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Hi everyone,

While my Thanksgiving dinner is digesting, I've gotten to thinking about how big a discrepancy I'm looking at between expectations priced in and what the company can reasonably be expected to do.

For reference, please read (if you haven't already) this piece from last week on adding Microsoft to my watch list.

In that article, I wrote that Apple wouldn't qualify for the MUE Port (by the way, did you notice the board name change?) because the expectation was for 17.5% annual FCF growth for the first five years. The company has done 49% FCF annually for the past five years.

I then went on to say that Microsoft had just 5.3% five year annual FCF growth priced in. It's managed to grow FCF by 8.4% over the past five years.

Ideally, I'd like to get both companies when the expectations are truly messed up -- that is zero or very little growth priced in, like Apple was in the spring of 2009 -- but, that aside, which one is more messed up? Put another way, which one is more likely to show that the expectation priced in is too low?

Apple's market cap is $288 billion; Microsoft's is $217 billion. Apple trades at EV/FCF of 15.9; Microsoft at 7.7. Wow, better than a two-fold difference. Microsoft is actually generating more FCF than Apple ($24 billion versus $16.6 billion TTM).

In order to be a good MUE, the market has to be seriously underestimating the potential performance of the company. That means psychology plays a role. Part of the thesis with Transocean is that the belief that the company won't be able to grow thanks to the debacle in the Gulf. Given the world's demand for oil and the company's dominant position in the field, that seemed absurd to me. Same kind of thing for Power-One. The worry that Europe (Germany, specifically) will cut back on solar expenditures next year was causing pessimism about the company's ability to grow. Germany and Europe is not the only place moving into solar and green energy and panel makers are already saying that 2011's production is mostly spoken for, so that also seemed absurd to me.

So what's the messed-up expectation between these two? (Or is there one at all?) Will Apple continue to grow FCF at 40+% per year and not the more modest (but still quite high) 17.5% priced in? Will Microsoft actually show the market that it isn't dead yet and deserves a higher multiple than it's currently receiving, while growing FCF at a modest pace, but still higher than 5.3%? Is 8% or 9% out of reach?

There is a lot of pent-up demand for Windows 7 and the system actually has a pretty decent reputation in what I've read so far. Many companies skipped the Vista upgrade cycle, so the jump from XP to 7 makes more sense. New computers, too, as companies also put that off during the recession and credit crunch. More growth there than expected? Could very well be.

As for Apple, it is priced much more rationally. Maybe not "fully" valued, but closer, I think, than Microsoft is currently. It could continue, of course, to crush analyst predictions. Plus, roughly $6 billion of the $18.6 billion it had in FCF this past year was from a change in accounts receivable bringing in a ton of money. I believe that was a one-time thing related to the accounting change at the beginning of the year. So sustainable FCF would have been more in the ball park of $13 or $14 billion. And putting that into the MUE calculator, calls for a 22% / 11% / 2.5% growth pattern (annual: 5 years, next 5 years, terminal).

If 8.5% is within reach by Microsoft, from 5.3%, is 35.3% within reach for Apple (same proportion)? That's an awful lot of growth.

I think there's less risk that Microsoft won't be able to exceed and grow at 8% to 9% than there is that Apple won't be able to perform at 22% or 35%.

I could turn out to be wrong based on outcome, but choosing Microsoft over Apple is, I believe, the correct decision as measured by my process. If the outcome is bad (that is Apple exceeds and Microsoft languishes in share price), then that will be a bad break. But if I'm right, it will be deserved success.

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I find myself nodding my head in agreement with your thoughts. And many thanks for taking time to write down a comprehensive thought process. I like to think that Ben Graham would be supporting your thoughts.

But Philip Fisher may not :)
--> maybe I will bet on both!

Must get Expectations Investing book from Michael Mauboussin -- this is on my to do list.
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No. of Recommendations: 1
Hi Chin,

By the way, the James Montier piece linked at the end of my original post is well worth the five minutes or so it takes to read and explains the rather cryptic "bad break" and "deserved success" comment I had at the end.

Montier got that from Paul DePodesta (of Michael Lewis' Moneyball fame) who had gotten it from Michael Mauboussin (of Expectations Investing) who had gotten it from Russo and Schoemaker, who have studied psychological mistakes (and show up in another Montier white paper, Seven Sins of Fund Management). Quite the chain! :-)

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..I liked this line:

Perhaps we would all do well to remember the late great Sir John Templeton?s words? "The time to reflect on your investing methods is when you are most successful, not when you are making the most mistakes"

..I'm not too sure I agree with it, but it's interesting to think about.. is true, in my case, the most money I ever made, by far, was when I was leveraged into one stock (110%)..

..but I was also young and foolish.. this day, I'm not sure the mental anguish was worth the monetary rewards..
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