A Justice Department Probe: How to Tell You Own a Great Business
By Dan Ferris
January 20, 2007

Trey's house is 50,000 square feet.

It has a large private library with lasers that scan the floor, killing insects and small pests.

Every door handle in the house – two per door – costs $2,000.

Trey doesn't like clutter. Many of the doors in his house blend into the walls so well, you can't see them. No electrical outlets are visible. If they so desire, Trey's guests can have their favorite music follow them into any corner of his house, including the bottom of the pool. An arched underground concrete building electromechanically transforms into a basketball court.

Trey's house cost $50 million to build. It took seven years. At one time, there were 300 workers building the house, including more than 100 electricians.

According to county records, the total assessed value of Trey's house and the five acres under it is $125 million for the 2005 tax year. The annual property tax is $990,000.

The other house that Trey built is the largest independent software company in the world. Trey got rich enough to build a $50 million house by first building his company based on a simple imperialistic formula: "embrace, extend, and extinguish."

Trey's company – his empire – has embraced product categories involving widely accepted standards, extended those products by using its own proprietary standards, and then extinguished the competition by exploiting the newer, stronger product. Trey's company is so effective, the Justice Department spent lots of time and money trying to get him to stop.

Trey's real name, of course, is William Henry Gates III (hence, Trey). His company, his empire, is Microsoft (MSFT).

Successful as it is, Trey's company has sorely disappointed investors for the better part of eight years. Century Management's founder and chairman, Arnold Van Den Berg, recently offered a typical anecdote. A client had called his secretary, wanting to know what the septuagenarian money manager thought of Microsoft. Van Den Berg asked why. His secretary told him the client was tired of the stock. The client knew it was a great company, but he didn't know if he should keep it or sell it. Van Den Berg said to tell him, "He can do whatever he wants, but I'm buying it."

Van Den Berg concludes that anyone selling Microsoft these days is doing so out of sheer apathy. He calls the stock "an amazing situation." According to Century Management's latest filings, Van Den Berg has 5.23% of his and his clients' money in Microsoft – his largest single position.

I find myself in total agreement with Van Den Berg, a self-avowed "deep value" investor (we like to think of him as an Extreme Value investor). Microsoft today looks even better than Korean electricity giant KEPCO did when I recommended it just over two years ago. Back then, KEPCO's stock price was wallowing near its 1998 level, just after the Asian crisis obliterated stock prices in that region. Yet, by September 2004, KEPCO's earnings had doubled since 1998, and its dividend had tripled. KEPCO, of course, holds a monopoly on South Korean electricity transmission and distribution, and a near monopoly in electricity generation.

With KEPCO shares selling at a 75% discount to book value, and a low single-digit P/E, we couldn't – and didn't – resist. Things were out of whack, and we took advantage of it. The market has since headed back toward whack. And here Extreme Value readers sit, two years later, having made a pretax return of about 37% a year. You simply can't ask for safer, bigger returns in common stocks.

Trey's empire, Microsoft, has gone the way of KEPCO. Like KEPCO, Microsoft has an economic moat, which some have called a monopoly. Microsoft, too, has seen earnings rise since 1998. Microsoft, too, has a moribund stock price. Microsoft, too, is dirt cheap.

The first thing I imagine most people notice about Microsoft these days is the share price. It closed Thursday at $31. The first time Microsoft hit that price wasn't this year, or last year, or the year before that. The first time Microsoft hovered around $30 per share was in 1998 – eight years ago. Since its November 2000 peak of $72.37, the stock has fallen about 65% to today's level, around $25. While the stock was falling, the business was rising. Since 1998, sales are up 206%, earnings per share are up 167%, and the P/E has fallen from its 2000 peak of over 80x to around 20x today.

Rational investor that you are, you want proof that Microsoft has a very wide economic moat, one that will likely last for decades to come. I give you the most reliably anti-freedom, anti-business, anti-competitive-advantage institution of them all: The United States government. When the Justice Department puts you on its front burner for being way too good at destroying the competition, you know you've got a great business.

Microsoft's moat is an impenetrable combination of intangible assets and high switching costs. Imagine Dell deciding it was going to scrap Windows and suddenly offer only Unix or Linux or some other operating system on its PCs. Imagine how much it would cost Dell to switch from Microsoft Windows to any other operating system. I would bet against Dell surviving such a move. Most of the business world's computers are PCs running Windows, as well as other indispensables like MS Word and the Excel spreadsheet program.

A moat should result in a superior financial performance. A highly competitive business is generally one that doesn't worry much about raising prices, or being undercut by the competition. The business winds up with consistently high profit margins. According to Value Line, Microsoft's operating margins have only dipped below 40% recently, and much of the time they've been above 50%. Microsoft's fiscal 2006 margins are as follows: operating margin, 37.2%, net margin, 28.5%.

Those margins, my friend, are only possible through a large and impenetrable moat. And when you have the opportunity to own a slice of that business for a reasonable price, you plow as much money into it as you can afford and forget about investing for years.

Good investing, Dan Ferris