Looking at the Magnificent 7

The "Magnificent 7" companies have replaced the "FAANG" stocks, which means that Netflix has been dropped from the growthy-tech investor zeitgeist and Microsoft, Nvidia, and Tesla have been added. The combined market capitalization of the Mag 7 is $14 trillion, which is equal to one-third of the total market capitalization of the S&P 500 companies ($43 trillion). 

That is a very high level of concentration in the top index picks, which means that the returns for the float adjusted, market capitalization weighted index that most index investors buy (SPY) will likely be meaningfully different than the returns on the equally weighted index (e.g. RSP). (The equal weight RSP is trading for 19x earnings versus 21.5x for the SPY.)

Since we are generalists at CBS, it is "our business to know" what is going on with everything, even the frothy Magnificent 7. I thought that we should take a look at the cash generation power of these businesses. What do you get for $14 trillion? How are the free cash flow conversion margins - are these actually good businesses - and what is the valuation (FCF/EV)?

Before I did that, I wrote down my subjective view of business quality or moat for each, on a one to five scale. I am a customer of five of the seven (i.e. all of them except Nvidia and Tesla). How hard would it be for me to fire them? How hard do I think it would be for a team of well-funded 10x engineers to disrupt them? 

Based on that framework, I think that Tesla is 1/5; clearly the worst. (It now has the smallest market capitalization by a significant margin, while it was once larger than Facebook.) I think that Apple is clearly the best, 5/5. I gave Nvidia 4/5 although I am not very familiar with the company or its products. I think that Microsoft, Amazon, and Google are 3s and Facebook is a 2. (Without Instagram, Facebook would be a 1.)

How did my subjective view line up with the numbers? Surprisingly well. Click the table below to enlarge:

Some observations that stand out:

Microsoft blew an entire quarter's revenue, $65 billion, on the acquisition of Activision. But even adding that back, Apple generated almost as much free cash flow ($34.5 billion) as the other six companies combined ($46 billion).

Apple has the second highest free cash flow margin (29% of revenue) of the Mag 7. Nvidia's was 46%, a tobacco-like margin. We know that Amazon is a low margin retail business, Tesla is a joke of course, but Microsoft and Google have very lackluster free cash flow conversion.

Google's stock based compensation (SBC) in the most recent quarter was equal to 30% of cash from operations, and capital expenditures were equal to 58% of cash from operations. (Or 6% of revenue and 9% of revenue, respectively, if you want to look at it that way.)

Apple spent only 8% of cash from operations on SBC in the most recent quarter (3% of revenue), and only 6% of CFO on capital expenditure (2% of revenue), leaving much more free cash flow.

We know that Google is an inferior business to Apple because Google pays a gigantic tithe to Apple. But notice that Apple's most recent quarter cash flow was running at a 5% yield on the enterprise value. That is much more attractive than the other companies in the Mag 7 (which otherwise seem quite expensive).

Apple seems to have the best combination of moat and valuation. If you had to own one of the Mag 7, Apple would be our choice, hands-down, based on business quality and valuation. (Maybe you do have to own one. How far from the S&P 500 index and its performance are you allowed to stray?)

Berkshire has $156 billion of Apple stock, just over a quarter of its own market capitalization. We do not like Buffett's energy pick, but we do like his tech pick.

Latest Horizon Kinetics On Indexing

They're talking about [pdf] how the S&P 500 used to be market cap weighted, but is now float weighted, which means that it will own smaller amounts of the "owner-operator" companies that have historically contributed a significant part of the index return:

"When added to the S&P 500, the share price [of Microsoft] was about $2.41. At January 1999, when the stock was $44.75, insiders still owned 31% of the shares. By September 1999, near the peak of the Great Technology Bubble, when the shares were $47.50 (when Microsoft’s weight in the S&P 500 exceeded 4%), inside ownership had been reduced to 26%, and by early September 2000, the very threshold of the collapse of that bubble, when the stock was $35, inside ownership had dropped to 19%. Today, 15 years later, the shares are only $44.37–a 1.6% annualized return –and were quite a bit lower than $35 only two years ago. Whether by fortune or perception, insiders were dramatically reducing their holdings going into a decade-plus period of decline and stagnation. What did outsiders do? Had the float-adjusted index weighting method been in place at the time, then as insiders sold, such that the float increased, the Index rules would have increased the Microsoft weighting, and mutual funds and other index investors would have been buying more—more of what the insiders were selling."

Index investing has all the signs of an investing fad that will be remembered as an embarrassing flop: nearly universal adulation, unthinking adoption, regulatory blessing.

