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Financial Times - Just the facts when weighing investments

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In the 1950s, an early detective series on TV was Dragnet, starring the fictional Joe Friday. In the opening sequence to every show he would say: “My name is Friday. I’m a cop”. His other famous one-liner, usually delivered while trying to extract evidence from a hapless babbling witness, was: “Just the facts”.

We would all do well to remember Joe’s witness interview technique when it comes to investing. So let’s start with a few facts – those shown in the table below. Would you want to own a company which had delivered those results?

Would you invest?

Year       Revenue    Operating cash flow

2006       44.3                          14.4

2007       51.1                          17.8

2008       60.4                          21.6

2009       58.5                           19

2010       62.5                          21.1

2011       70                              27

2012       73.7                          31.6

Source: Fundsmith

It has seen revenues rise by 66 per cent over the past six years, a compound growth rate of 8.8 per cent, which was no mean feat for a period which spanned the financial crisis and a deep recession. The company experienced a downturn in 2009, but revenues only fell by 3 per cent, so it is barely cyclical.

Its cash flow performance has been even better. Operating cash flows grew by 119 per cent over the same period – a compound annual growth rate of 14 per cent – and its operating cash flows are 43 per cent of its revenues, so its margins are exceptionally good.

All in all, it’s an impressive operating performance. Of course, you can’t make an investment decision on the basis of that alone. You’d need some data on valuation – and you could be forgiven for thinking that, given its recent record, its shares must be so highly valued as to be uninvestable.

What if I told you that you could currently buy this company on a free cash flow yield (the free cash flow it generates, divided by its market value) of over 8 per cent? That it is on a prospective price-earnings ratio of 12? It pays dividends too – giving a 3.2 per cent yield covered 2.4 times. To cap it all, it has cash on its balance sheet equivalent to about a quarter of its market value.

“How do I buy the shares?” might well be your response. It was certainly mine. If you put a dollar sign at the beginning of those figures and “billions” after them, the company I have described is Microsoft.

At this point, I would guess that investors who might have been salivating at the prospect of this investment opportunity will be surprised. Surely Microsoft is a loser in the tech wars? I have lost count of the number of articles I have read in computer publications, business magazines, newspapers, analysts’ reports and blogs questioning whether Microsoft can “save itself”.

Save itself from what? Bears argue that Microsoft has lost out to Apple in mobile devices and Google in online search and mobile operating systems. It is also inextricably linked to the declining PC replacement cycle as that uses its Windows operating system, which is the Microsoft product most of us know.

That is certainly the view you will get if you read most commentary on Microsoft. However, back to those pesky facts. Microsoft’s largest division by both revenues and profits is its servers and tools division which develops and markets software for servers and software developer tools. Its customers are IT professionals and software developers. How much do you know about that?

If you use Microsoft software in work, and the vast majority of us do, then I would guess that you have gone through, or are about to go through, an upgrade from Windows XP to Windows 7 as Microsoft is halting support for the older product. Windows XP runs 95 per cent of the world’s cash machines. This is an example of a gift which keeps on giving – an annuity income for Microsoft which results from us all having to update to more recent versions of its operating system.

I do not profess to know anything about technology investment (although at least with this awareness of my limitations, I suspect I am one step ahead of most of those who think they do). Nor do I have any insight into who will take over from Steve Ballmer as chief executive. But I do know something about financial analysis, which often seems to be ignored, as it has been by many commentators on Microsoft.

Worse, much of the “research” and commentary about Microsoft is not about whether it is doing well or badly. It’s more about the biases of the commentators, who often seem to feel that because Microsoft is not hip or fashionable, and doesn’t have the design sense of Apple, it doesn’t deserve to succeed.

The facts suggest otherwise. Just stick to the facts.

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Terry Smith

Financial Times