Fund World's Ruling on Microsoft Is Less Rosy

Value and growth fund managers don't tend to agree on much, but both might see little reason to buy more shares of Microsoft(MSFT), even though they've gotten a pop from the U.S. justice system.

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Fund World's Ruling on Microsoft Is Less Rosy

Thursday's news that the U.S. Court of Appeals in Washington, D.C., overturned a ruling to break up the world's largest software shop at least partially lifted the judicial cloud that helped shave more than 60% of the company's value last year. Microsoft's shares, after being halted for much of the afternoon, rose 2.2% to $72.74, and the news buoyed other tech stocks as investors starved for any good news rejoiced. But don't expect growth fund managers, who typically focus on stocks of companies with white-hot earnings growth, or value fund managers, who usually hunt for bargains, to belly up to the MSFT buffet.

The reason: The massive company can't ratchet up its earnings fast enough to tempt growth types and after rising 64% this year, the company's shares are just too pricey for bargain-hunting value managers. The company's shares currently trade at 40 times forward earnings, compared with 22 for the S&P 500, according to Baseline/Thomson Financial.

"Where are we now? It's hard to make a case for the stock being cheap at present. You're talking about a company that has double the market's [price-to-earnings] multiple and is back to selling at about 16 times revenues. I don't see how a value manager would step up and buy it here," says Howard Ward, who owns the stock in his (GABGX)Gabelli Growth fund. "But as a growth holding, the risk/reward [proposition] on the stock is sort of limited here. Given the carnage we've seen in the tech sector, people will find better value and make more money in more depressed tech [stocks]."

Indeed, growth managers have cooled to the company's shares over the past 17 months. Rattled by the antitrust beef and concerns that the company -- with a market cap of $375 billion and fiscal-year 2000 revenue of $22.96 billion -- could keep growing at an attractive rate given its girth, many have dumped their shares. The stock boasts a 36.3% average annual gain over the past five years, compared with 14.3% for the S&P 500.

The Rise, Then Fall, Then Rise of Microsoft

Source: Morningstar.

The stock is held in more than 1,100 funds at present, with funds holding 13% of the company's shares.

At the end of 1999, on the heels of a 68.4% gain, a whopping 88% of big-cap growth funds own Microsoft shares, according to Morningstar. But by the end of last month, that had fallen to 64%.

Lower Growth Since the end of 1999, the percentage of big-cap growth funds has dropped from 88% to 64%.

Source: Morningstar.

"We're right in that group," says Alan Loewenstein, co-manager of the (NTTFX)John Hancock Technology fund, which doesn't currently own Microsoft shares. "We bought the stock in the low 50s and sold it a few months ago when it got toward $70. ... The reason we sold Microsoft is because we saw greater growth in other software companies where valuations had come down, like Oracle(ORCL) and Siebel Systems(SEBL)."

While Loewenstein and other managers of tech and tech-heavy funds were hitting the exits, value managers were taking the sagging shares off their hands. At the end of 1999, just 12% of big-cap value funds owned Microsoft shares, but that number was up to 33% by the end of last month, according to Morningstar.

A Shifting Fan Base One-third of big-cap value funds owned Microsoft shares at the end of last month, way up from just 12% at the end of 1999

Source: Morningstar.

It's easy to see why value managers would be tempted, given that the software industry is growing more quickly than that of many companies in their usual sectors of choice, like financial services. And those who bought shares have been well-rewarded, given its 64% gain so far this year, compared with losses of 7.1% and 14% for the S&P 500 and Nasdaq Composite, respectively.

That said, the stock's recent success makes it tough to justify as a "value" compared with other options.

"I certainly believe it's reasonable for value investors to investigate fallen angels in tech or other industries, but we're still looking at nontech industry leaders selling at barely double-digit [price-to-earnings] multiples of next year's earnings," says Bill Nygren, who doesn't own Microsoft in his value-oriented (OAKMX)Oakmark and (OAKLX)Oakmark Select funds. "It's in a rapid growth industry, but it's trading at about 40 times next year's earnings. That's about three times the multiple we're paying for traditional companies that are leaders in their businesses. It's a great company, but it's a question of price, and we're not willing to pay that price."

Nygren's top holding is low-tech bank Washington Mutual(WM), which currently trades with a forward P/E multiple of 11, compared with Microsoft's 40. The bank's long-term growth rate is 13%, compared with 15% for Microsoft, according to Baseline/Thomson Financial.

In a panel at the 2001 Morningstar Investment Conference in Chicago on Wednesday, veteran value managers such as Michael Sandler ((CFIMX)Clipper), David Dreman ((KDHAX)Scudder Dreman High Return Equity) and James Barrow ((VWNFX)Vanguard Windsor II) said Microsoft and battered tech highfliers weren't in their portfolios and wouldn't be anytime soon.

Still, they might wish they had bought the stock last year given its run. The stock makes up nearly 3% of the S&P 500, but value funds such as (SHAPX)Smith Barney Appreciation have bet on the stock and beaten the benchmark. At the end of April, the fund had 3.4% of its assets in Microsoft and it's down just 0.6% so far this year.

The Believers Here are the five big-cap value and growth funds that have the biggest bets on Microsoft, screening out funds with portfolio reports older than March 31 and those with less than $250 million in assets.
Large-Cap Value Funds
Large-Cap Value fund	Percentage of Assets in MSFT	YTD Return
(SAFQX)SAFECO Equity	4.9%	-7.2%
(GSGRX)Goldman Sachs Growth & Income	3.7	-7.1
(SHAPX)Smith Barney Appreciation	3.4	-0.6
(PMCFX)Pilgrim MagnaCap	3.2	-10.7
(PDIAX)Phoenix-Oakhurst Growth & Income	3.1	-4.3
S&P 500	2.9	-7.8
Large-Cap Growth Funds
Large-Cap Growth fund	Percentage of Assets in MSFT	YTD Return
(NVLAX)Wells Fargo Large Company Growth	7.0%	-18.2%
(DVEGX)Diversified Investors Equity Growth	6.2	-15.5
(USAAX)USAA Growth	6.2	-16.0
(TLGVX)Consulting Group Large Cap Growth	6.1	-15.8
(CFLGX)Smith Barney Diversified Large Cap Growth	5.8	-9.8
S&P 500	2.9	-7.8
Source: Morningstar.

And many big-name fund shops among the five biggest Microsoft holders are probably smiling, too. Fidelity, for instance, owns 3.6% of the company in its mutual funds. All five of the biggest institutional Microsoft holders, a list that includes fund shops such as Vanguard and Putnam, added to their positions in the first quarter, according to the most recent data available from Lionshares.com.

They Like It, They Really Like It These five fund shops owned the most MSFT at the end of the first quarter -- during which each bought more shares
	Percentage of Company	Percentage of Portfolio
Fidelity	3.6%	2.5%
Barclays Global Investors	3	2.4
State Street Global	2	2.3
Vanguard	1.6	2.9
Putnam	1.3	2.1
S&P 500	N/A	2.9
Source: Lionshares.com.

Of course, if the growth managers roaming the halls of these companies don't think Microsoft is growing fast enough, they could send the stock on its next tumble. And that fall might last until value managers decide the shares are cheap again. Given that scenario, folks who own Microsoft shares on their own or through funds might find the place between value and growth to be awfully lonely.

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