Saturday, July 7, 2012

Viable Stock Market Investments – Part IV

Let’s look at a real life but simplified example: Microsoft. This is not a recommendation to buy or sell Microsoft. This is just an example and neither do I warrant that the data used is correct. In fact, Microsoft’s financials are way too complex to down load from a website such as Globe Investor or Yahoo.  The data contains contradictions or is incomplete and I adjusted numbers to fit in our example.
We’re looking at this data as if we are the business owner rather than the traditional ‘make-a-quick-buck’ stock market investor who moves in and out of the stock at the first whiff of good or bad news.  In the end, we all want to invest our money to make more money; the ultimate goal being the ability to have your money work for you rather than you working for money.
In fact, we’re not that different from the business owner, who also wants to have his money work for him rather than the other way around. The difference is, you sit in your arm chair or are employed elsewhere (passive investor) and the business owner works for his company (active investor). In fact, each investor in rental properties is a business owner as well. The real estate investor runs everyday her rental company; she maintains the property or have a rental manager do this for her (I am using ‘her’ although I do know that there are male investors as wellJ), she sets the rental rates based on the market, she arranges for financing, manages cash flow, etc., etc.
But in the end, both the passive investor and the active business owner investor, both draw a salary, cash flow (dividends) and have appreciating and growing assets. The active investor controls the business; the passive investor does not. Apart from control, there is no real difference and thus we should know and understand how our business makes money and how much. We also should expect like any business owner to hold on through good and bad times. If we think the business model has changed and results become unpredictable, we should consider selling. If the business is no longer viable sell it or its assets and use the proceeds to invest elsewhere. 
There is another investor out there, the trader. The trader doesn’t care about the underlying business. He cares only about buying an investment product and selling it at a profit. Sometimes he loses money and at other times he wins. Investors such as me do all three: I do active investing (I own rental real estate and a real corporation), I do passive investing – I am a small silent partner in a ‘Mortgage Investment Corporation’ or MIC, I am a silent partner in a joint real estate venture and I own shares in public companies. I also trade on occasion – sometimes, a minor bit in stock arbitrage and in options.  Whatever I do, I have to keep in mind what kind of investment I do. Is this deal a trade, an active or a passive investment? Many investors don’t know what type of investor they are or what kind of deals they are doing – this is where many lose their shirt.
Warren Buffett does everything as well, but he is best known for investing in stock of public companies. He is a passive investor in those cases but still often sits on the board of directors of his investments and he looks at their financial statements. His buddy, William Gates used to be an active investor with Microsoft but now he has moved on to the Bill and Melinda Foundation and leaves the work in the hands of his university friend Steve Ballmer. If you are an owner of Microsoft shares then you’re buddies with both Steve and Bill. If they understand where Microsoft’s money comes from shouldn’t you as well?
Every company provides a service or product that it makes at a certain cost (expenses) and sells at a profit  (Operating Income) for a certain price (revenue). Microsoft sold $70 billion of goodies in 2011. Two years earlier, in 2009 it sold $58 billion. On average it sold each year 10% more. With Windows 8, the windows phone and the Surface tablets coming that revenue growth is likely to accelerateeven further.
It cost $42 billion and $39 billion to make those goodies in 2011 and 2009 respectively. In other words, Microsoft sold 10% more per year for goods that cost it 4.2% more per year to produce. Guess what, their operating profit increased from $20 billion to $ 28 or it increased by 21% per year. Microsoft’s profit margin (profit divided by the costs to produce) increased from 34% to 40% - not did Microsoft sell more, they also produced each goodie at a lower price!
Now that is a good looking business wouldn’t you say?  Not something you learned from the newspaper headlines, he?  No, from the headlines you would think that Microsoft is passé!  
If we used the new profits to reinvest, we could create next year 40% more goods. We could sell for a profit margin of 40% or better if we could lower our production costs per unit. That is if market demand also grows by at least 40%!

A lot of products are sold at a much higher profit margin when they just come out and after that competition will force the profit margin down. If Microsoft had never developed newer and better versions of Windows, Office or Xbox games, its customers would have switched to Linux, Apple Macintosh, Sony, Playstation, Firefox, Google Chrome, Android, etc, etc. Its profit margin would have dropped to the point that nobody makes a profit.
That is what happened with cell and smartphone producers. Everyone is making them in a brutally competitive market where only Samsung and Apple are currently profitable! Look what happened to PC makers – last year even HP wanted to stop making desktops and they gave up on tablets within months after launching it!  Microsoft’s profit margin is currently 40% and it is climbing! Apple’s is 23%
In other words, Microsoft’s profit margin could allow it to grow its production by 40% while Apple could only grow by 23%. Of course a company can borrow more money or issue more shares to build more facilities. But that falls under financing and the balance sheet; we will talk more about that later. It must be clear by now, that in today’s competitive high-tech market both Apple and Microsoft are formidable competitors – both with a good chance to exist still a hundred of years from now similar to companies such as CocaCola, IBM, Johnson and Johnson, GE, Ford, GM and RCA.  Oops!  RCA the television maker did bite the dust and GM and Ford were nearly bankrupt in 2008. That is the world of competition! Even after being in business for a hundred years you are not safe. Neither was the world dominance of the U.S. China, Russia, the British Empire, the Ottoman Empire or Rome and Greece. Greece? Italy?  Well, you get my drift.
He Godfried, did you learn all that from a financial statement?  Wow man!  But I digress. In fact, we did not learn this from the financial statements; we learned it from looking at the INCOME Statement only. The numbers are shown below. As I said:’high school math’. You’d think that the news media could do that wouldn’t you?
Click to magnify (Don't you think 'Click to Enlarge' sounds not quite appropriate? :))

See you next post! Then we’ll discuss Microsoft’s Balance Sheet. We don’t want you to get a headache.
We? The royal ‘I’? Godfried it’s all going to your head!

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