MSFT - The Crash Higher Is Coming

2023-11-08 22:09:03 ET

Summary

• Whatever the combination of reasons for the rally in the past two weeks, it has been most welcome.
• Big-cap tech and large-cap growth stocks continue to outperform, and we expect them to lead in the future.
• AI and cost-saving initiatives could drive further growth and efficiency in the areas of big-cap tech and large-cap growth.
• If this decade turns into the age of efficiency and the markets start to sniff this out, a "crash higher" could be on the cards.

By Brian Nelson, CFA

The past couple of weeks have been met by buying pressure that the markets haven't seen in some time. Some are attributing it to many investment houses being wrongly positioned and having to make moves on the fly to correct to a higher weighting in equities. Some have pointed to dovish Fed commentary and the 10-year Treasury rate falling under 4.6% as a relief to all the bear cases pointing to the U.S. sovereign debt load. Others say it's a strong technical bounce off the downtrend in major averages. Still, others say it was a relatively strong third-quarter earnings season, which suggests a recession in the U.S. may still be far off. Whatever the combination of reasons for the rally the past two weeks, it has been most welcome and ran counter to the view that a washout may be nigh .

Fundamental investors have been well-rewarded, too. Those that have focused on the cash-based sources of intrinsic value -- net cash on the balance sheet and future expectations of free cash flow -- have had tremendous exposure to big cap tech and the stylistic area of large cap growth ( SCHG ) during 2023, and these two areas have led, and we expect them to continue to lead. Back in July, we highlighted 5 stocks for a new bull market in this article , and we're reiterating that view today. Microsoft ( MSFT ), Apple ( AAPL ), UnitedHealth Group ( UNH ), Visa ( V ), and Alphabet ( GOOG ) ( GOOGL ) all have excellent financials. We remain humble and so thankful for the past two weeks, and it has reinforced our view that big cap tech and the stylistic area of large cap growth remain the places to be.

It is our view that stock prices and returns are in part a function of net cash on the balance sheet and future expectations of free cash flow. If future expectations of free cash flow increase, so should the stock price, all else equal. If future expectations of free cash flow decline, so should the stock price, all else equal. Investing is never this easy, of course, because there are always moving parts and confounding variables, but focusing on the key components of the discounted cash-flow model has always served investors well, or at least kept them out of trouble. Net cash on the balance sheet is a direct add-back to the sum of future expectations of free cash flow in arriving at an intrinsic value estimate, and we love companies that have this balance sheet component of intrinsic value, which offers so much optionality going forward, too.

Most areas outside of big cap tech and large cap growth often fall short. Consumer staples ( XLP ), equity REITs ( VNQ ) and utilities ( XLU ) suffer from large net debt positions that hinder their equity values. Many industrials suffer from cyclical tendencies and sometimes net debt burdens, while retailers and restaurants are struggling to factor in how weight-loss drugs will impact their operations. Pharma ( XLV ) always has to contend with changing healthcare regulations, and while there are some gems in biotech ( IBB ), they tend to be hit or miss, most of the time. Most of old media is struggling from a streaming hangover, and their balance sheets leave a lot to be desired, too. We've never been fans of financials ( XLF ) due to the arbitrary nature of their cash flows, and the view that a "run-on-the-bank" dynamic will always be present will almost always keep us on the sidelines. However, a look at big cap tech and large cap growth shows secular-growing, net-cash-rich, free cash flow generating powerhouses.

Microsoft ended its third quarter with ~$144 billion in total cash and short-term investments and short-term debt of ~$25.8 billion and long-term debt of $41.9 billion, translating into a very robust net cash position. The company's operating cash flow absolutely exploded during the first nine months of this year, coming in at ~$30.6 billion versus ~$23.2 billion in the same period last year. Capital spending was ~$9.9 billion for the first nine months of 2023, and while this is up from ~$6.3 billion in last year's quarter, Microsoft's free cash flow generation has nonetheless been phenomenal so far in 2023. Microsoft's revenue growth was a stellar ~12% in constant currency during the third quarter, too, making Microsoft a net-cash-rich, free-cash-flow generating, secular growth powerhouse.

