Expensive or opportunity?

Analysts at Morgan Stanley made a big hullabaloo about it, as would I if ever I came to walk in their shoes, with early market leadership in Generative AI now projected to result in Microsoft doubling its earnings per share by FY29.

Let's pause for a few seconds and think about this a little longer. 

Microsoft (NASDAQ: MSFT), one of the largest companies of our time, generating some US$244 billion in annual revenues, of which US$107 billion ends up as operating income, with free cash flow estimated in excess of US$63 billion, is set to double its profits for shareholders over the next five years.

For the mathematically gifted among us, doubling profits in five years requires a cumulative annual growth rate (CAGR) of circa 14.87% per year. Morgan Stanley's recently updated projections are actually above that with revenues expected to grow at a CAGR of 14% and EPS at 16% per annum.

Hence, to be precise about this: Microsoft is projected to MORE than double its EPS in the next five years.

There are multiple reasons why I bring this up.

With bond yields rethinking the pace and starting date for Fed rate cuts, and geopolitical tensions lifting, the natural response from most investors is to sell exposure to equity markets that are being perceived as too 'expensive'.

It's good to be reminded that if the above projections prove accurate in the years ahead, Microsoft shares will be trending a whole lot higher than where they are today.

No doubt, were Risk-Off sentiment to dominate in the days or even weeks ahead, Microsoft shares will likely weaken, maybe even weaken a lot, but should this be our only and key focus? The world will be a very dark place for this company to not grow at all from here onward.

In Australia, analysts at Macquarie recently published similar forecasts for leading biotech CSL (ASX: CSL) with a five-year EPS CAGR projection of 15% per annum which, you guessed it already, implies that the company's EPS should more than double by FY29. Little surprise thus, Macquarie thinks CSL's share price could well reach $500 in three years' time from around $280 now.

To the sceptics out there, would it really be such a great disaster if these companies only grew by, say, 12% per annum? Or if those anticipated rate cuts come in fewer doses and later than expected? When a fresh growth driver announces itself, investors tend to significantly underestimate the impact on well-positioned beneficiaries.

We all get drawn in by risks and developments in the here and now, but keeping a broad perspective is imperative if we aim to be successful investors long term.

These projections equally shine a light on the ongoing opportunities that remain with large-cap companies, both in the US and on the ASX. This equally serves as a timely reminder when all and sundry are looking for the next ten-bagger in the small-cap space.

It is also one key reason as to why I am not joining the chorus of nervous nellies on the sidelines who keep using terms such as 'bubble' and 'excessively priced equities'. Putting a valuation on listed companies goes well beyond referencing a generic PE ratio.

In Australia, mid-cap IT services provider TechnologyOne (ASX: TNE) has managed to double in size every five years for circa two decades now. I remember back in 2022, one fund manager published an extensive expose as to why, at $10, there was no chance in hell investors would see a profitable return from their shares.

The arguments put forward read very convincingly.

That share price surpassed the $17 mark last month; 70% above where any further upside was considered negligible. Management at TechOne continues to express confidence the business will yet again double over five years.

Has the share price is volatile in between? You bet! But volatility, no matter how scary in the short term, is beyond anyone's control and ultimately it is just that. 

It is also what provides the better entry points for those investors not yet on board or who like to top up their exposure.

Aussie Banks - The Debate Is Raging

Having said all of the above, investors should never be afraid to question the appropriateness of share prices and asset valuations. Plenty of examples around of share prices that once were trading on much higher levels, never to be seen again.

The key debate in Australia is once again surrounding the local banks. With share prices rallying by double-digit percentages, and CommBank (ASX: CBA) shares posting an all-time record high above $120, the public debate is yet again zooming in on bank share prices and whether the sector's de-coupling from wobbly-looking fundamentals is a bridge too far, or doesn't have to be.

On current forecasts set by most analysts covering the sector, margins will likely remain under pressure for longer and loyal shareholders should not expect anything spectacular in terms of further increases to dividends. Some analysts, it has to be said, are toying with the idea that dividends won't increase at all, possibly for two years in a row, with the risk of small decreases.

The reason as to why share prices have rallied hard is usually framed through index-buying (ETFs and the like) while safe-haven seekers in Asia, China in particular, might have contributed as well. The prospect of RBA rate cuts and ongoing buoyancy in the local property market are oft-cited as supportive factors as well.

Traditionally, I regard Aussie banks, the Four Majors in particular, as an obvious barometer for investor sentiment and the recent months have again played to that script.

Whatever the reasons, most strategists at the brokerages that dominate investor fund flows for the local share market are negatively disposed towards the sector. If it's not because valuations are seen as 'bloated', and undeservedly so, the reason cited are questionable fundamentals, if not a soggy outlook with only a tepid recovery expected for next year.

One notable exception is analysts at Morningstar who seem to have adopted the view that, by the time the dust has settled regarding household budget stress, cost inflation, and RBA rate cuts, Australian banks will likely prove relatively resilient, and thus reasonably okay.

No doom scenarios from mortgage arrears or bad debts should be expected, and with the demand for credit continuing to grow, and competition to lessen, net interest margins should bottom soon and start trending upwards again, predicts Morningstar.

The other side of the argument this time around is put forward by veteran Jonathan Mott, once revered at UBS and nowadays continuing sector analysis at Barrenjoey, and his team.

Mott's analysis should be compulsory reading for every investor whose portfolio has a large exposure to the local banks. If Mott's analysis proves correct, bank share prices will, longer term, trend in the opposite direction of the Microsoft's in this world, as they (ex-CBA) have done post-GFC.

The key thesis put forward is banks have increasingly scaled back risk-taking and this is reflected throughout their operations. Mortgages are heavily skewed towards wealthier households, small businesses without property ownership (collateral) are largely ignored, mortgages are predominantly sold through external broker networks.

The result is banks in Australia are increasingly looking like each other's copy-cats, with competition for growth and market share essentially coming down to 'price' in a commoditised market for lower-risk loans. This is, essentially, the road to nowhere for the sector, and if things don't change in the foreseeable future, the research states bank dividends are at risk of becoming unsustainable.

Bank of Queensland (ASX: BOQ) opened the results season for the local sector on Wednesday this week with yet another weak result (though you wouldn't know when looking at the immediate share price reaction).

Three of the Majors - ANZ Bank (ASX: ANZ), National Australia Bank (ASX: NAB), and Westpac (ASX: WBC) - are set to follow suit in the following weeks.

I doubt whether the debate will swing decisively either way with these upcoming financial updates, but each release has the potential to become a catalyst either way, both for the sector and for the local share market generally.

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