What if Windows 8 flops?...

What if Windows 8 flops?... The commoditization of the PC... Bond King: 'Buy hard assets, sell Treasurys'... Precious metals are more attractive than ever... Buying silver... Porter on 'trophy assets'...

 Our friend and money manager Vitaliy Katsenelson says he's sold his Microsoft shares because he's afraid Microsoft's new Windows 8 operating system will be a flop. In a recent article about his decision, Katsenelson quoted tech guru John Dvorak, who said Windows 8 was "unusable and annoying." Perhaps even more ominously, Dvorak called Windows 8 "an unmitigated disaster that could decidedly hurt the company and its future."

I (Dan Ferris) have been recommending Microsoft since September 2006 and have no current plans to recommend selling. And I like Vitaliy a lot. He's a smart guy. He's one of the few hedge-fund managers who contact me now and then to see what value I'm finding. I've written about him in the Digest before... so I figured I should let readers know why I'm not ready to exit Microsoft.

 Windows 8 could be a big flop. For an understanding of how to think about that scenario, let's take a look at the disastrous rollout of New Coke back in 1985... It was exactly the kind of disaster John Dvorak is predicting for Microsoft.

After building up a 60% market share right after World War II, Coke was down to just 24% by 1980, due to competition from Pepsi. Pepsi was beating Coke in grocery stores, but Coke remained No. 1 through vending machine and fast-food restaurant sales.

Coca-Cola responded to the challenge by reformulating Coke, based on taste tests against Pepsi and original Coke. New Coke launched April 23, 1985. At first, it got a warm reception. But pretty soon, letters began pouring into Coca-Cola's Atlanta headquarters, expressing disappointment and even hatred of New Coke. The company's hotline went from 400 calls a day to 1,500 calls. A psychiatrist hired to listen to the calls said people sounded like they'd lost a family member.

Old Coke was reintroduced as Coca-Cola Classic in early July, less than three months after New Coke's debut. Classic immediately outsold Pepsi and New Coke. The real problem with New Coke was simply that it was different. People didn't want different. Coca-Cola's marketing called it "The Real Thing." It's hard to change the taste of a product that your customers think of as "the real thing."

After the whole mess was over, a Coke executive summed it up this way: "The simple fact is that all the time and money and skill poured into consumer research on the new Coca-Cola could not measure or reveal the deep and abiding emotional attachment to original Coca-Cola felt by so many people."

 In the end, the World Dominator Coca-Cola maintained its No. 1 status. Coke shares returned 46% that year. Coke never missed a dividend increase, and the crisis was over in less than three months.

Coke was to Coca-Cola what Windows is to Microsoft – its flagship product and the foundation of its business. Sure, beverages are not software. No such comparison is perfect, but the analogy is close enough.

So if the early reviews are correct... Microsoft could have a "New Coke" moment on its hands. It's hard to believe it would stick with the new version if it's a total flop. If Windows 8 tanks hard enough, Microsoft will scrap it and restore the features and feel people have come to rely on.

 Overall, I think Microsoft will maintain its dominance in PC operating systems. Even if people don't love Windows the way they love Coke, Windows is how most people in the world think about using a computer. The commands, design, and organization define how most people use this vital tool of modern life. I doubt users will abandon Windows because version 8 feels unfamiliar, only to adopt another even more unfamiliar product.

And remember, people love to hate Windows and Microsoft. Many have been questioning Windows' quality and functionality and predicting Microsoft's demise for many years. The "Vista" version of Windows met with catcalls when Microsoft first released it in 2009. The company retooled and the next version, Windows 7, became the bestselling operating system in history.

I think it'll continue to gush free cash flow and raise its dividend for another few years at least. I'm not ready to hit the sell button, not even close.

 But... you ask... what about "the death of the PC"? What about the popular idea that smartphones and tablets will make your personal computer obsolete? I don't see that happening anytime soon... The industry sold 350 million PCs in 2010 and another 352 million in 2011. I expect we'll see about that many sold this year, too.

What's happening in the PC market is more subtle than death. It's the total commoditization of the PC. The hardware is a low-margin commodity business. It's almost impossible to differentiate yourself as a PC maker. That's why Hewlett-Packard (HP) and Dell are struggling. It's also why both stocks remain dirt-cheap.

I owned an HP two computers ago. My last one was a Dell. My current one is a Toshiba. Next, I'll almost certainly get something else, with little consideration for brand name... I don't expect to ever recommend HP or Dell to my readers for that reason.

 But Microsoft is not in the hardware business. Microsoft makes consistently thick profit margins year after year. Windows and Office – its other franchise software product – do not give up market share. Microsoft has a 92% share of PC operating systems globally. Microsoft Office has about 90% of the office productivity software market.

Windows and Office provide 97% of Microsoft's operating profit. They essentially ARE Microsoft. So as long as you believe nothing is going to change much about the products or markets, you have to believe the stock is dirt-cheap at an enterprise value (market cap + debt - cash) of about seven times free cash flow.

 Sure, Windows 8 is a big change from Windows 7. But even if it engenders as much ill will as New Coke did... that's still just a big one-time problem that can be solved. Legendary investor Warren Buffett says you should buy a great business when it has a big, one-time solvable problem. So maybe the stock price falls, but I don't think the business will be permanently impaired by a Windows 8 flop.

