Values and Opportunity in Tech

Dorsey: Another sector that shows up I think fairly prominently in both [Tom's and Charlie's] portfolios is technology, especially the mega-cap names, so IBM, Microsoft are in both your portfolios. Tom you're also own Oracle and I think HP as well.

So, again it's fascinating, if you roll the clock back 10 years, and these were all companies trading at utter nosebleed valuations that had one thing on their mind, which was grow, grow, grow, grow, grow. And now you're seeing them maturing and going into mid-life crisis and the valuations associated with that.

Forester: Ten years ago we had 0% weighting in technology. We just couldn't touch them. We were strict valuation discipline, and at 30, 40, 50, 60, 70 times earnings, I mean, there was no…

Dorsey: ... [Laughing] Those were the cheap ones, Tom!

Forester: Yeah. Those were the "values."

Now we will buy Microsoft for 10 or 11 times earnings, which is as good as any other value that's out there right now, that we're seeing right now. And we actually think the fundamentals are pretty strong there. Windows 7 has been a great hit. Vista, I think, had like a 15% or 20% penetration rate amongst corporations. And I think Windows 7 has that much penetration already, and I think there is another 50% additional corporations that are looking to implement that over the next year or two. So we think it's gotten great writeups. It's been a great product for them. Their Office product just came out over the last year or so and has done fairly well. They've got this Kinect. I don't know if you've seen that, if you have kids or not, but when we came out they had a controller that you held and you could play tennis or whatnot. Now you don't need a controller in your hand, you make full body movements. So you can actually – probably pull a hamstring trying to play football or something like that, because it all goes on body movements. And I know they are expecting to sell somewhere between 1 or 3 million of them, and they've already sold 3 million, so now they've upped it to 3 to 5 million, so that could be a big, big product for them this winter, this Christmas season. They seem to be really hitting on almost all cylinders right now.

Bobrinskoy: These technology companies are also a great way to play the emerging markets. They're seeing great growth in China and Russia. IBM had 40% growth in China, 35% growth I think it was in Russia, and Brazil similar numbers, and you're getting them for 10 or 11 multiples.

So we just think it's a great way to play the international trends. A lot of the people that are negative on the market tend to focus on the U.S. economy with 2% and 3% GDP growth, but a lot of these large-cap quality companies have half their business overseas, and so it's a great way to buy, we would say, a global company and global fund at a U.S. market multiple that's much cheaper than those emerging-market multiples.

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Dorsey: Before dig in with Doug on tech in general, I want to ask a question about Microsoft in particular, because when you think about cloud computing and the movement of processing power off the desktop into remote server farms and Microsoft losing some of its chokehold on the computing experience. We've thought about this at Morningstar as either being Microsoft's greatest opportunity and also their greatest threat. How are you thinking about the movement towards cloud computing and virtualization as it impacts their business, not over the Windows 7 product cycle, but more over the next, say, three to five years or longer?

Forester: Well, I think as far as delivery goes, actually, Microsoft is one of the largest cloud computing companies as it is right now. I think I've looked at some of the Google products where they are kind of using their office software on a server and whatnot, it tends to be pretty bulky and slow and clunky, and most of things that Microsoft sells in their Office suite and some of the other things aren't that expensive. So I'm happy to pay $100, $200 for an Office suite that I have control over, that I know what it's doing, it's right there for me. I think if it was more $1,000, $2,000 software thing, I would be more apt to switch it off my local desktop, but for the price it seems fine to me. I'd rather have the control. So I think they'll do fine with that, and I don't really see it as that big of a threat to them.

Bobrinskoy: Try sending a non-Word document to somebody some time. You can't. I mean they can't edit it, they can't open it. It's amazing, and that doesn't change in a cloud world. So I think the app market is very solid, and I think people are nervous. One of the reasons the stock is so cheap is people are baking in a fair amount of concern about cloud computing, but we would agree, we think certainly the app business, but even the operating system business is going to come through this absolutely fine.

Dorsey: [Doug,] how is tech showing up on your models?

Ramsey: Very well. We've got a number of tech groups right up at the top of our rankings; communications equipment, the semiconductors, semi equipment. We've got a thematic group that we call technology top 10 or technology big 10, I guess it is, so it is what it sounds like. It's the largest 10 technology stocks that the valuations are very cheap.

I mean the sector as a whole I like where it is in the process of, remember, unwinding that big bubble of a decade ago, and we've looked at this across a lot of different what I'd call sector bubbles that have busted in the past. We've looked at the oil stocks in the late 1970s and the packaged food stocks, for example, sort of the consumer unit growers into a big top in '91 and '92, and I mean tech has traced out sort of a classic recovery pattern in terms of going down about 80% during 2000 and 2002, having a little bounce the next year as the new bull market got under way, and then just flat lining on a relative basis all the while cutting back on spending dramatically in asset growth. I mean just a very long period of retrenchment. And now the sector's really broken out from that.

So when I look at tech, and again this is more of a blanket statement--there are certainly pockets within financials that we would like, but I think financials is more on the front end of that; it built up tremendous capacity in terms of aiding and abetting the big housing market bubble in the middle of last decade, and we're about three and a half years off the top in financials. And I think they've had a big bounce, and I think by and large the sector as a whole there will be some good individual opportunities, but the sector as a whole is probably going to have to go through what technology has, but technology has done it now. We're 10 years departed from that extreme peak in spending. So if any sector I think has a very good chance to be sort of the secular leader, secular being five to seven years, maybe, I'd say it's technology. Our work would show that.

Dorsey: Before we move off tech, I wanted to ask about Cisco's recent 17% drubbing. If you ever told me I'd see the stock at a 10% free cash flow yield, then I would have put you in the loony bin. This is a company with a $90 billion market cap, did about $8.5 billion to $9 billion in free cash flow this year. So has it hit any of your screens at all or are you just finding other ideas?

Bobrinskoy: The only challenge we have is whether it fits that "too hard" category. We do struggle a little bit about whether we have the expertise to evaluate whether there is some killer competitor that could really hurt their whole server market and all the technology that's obviously so important to the net. So, we are trying to decide whether we can get smart enough to value it, but right now it's on that edge.

Forester: I think we're kind of in the same camp there with it being attractive from a valuation standpoint, and I think the other work that we've done on it, we're just trying to decide--the Microsoft model is more of a subscription model, and so it's renewable cash flow, you don't have to go out and find new clients all the time, whereas the Oracle model is you keep having to buy a new product every year, and I think that's a tougher model. But I'll tell you, valuations are attractive.

Dorsey: Just thought I would ask.

Ramsey: And then that stock is certainly in our technology big 10 group, and I mean the question is, can it remain big enough to stay within that top 10. So, if it were to fall below that, I don't know, maybe we'll do what the Big Ten Conference did and add a couple more schools, add a couple more stocks, lower the hurdle so that we can get Cisco in there.