Microsoft Stock: A contrarian choice for a high inflation environment (NASDAQ: MSFT)

Thesis

Microsoft (NASDAQ: MSFT) is one of the best companies in the world, and that won’t change even if the Fed tightens or inflation stays high. In fact, history indicates that deflationary technology can be an alpha-generating investment in this macro environment. The market seems to overlook this given the recent tech sinking, which creates a contrarian buying opportunity.

The lessons of history

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

Hopefully inflation will start to moderate and we won’t see such high rates in the future. But investors should be prepared anyway and anchor their portfolio 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 rates are rising. The argument makes sense; inflation drives up energy/materials prices, which increases the profits of these companies. Additionally, stocks in these sectors are generally considered value stocks, and value traditionally outperforms growth in an inflationary environment.

However, the results for the period 1975-1982 contradict this thesis. The chart below compares the returns of the major energy and materials companies with the major tech companies of the time. Microsoft didn’t go public until 1986, so I used a few other companies with similar characteristics – namely low entry costs – as proxies. ADP (NASDAQ: ADP) is a predecessor to modern SaaS companies like Paycom (NYSE: PAYC), and focuses primarily on payroll services. Like Microsoft, it has a low-resource business that saves its customers money by automating back-office processes. Equifax (NYSE: EFX) is a credit reporting agency. And of course, IBM (NYSE: IBM) was a leading technology company at the time.

Source: The author

Admittedly, this method is not very scientific, since I only chose a few companies that I know were public at the time, and these results do not represent all sectors. Unfortunately, the sectors were not defined as they are today in the 1970s, so we will have to live with it.

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

This goes against the panicked “sell technology buy real assets” narrative that is prevalent today. These results prove that several types of companies can have strong returns even in times of high inflation and rising rates. While it is clear that energy/materials benefit from higher spot prices in times of inflation, it is also true that demand for deflationary technologies may increase in times of high inflation. And that top tech companies have strong pricing power to offset inflation.

Why Microsoft?

The interesting thing that I find in past challenges, whether macro or micro, is that I don’t hear of companies viewing their IT budgets or digital transformation projects as a place for cuts. If anything, some of these projects are how they are going to accelerate their transformation or for that matter automation for example. I haven’t seen this level of demand for automation technology to improve productivity because in an inflationary environment the only deflationary force is software. – Satya Nadella

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

One reason for the current environment is Microsoft’s revenue defensiveness. People won’t leave Azure or cancel Office subscriptions to save money because alternatives of similar quality don’t exist or are more expensive (eg, hiring developers to build your own network infrastructure). In fact, as Microsoft’s CEO pointed out above, demand for Microsoft’s services as a way to reduce other costs may actually increase in the current environment.

On the other hand, consumer-facing brands that make up a large part of the tech sector could be more at risk. If people have to cut their budgets due to inflation, they might delay buying a new phone or running digital ads for their business.

Looking at the 1975-1982 period, there’s actually not much evidence that the more cyclical consumer brands suffered, even though there were several recessions from 1980 to 1982:

Source: The author

Even so, a closer look shows that these companies had many years of poor performance, but offset those that had good years as they emerged from the recessions of 1975 and 1982. For example, by excluding those two years, Lowe’s has obtained an average return of -7% compared to the 12% of ADP.

The best approach to investing is clearly to buy big companies and hold them through the economic cycle. But for those worried about the risk of a recession caused by Fed tightening amid high inflation, it makes sense to hold more defensive stocks. And I don’t know of a better defensive tech value than Microsoft.

MSFT Stock Valuation and Factor Ratings

Microsoft scores very well on the Seeking Alpha factor ratings for profitability, momentum, and reviews. That’s no surprise given Microsoft’s 38.5% profit margins, strong historical returns and recent upbeat forecasts. Although they get a D on their growth score, most large-cap blue chips do, and Microsoft is growing faster than most other companies of comparable size with a revenue growth rate. a very respectable 18%.

However, the company gets a poor D- score on the assessment. 30 P/E certainly isn’t cheap, and that’s probably the biggest risk with Microsoft. Even so, Microsoft is reasonably valued relative to other defensive mega-caps like UnitedHealth Inc (NYSE:UNH), Thermo Fisher Scientific Inc (NYSE:TMO), Costco Inc (NASDAQ:COST), and Adobe Inc (NASDAQ:ADBE). ) despite growing faster than them.

In my opinion, a PEG ratio of 1.5 for one of the most qualitative companies in the world is reasonable. Analysts tend to agree, and they maintained their average target price of $366.23 (implying a 29% upside) even as Microsoft sold off recently. As the chart above shows, this is one of the biggest price deviations from target price for Microsoft in recent years, and analysts don’t tend to lower their target price for Microsoft in sales case.

Risks

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

There are other, more minor risks to consider. As one of the largest companies in the world, Microsoft could face antitrust scrutiny, including for 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 get riskier.

Conclusion

History shows that inflation and rising rates don’t mean bad luck for the stock market, not even for tech stocks that have been under fire lately. Microsoft is one of the most defensive and highest quality technology stocks available. Despite this, it sold 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 most important positions.