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stock pick

Fabrice Taylor, CFA, publishes the President's Club investment letter. His letter and The Globe and Mail have a distribution agreement.

Few companies, if any, have gone from startup to the Dow Jones in as little time as Microsoft Corp., yet the software giant doesn't get a lot of respect. That's part of what makes it an interesting investment. I think Microsoft is on the cusp of a period of outperformance compared to other blue chips, in the Dow or otherwise.

The thesis begins with the lack of respect the stock commands from investors. After years of Steve Ballmer and his repeated errors (how did he ever let Vista out the door?), Microsoft was written off as a has-been that consistently missed the boat. No real presence in smartphones or tablets. A second-rate search engine. Late to the cloud. Cheaper, or even free, competitors nipping at the heels of one of its cash cows, Office. There were few bright spots (Xbox might be one).

It wasn't that hard to argue that in, say, 50 years this amazing cash cow might become another Eastman Kodak, a victim of its well-fed indolence.

So the company traded at a lower valuation than its nimbler rivals like Apple and Google.

But Microsoft has a new leader, and he seems to be doing the right things. Satya Nadella joined Microsoft in 1992. He moved up the ranks and ran a number of divisions before winning the corner suite earlier this year. He's Microsoft's third CEO, but the first who was not part of the founding group – as fresh a start as you'll get at the company.

Mr. Nadella's role is to make the company more innovative and more relevant through research and development. He is well incentivized to do so. Historically, there is a very strong correlation between a tech stock's performance and the amount and manner in which it spends on R&D. If the stock outperforms other large caps over the coming years, he will potentially make tens or perhaps hundreds of millions of dollars, and the only way to achieve that is to turn this big ship around.

Can he, or should he, try to innovate by taking on Apple, Google or Samsung in tablets, smartphones or search? The company chips away at these important areas and a new, fresher culture where innovation is encouraged should help make those inroads.

Already we see that Microsoft is moving away from its historical and crippling insistence that everything should run on its Windows Mobile platforms. The company has released mobile versions of Office that run on Apple's iOS. An Android version is likely not far behind. Its anticipated wearable computer will, the tech press has it, also work with competing platforms.

These sound like small things, and perhaps they are, but they speak to a change in mentality that should, or could at least, finally spawn some big ideas.

In the meantime, Microsoft has its trusty Windows and Office franchises that crank out significant cash and grow modestly but reliably.

And hidden beneath it all is what might be a stealthy growth machine: the enterprise business.

Microsoft's commercial cloud computing has grown by more than 100 per cent year-over-year for five straight quarters, and while it currently makes up only a very small part of revenue, at that rate it will soon be meaningful. The server-products business is also growing at double-digit growth rates, partly by winning market share from competitors.

The backdrop to all this is a company that churns out cash at an astonishing rate, $30-billion (U.S.), a year, which funds a growing dividend (yield of 2.7 per cent) and aggressive stock buybacks, which were recently increased when the company easily beat earnings estimates last week.

The balance sheet is a sanctuary, with $20-billion of debt easily offset by $85-billion in cash (although much of that is "trapped" offshore for tax reasons).

This is, in short, a company that investors and analysts have longed to love for years, and yet for years it has disappointed with "mediocre" results compared to Google and Apple.

If this thesis is correct, Microsoft investors will benefit from rising earnings, but also from a rising price-earnings multiple, the kind of twin-turbo performance that allows you to do better than average in large caps.

It takes a while for investors at large to come around, but if they do, and you beat them to it, you will do well.