Microsoft Stock: A Contrary Pick in a High Inflation Environment (NASDAQ:MSFT) – Advice Eating

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thesis

Microsoft (NASDAQ:MSFT) is one of the best companies in the world, and that’s not going to change even if the Fed tightens or inflation stays high. In fact, history suggests that deflationary tech can be an alpha generating investment in this macro environment. The market appears to be ignoring this given the recent technical wreck, creating a contrarian buying opportunity.

lessons from history

The last time inflation was a real problem was in the 1970s. In particular, the period from 1975 to 1982 had very high inflation between 6% and 14%. During that time, the Fed quickly raised interest rates from 5.82% to 11.2%, and they peaked in 1981 at a staggering 22.36%.

Hopefully, inflation will begin to ease and we won’t see rates anywhere near as high in the future. But investors should be prepared either way and anchor their portfolios with stocks that can perform well in any environment.

If recent price action is any indication, energy and materials are the best sectors to own when inflation is high and interest rates are rising. The argument makes sense; Inflation drives energy/material prices up, which increases profits for these companies. Additionally, stocks in these sectors are generally considered value stocks, and value has traditionally outperformed growth in an inflationary environment.

However, the results from the period 1975-1982 contradict this thesis. The chart below compares the returns of leading energy and resource companies to leading “tech” companies of the era. Microsoft didn’t go public until 1986, so I used a few other companies with similar characteristics—namely, low input costs—as proxies. A predecessor of modern SaaS companies like Paycom (NYSE:PAYC), ADP (NASDAQ:ADP) is primarily focused on payroll services. Like Microsoft, it has an asset-light business that allows its customers to realize cost savings by automating back-office processes. Equifax (NYSE:EFX) is a credit bureau. And, of course, IBM (NYSE:IBM) was a leading technology company at the time.

Source: The Author

Admittedly, this method is not very scientific as I only selected a few companies that I know were public at the time and these results do not represent all industries. Unfortunately, in the 1970s, sectors weren’t defined like they are today, so we’ll have to settle for that.

While the three ‘tech’ companies ADP, EFX and IBM all outperformed the market, results for energy and resource stocks were more mixed. Steel (NUE) crushed the market while Air Products and Chemicals (APD) and Exxon (XOM) underperformed. Chevron (CVX) and Gold (NEM) did outperform, but not to the same extent as the ‘tech’ companies. On average, the energy/materials companies returned 21% per year and the ‘tech’ companies returned 23%.

This contradicts the panicked “sell tech, buy real assets” narrative that prevails today. These results prove that multiple types of companies can generate strong returns even in times of high inflation and rising interest rates. While it is clear that energy/materials benefit from higher spot prices during inflation, it is also true that demand for deflationary technologies can increase during periods of high inflation. And that the best tech companies have strong pricing power to offset inflation.

Why microsoft?

What I find interesting about previous challenges, whether macro or micro, is that I don’t hear from companies that see their IT budgets or digital transformation projects as a place to cut corners. If anything, some of these projects are how they will accelerate their transformation or automation, for example. I’ve never seen such great demand for automation technology to increase productivity because in an inflationary environment, software is the only deflationary force. -Satya Nadella

There are many reasons to choose Microsoft over other companies that make deflationary technology. It has large profit margins, market leadership, strong pricing power and a solid balance sheet. It is one of only three companies in the world with a credit rating higher than that of the US government. And it’s one of the world’s strongest brands and best places to work, according to Glassdoor.

One reason that’s unique to the current environment is how defensive Microsoft’s earnings are. People won’t move away from Azure or cancel their Office subscriptions to save money because alternatives of similar quality don’t exist or are more expensive (e.g. hiring developers to build your own network infrastructure). In fact, as pointed out by Microsoft’s CEO above, demand for Microsoft services as a way to reduce other costs may actually increase in the current environment.

On the other hand, consumer-focused brands, which make up much of the tech sector, could be at greater risk. When inflation forces people to cut their budgets, they may hesitate to buy a new phone or run digital ads for their business.

Looking back to 1975-1982, there really isn’t much evidence that more cyclical consumer brands suffered, even when there were multiple recessions from 1980-1982:

company Average yield ’75-’82
LOW 24%
TGT 56%
MCD 19%

Source: The Author

Still, a closer look reveals that these companies had poor performance for many years, but those with great years were able to recoup after the 1975 and 1982 recessions. For example, without those two years, Lowe’s had an average return of -7%, compared to ADP’s 12%.

Clearly, the best investment approach is to buy great companies and hold them through the economic cycle. But for those worried about the risk of a recession caused by the Fed’s tightening amid high inflation, it makes sense to own more defensive stocks. And I can’t think of a better defensive tech stock than Microsoft.

MSFT stock rating and factor classes

MSFT factor grades

Alpha wanted

Microsoft performs very well on the Seeking Alpha factor classes for profitability, momentum, and revisions. Given Microsoft’s 38.5% profit margins, great historical returns, and recent upbeat guidance, that’s no surprise. While it gets a D on its growth rating, most large-cap blue chips do, and Microsoft is growing faster than most other comparably sized companies, with a very respectable 18% revenue growth rate.

However, the company gets a bad D-score in the evaluation. 30 P/E certainly doesn’t come cheap, and that’s probably Microsoft’s main risk. Still, Microsoft is reasonably valued compared to other defensive mega-caps like UnitedHealth (NYSE:UNH), Thermo Fisher Scientific (NYSE:TMO), Costco (NASDAQ:COST), and Adobe (NASDAQ:ADBE), despite growing faster than them .

Microsoft price vs. target price

Alpha wanted

In my view, a PEG ratio of 1.5 is reasonable for one of the highest quality companies in the world. Analysts tend to agree, and have kept their average price target of $366.23 (implying a 29% upside potential) even as Microsoft recently sold off. As the chart above shows, this is one of the largest discrepancies between price and target price for Microsoft in recent years, and analysts tend not to lower their target price for Microsoft when it’s sold out.

risks

The primary risk for Microsoft is valuation, because while I think it’s reasonably valued relative to its growth and quality, a 30x P/E still isn’t cheap. The market can be irrational in the short term, and a high P/E carries greater downside risk.

There are other minor risks to consider. As one of the largest companies in the world, Microsoft could face antitrust scrutiny, in part because of its recent acquisition of Activision. They could also be targeted by hackers, especially given their recent support for Ukraine. And given enough time, the competition could become a bigger risk.

Conclusion

History shows that inflation and rising interest rates aren’t a doom for the stock market, even for tech stocks, which have come under fire lately. Microsoft is one of the highest quality and most defensive tech stocks out there. Still, it’s sold out with everything else, giving investors a rare chance to buy the company at a price well below analysts’ target. I continue to hold Microsoft as one of my largest holdings.

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