Alphabet ended its most recently-reported third quarter of 2023 with total cash, cash equivalents and marketable securities of ~$119.9 billion versus long-term debt of just ~$13.8 billion, good enough for a huge net cash position. Alphabet probably has the best balance sheet out there given how much financial flexibility it has to defend its economic moat in search and other areas. The company's free cash flow during the first nine months of 2023 came in at a whopping ~$61.6 billion, up from $44 billion during the same period a year ago. For the three months ended September 30, 2023, revenue growth at Alphabet was ~11%, putting it in a similar class as Microsoft with a label as a net-cash-rich, free-cash-flow generating, secular growth powerhouse.

Meta Platforms ( META ) ended the third quarter of 2023 with total cash, cash equivalents and marketable securities of $61.1 billion versus long-term debt of ~$18.4 billion, also good for a very nice net cash position. Meta's adjusted free cash flow came in at $31.5 billion through the first nine months of 2023, up materially from the depressed levels of ~$13.2 billion it achieved during the same period a year ago. The free cash flow growth at Meta was very welcome news, and something that was a big concern of ours toward the back half of 2022 when things really fell apart at the company. Revenue growth came in at a whopping 23% for Meta, which was very welcome given the competitive environment with respect to TikTok, and putting things all together, Meta is yet another net-cash-rich, free-cash-flow, secular-growth powerhouse.

During much of 2022, pundits championed the 60/40 stock/bond portfolio and the equal-weight S&P 500 ( RSP ), but these areas have unfortunately underperformed during 2023. I don't want to jinx the current state of trends because I'm a big fan of how the market has gone thus far in 2023, but it seems that sticking with the DCF-backed big winners thus far in 2023 in big cap tech and large cap growth could make for a good strategy for the remainder of 2023 and into 2024. These areas aren't resting on their laurels either. Big cap tech and large cap growth continue to disrupt themselves in artificial intelligence [AI], and to me, this speaks to the sustainability of their business model. Whether it's Alphabet or Microsoft that gain in search due to AI, for example, they're both nicely represented in big cap tech and large cap growth.

The reality is that the markets could very well be at the top of the first inning when it comes to AI. Big cap tech and large cap growth have already taken steps to become leaner, but could you imagine if they really turn up the gears in cost savings, not only with respect to headcount but also when it comes to the applications that AI may bring? Big cap tech and large cap growth tend to keep plowing money into their businesses to keep innovation moving in the right direction, but this decade could turn into the age of efficiency, too. If the market starts to sniff this out in the coming quarters and years, we could very well "crash higher." Meta Platforms has shown what it can do when it focuses on efficiency. Can you imagine if this becomes the norm among the largest enterprises? It's just hard not to be bullish on big cap tech and large cap growth these days.

Sometimes, commentators say it's too late to the game to jump on the bandwagon. For us, however, we've been huge fans of these areas for a very long time now, but just like it may be the top of the first inning for AI, it may be the top of the first inning when it comes to cost savings and productivity initiatives for these two important leadership areas of the market, too. I'm talking huge earnings expansion and tremendous free cash flow growth in these areas because of AI--not just what it may bring on the top line but the savings on the expense line, too. AI may bring the best of both worlds to the financial statements, and while AI may benefit other names in other sectors, too, it's clear that big cap tech and large cap growth whether via Microsoft or Alphabet or another large name holds the keys to the castle. This isn't the dot-com bust by any stretch, as big cap tech and large cap growth already generate tremendous amounts of free cash flow and have balance sheets that are simply impregnable.

During the raging bull market of 2021, many were excited about the potential for this decade to be the Roarin' 20s, and while I've jokingly joined in on such excitement, I really do believe that this decade will be absolutely phenomenal for equity holders, but for those equity holders that are in the right spots, as 2023 has shown. Many may be flocking to bonds now as interest rates rise -- in similar fashion as perhaps others did with the 60/40 stock/bond portfolio and equal weight S&P 500 last year -- but to me it's a great time to be a long-term equity investor in big cap tech and large cap growth. I see AI as a huge game changer, and I view all the work the Fed has done in raising rates as potential dry powder to stimulate this Roarin' 20s economy on a continued upward trend. Maybe it's not this quarter or even next year when it happens, but I think this market has all the potential to "crash higher." I continue to be bullish.

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