Michael Kramer and the clients of Mott Capital own MSFT.
Microsoft Corp.’s (MSFT) shares have soared in 2020 by nearly 44% as the S&P 500 has climbed by around 8%. The stock’s performance comes as the coronavirus pandemic has changed the way people work and collaborate, as more people work from home. The trend has helped to boost Microsoft’s revenue and earnings while pushing the companies market cap higher by nearly $500 billion to nearly $1.7 trillion just this year.
Despite the significant gains, someone is betting that Microsoft’s stocks big run is due to cool-off, or potentially fall. The big run higher has pushed Microsoft’s one-year forward PE ratio to over 30, its highest level in nearly 20 years.
Hedging Against A Decline
The massive gains are resulting in someone to either hedge a long position or bet the stock is going to fall using options. On August 26, the open interest levels for the September 25 $215 calls rose by nearly 16,000 contracts. Additionally, the open interest level for the September 25 $205 puts rose by around the same number of contracts. The data shows, the $215 calls were sold for approximately $7.96 per contract, while the $205 puts were bought for around $3.41 per contract. It created a spread transaction and a bet or hedge that the stock would be below $205 by the expiration date in September, a decline of nearly 11% from its current price of around $228 on August 27.
The stock has seen a significant amount of multiple expansion in 2020, with the PE ratio rising to around 32 times next year’s fiscal earnings estimates. Part of the reason why we have seen such a rapidly growing PE ratio is because of the low-interest-rate environment with the 10-year yield plunging below 1%. Some investors have pointed to the vast spread between the earnings yield of Microsoft and Treasury rates. For that spread to narrow, the earnings yield would need to shrink, pushing the price of the stock higher, and thus supporting the higher earnings multiple.
Whether or not the stock can continue to rise, will largely depend on the ability the company has to continue to drive earnings growth in the future. Currently, analysts see earnings for the company growing by 12% in 2021, while increasing by 13.6% and 13.4% in 2022 and 2023. The earnings growth rate alone is not enough to support the high earnings multiple the stock currently carries. Therefore, the company needs to be able to continue to beat those estimates and provide upside guidance.
Microsoft’s stock has certainly been on a fantastic run over the past few months, and even if the shares should pause and reverse lower as some traders appear to be fearful may happen. The company is still well-positioned to thrive in an environment where more work is likely to be conducted at home than in the office. If the long-term growth story remains, then the stock should be rewarded in a low-interest-rate environment or not.
Michael Kramer is a financial market strategist and the portfolio manager of the Mott Capital Thematic Growth Portfolio.
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