding so far.
In this case, MSFT is a tech/value hybrid. It has very high growth rates and high free cash flow, which protects it against steep declines - unlike some of ARKK's holdings.
Takeaway
In this somewhat lengthy article, I started by explaining what I'm looking for in a dividend growth stock. The best way to generate long-term wealth is by focusing on companies that can grow their dividend over time while maintaining a somewhat low volatility profile on the stock market. This protects investors against large drawdowns and allows them to generate outperforming total returns on a long-term basis.
Microsoft is a perfect stock to achieve this. It has a business model capable of maintaining strong, double-digit EBITDA, earnings, and free cash flow growth, thanks to outperforming cloud computing, its dominant position in personal computing and related services, as well as new endeavors like the pending acquisition of Activision.
While its yield isn't high, dividend growth is high and consistent. This is further supported by buybacks and excess free cash flow used to boost the company's cash position.
The only problem I see is that the valuation isn't attractive yet. I'm looking for an entry closer to $240 if I get the chance. Other than that, I will still assign a bullish rating, which covers my longer-term view and because it cannot hurt to start buying at current prices (my breakup strategy).
So, long story short, MSFT is a fantastic tool to build wealth, and I doubt that there are many alternatives that will be able to keep up with this famous tech giant.
Source: Seeking Alpha
Comments