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Mixed Signals From Microsoft


It's one of the toughest battles Microsoft Corp. (MSFT) will face. No, not the withering competition from Web search kingpin Google Inc. (GOOG) or the regulatory challenges posed by Europe's trustbusters. This is a war over definitions: Should investors invest in Microsoft for growth or value?

Their inability to answer that question became painfully clear on Apr. 27. That's when Microsoft shocked Wall Street with news that it would boost spending in fiscal 2007 by $2 billion more than expected, much of it to fund product initiatives. Investors had just seemed to be coming to terms with the idea that Microsoft, one of the great growth stocks in corporate history, was settling into life as a value play. But the new spending -- which translates into a 10% drop in projected operating income -- is really the purview of growth companies. So shares spiraled down 11%, to $24.15 the next day, erasing $32 billion in value.

Why does it matter that investors can't categorize Microsoft shares? Isn't it enough that the Windows and Office monopolies, though slowing from their heyday of the 1990s, help the company generate $1 billion in free cash each month? Sure, Microsoft has misfired in some of its attempts to seize new markets and is in the midst of adjusting to the new world of Web-delivered software. But it is posting solid results with its server software and winning a growing share in video games.

The problem is that investors like to build their portfolios in buckets. If they're willing to accept some risk for the possibility of higher returns, they load up on growth companies. Value investors forgo the volatility of growth stocks for steadier returns.

In truth, investors have wrestled with Microsoft's split personality for four years. The stock climbed 61,000% from the 1986 initial public offering through the end of the 1990s. But since 2002 it has traded sideways in a range from $20 to $30. "It's been in growth stock purgatory," says Todd S. Lowenstein, co-portfolio manager of the HighMark Value Momentum Fund in Los Angeles. In recent months value funds such as Vanguard Windsor and Clipper added to their Microsoft holdings while growth funds, including Fidelity Magellan and Janus Mercury, sold shares.

"BIG, BOLD BETS"

News of the spending spree sent many of those value investors running for the hills. Adding to the confusion is that Microsoft execs use the language of growth as they talk about opportunities. "Throughout our history, Microsoft has won by making big, bold bets," CEO Steven A. Ballmer wrote to the company's more than 60,000 employees after the markets closed on Apr. 28. "I believe now is not the time to scale back the scope of our ambition or the scale of our investment."

Most analysts think a substantial share of that outlay will go to building Microsoft's online business to compete more effectively against Google and Yahoo! Inc. (YHOO). But without details, investors can't decide for themselves if that will generate solid returns. In hindsight, Microsoft concedes its misstep. "We could have communicated this better," says spokesman Larry Cohen. Over the next few months the company will offer more insight into its investments. That's likely to start on May 4, when Ballmer addresses online advertisers at headquarters.

But until the spending details are clear, the shares are likely to drift. "This stock will test your patience in the short run and even the medium run," says HighMark's Lowenstein. For now he's keeping Microsoft firmly in the value camp. His $500 million fund added shares on Apr. 28, after the sell-off, raising its holdings from 1.7% to 2% of total assets.

By Jay Greene


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