Microsoft (NASDAQ:MSFT) stock has a lot to answer for. Its last quarterly report, while beating on earnings and revenue, pushed software stocks into a bear market — this is typically defined as a drop of 20% or more from recent highs. Microsoft shares fell as much as 13% on Thursday.
So what’s behind the drop? Well, there are several interpretations. Slowing cloud growth’s one angle.
The “show me the money” era has arrived. While the top-line beat was solid, the staggering $37.5bn in quarterly capital expenditure — a 66% year-on-year surge — has sparked fears of an “AI tax” with a distant exit ramp.
Investors are no longer content with potential. They demand proof that these massive investments in GPUs and data centres will translate into margin expansion and improved earnings, not just increased overhead.
What’s more, with 45% of commercial obligations now tied directly to OpenAI, the risk concentration is starting to rattle even the most disciplined portfolios.
Short-term performance
Investing £10,000 into Microsoft a month ago wouldn’t have been a successful move. The 13% share price slide would have slashed your capital to £8,700, while a 2% depreciation in the dollar further eroded value when converted back to sterling.
Interestingly, the stock’s now down 2% over the year.
The broader exodus from software stocks explains part of this underperformance. Hedge funds have slashed software exposure to a record low of 4.5%, a staggering 12-point decline since the mid-2023 peak.
Investors are aggressively rotating into hardware, with semiconductor exposure surging to a record 8%. This pivot suggests the market’s currently prioritising the shovels (chips) over the gold (software).
That’s certainly an interesting conclusion because for years investors have coveted software companies with their strong margins and potential for rapid growth given that software can typically be scaled almost infinitely with near-zero marginal cost. For a decade, the “capital-light” nature of SaaS was the gold standard for growth.
What happens next?
What happens next operationally is beyond my knowledge. However, I can look at the valuation and come to some conclusions as to where the stock might be going next.
It’s now trading around 24.3 times forward earnings. That’s pretty much in line with the information technology sector average. But this figure doesn’t tell us a lot on its own.
Another factor is growth. So with earnings expected to grow by around 14% annually over the medium term, we actually come to a price-to-earnings-to-growth (PEG) ratio around 1.75. This is just a little above the sector average.
And then it’s got a near-perfect balance sheet with around $20bn in net debt — that’s tiny for the size of the company.
So what does all of this tell me? Well, it’s not bad value compared to the sector average. But Microsoft isn’t any average company — it’s a market-dominating titan with a massive competitive moat that arguably justifies a valuation premium over its peers.
With that in mind, it could be worth considering, but I’d suggest the margin of safety isn’t huge in the near term.