Does Bill Gates Use Windows 8? ($MSFT)

Bill Gates has been reducing his holdings:

"Somewhere along the line, this massive and ongoing liquidation became a short-sale of his old friend (and current Microsoft CEO) Steve Ballmer. And it looks to have been a smart 'trade'."

Microsoft is loathsome, and it's too bad the valuation is cheap enough that you can't really short it. Kind of like Herbalife.

Doomed Operating System ($MSFT)

A Credit Bubble Stocks correspondent writes in with this gem from the Phoenix airport.

I assume they are going to be pushing their stupid tablet and/or doomed operating system. Maybe you'll get to hold something sticky that a bunch of bored proles played with after eating Pizza Hut?

Is a quick demo in a crowded, noisy environment going to be what sells people on the ease of use of Windows 8?

It's times like this I wish Apple stock was trading at book value ($125, which is my bid) so I could buy some.

Also, Microsoft, the downside of "leveraging" your monopoly through brutal customer service and gouging for two decades is that we're going to be glad to twist the knife.

"Christmas gift for someone you hate: Windows 8"

Microsoft has had since October 2008 to study Android. It has had since June 2007 to study iPhone. It seems as though they did not figure out what is good about the standard tablet operating systems.

Windows 8/Microsoft ($MSFT)

Two good posts:

• "For the first time, however, businesses can look to Google and to Apple and see plausible, battle-tested alternatives to the products they have used from Microsoft—for much less money. And in a bizarre way, Microsofts spasm of innovation has made the company now a destabilizing factor for IT departments and Google Docs is looking an awful lot like the old guard."
• "A company that plays this game for too long becomes set in their ways, and any chance of real change simply becomes impossible. Microsoft is there, and has been for a long long time. Their product lines have stagnated, creating customer lock in is prioritized over creating customer value, and the supply chain is controlled by an iron fisted monopoly. Any attempt at innovation with a Windows PC has been shut out for over a decade, woe betide anyone who tried to buck that trend. The history books are littered with the corpses of companies that tried to make change the Windows experience. Microsoft's displeasure is swift and fatal to those that try. Or at least it was."

I think I will switch to iOS. I've loathed Microsoft for a long time.

The real question is whether it should be shorted. A $180B EV is a lot for a company that will be non-existent in a decade, even if it does have $16B in net income.

Have these people been in a Microsoft store recently?

Microsoft is a Dog ($MSFT)

I've been reading about the new Microsoft OS, "Windows" 8, that looks like a total disaster. Here is one interesting take on it:

No business will tolerate this software, let me assure you. As a productivity tool, it is unusable.
[...]What is this departure based on? It’s based on the pipe dream that the unsuccessful user interface used by Windows Phone will turn into a success on the tablet — to such an extreme that people will also demand it on the desktop, so all the platforms can have the same look and feel.

And more good analysis from another source:

I think Microsoft is scared that it might be permanently closed out of the new markets, so it wants to force people onto Metro before that happens. I believe that's really why it eliminated the Start menu. If Start is still there, Windows users could live for years without learning much about Metro. But with Start gone, Windows users will have to use bits of Metro now, and Microsoft believes they'll naturally embrace it once they've been forced to use it.
[He goes on to describe one out of three possible scenarios for how customers react to Win 8:]
Windows users cling to Windows 7 tenaciously. In this scenario, Windows 8 becomes the new Vista. Microsoft's anticipated revenue from Windows 8 upgrades does not materialize, hurting the company's stock price and forcing layoffs to maintain earnings. Microsoft's hardware partners are left with big stockpiles of unsalable Windows 8 PCs which they have to write down. This accelerates the share growth of the Asian PC makers, who can best withstand a price war. HP kills its PC division, and Dell is in deep trouble.

Microsoft is so loathsome! They have been fat, lazy, complacent, and customer-unfriendly for years, coasting on their monopoly. Maybe now this will kill the golden goose.

I'm finally going to switch to Apple this year. Over/under on how much longer these clowns stay in business?

Microsoft's New "Surface" Tablet

Not that I care about consumer tech, but thought this analysis of the change in Microsoft strategy was interesting. Key points:

• The only hard decision they made was the big one: to turn against their OEM hardware partners.
• After 37 years, Microsoft agrees with Alan Kay: "People who are really serious about software should make their own hardware."
• it directly pits Microsoft not against Apple but against Dell, HP, Toshiba [...] the radical shift in Microsoft’s strategy is about the fight over the profits that remain after Apple’s. The math no longer works out for the Windows you-sell-the-hardware-we-sell-the-software model. It works for unit share (cf. Android), but it doesn’t for profit share.
• Microsoft Surface is not fundamentally about Microsoft needing to control the entire integrated product in order to compete with the iPad on design. It’s about Microsoft needing to sell the whole thing to sustain its current profitability.

No position.