And of course, nobody is talking about the possibility of Windows 8 succeeding. As I said, Windows Vista was hailed as a flop... at first. Eventually, it sold more than 160 million copies and kept the cash flowing into Microsoft.

I don't think a possible Windows 8 flop is a reason to sell the stock. If New Coke can flop and make no difference to Coke shareholders, the same thing can be true for Windows 8 and Microsoft shareholders. I expect this World Dominator will be as dominant a year from now as it is today.

 On Sunday, Bond King Bill Gross said something unusual on social-networking site Twitter. Gross manages the world's largest bond fund – the $263 billion PIMCO Total Return Fund. He's one of the smartest bond investors on the planet. And right now, he's scared of U.S. Treasury bonds, the world's "safe haven" asset.

Gross has long been critical of the U.S. government's loose monetary policy and its eventual negative impact on bond prices. And over the weekend, he "tweeted" – as posting on Twitter is known – that negative real interest rates will kill investors... He wrote... (Note: we've spelled out some of the shorthand commonly employed by Twitter users.)

Negative interest rates occur when inflation is running higher than the so-called "risk-free" bond rate (Treasury yields). Right now, inflation is probably running around 4%... And that number likely will increase in the future. Meanwhile, 10-year Treasurys yield a record-low 1.43%. In other words, if you hold Treasurys, you will lose 2.5% a year of "purchasing power."

 Gross recommends holding real assets in lieu of bonds. Real assets are tangible goods... things like gold, oil, wheat, and real estate. Think about that for a minute... PIMCO is the world's largest bond investor. It makes money when people invest in its bond fund. It has more than $1 trillion in assets under management, most of it in bonds. Its Total Return Fund is the largest mutual fund in the world, with more than $260 billion in assets. And one of the guys who founded PIMCO is telling the whole world to ditch bonds for real assets.

 The next question is which real asset you should hold... Steve Sjuggerud is bullish on real estate. He wrote about it in today's DailyWealth. Steve says real estate is "dirt-cheap by any measure." You can get a mortgage at record-low rates (30-year mortgages are around 3.5%), and the uptrend in real estate is just beginning.

But not everyone has the means or desire to buy a house. Yes, there are proxies for housing in the stock market, but the real opportunity is in owning the physical properties.

 So we turn to commodities...

Digest readers know we're bearish on oil. Most investors think the European crisis and a Chinese slowdown will hurt oil prices. They will (and have). But we think there's a larger trend in play... The drilling happening right now in the shale-rock formations (in places like Texas' Eagle Ford and North Dakota's Bakken shales) will create a glut of domestic crude and slam prices.

And agricultural commodities are due for at least a short-term correction soon... Thanks to a U.S. drought, corn and other grain prices are near all-time highs.

 That brings us to precious metals... In today's market, gold and silver are part of a small group of attractive assets. They're both trading down from their highs. Gold fell from its September 2011 high of $1,895 an ounce to $1,577 today. And silver fell from around $50 an ounce to $27 today.

But we think the metals are more attractive than ever. The time to buy precious metals is when the world's central banks are printing money. In our opinion, metals (not Treasurys) are the ultimate safe haven asset. They're insurance against the destruction of paper money – which governments continuously debase.

No fiat currency has succeeded throughout history. And as we discussed yesterday, today's paper money will be no different.

 We're just beginning to see the bailout cash flow to Europe. And as Federal Reserve Chairman Ben Bernanke has repeatedly said, he stands ready to print more money should our economic recovery stall.

 In addition to the macro trend for gold and silver, S&A Short Report editor Jeff Clark sees a short-term profit opportunity in the sector. Last week, he told readers silver is ready to break out to the upside. He wrote...

 And in the July issue of Stansberry's Investment Advisory, Porter wrote about investing in "trophy assets." He told subscribers...

 In that issue, Porter published a list of 20 companies that own trophy properties. Several of those companies are miners.

So precious metals protect investors from the global race to devalue paper money. And from a trading perspective, they're attractive today. Add to that, many of the companies that pull the metals from the ground own "trophy assets" – meaning they're super safe and will have access to credit markets regardless of what happens in the world.

 When we want to buy mining stocks, we turn to one person... John Doody, a former economics professor turned resource investor. He's made a personal fortune of around $11 million just from investing in mining stocks. He made most of his money investing in gold stocks. In his newsletter Gold Stock Analyst, the stocks he featured (using his proprietary method of analysis) have returned more than 1,000% for subscribers since 2001.

But today, he's investing in another type of mining stock... silver miners. During the bull market between 1975 and 1980, gold increased 500%. But silver went up 1,140%. And certain silver stocks soared as much as 5,329%...

John sees the same opportunity setting up today. That's why he recently created a service to focus exclusively on silver stocks. It's called the Silver Stock Analyst.

John thinks we'll soon see a full-blown monetary crisis (like the breakup of the euro or the collapse of the U.S. dollar). And when that happens, he expects silver to soar much higher than gold.

 That's why he's prepared a report of his five favorite silver stocks to own today. If you'd like to know more about investing in the world's most attractive silver companies, you should consider subscribing to John's silver-focused service, Silver Stock Analyst. And until midnight tonight, they are offering you a generous discount to the normal subscription price. You can learn more about his newsletter – and how to access his five top silver stocks – here...

 New 52-week highs (as of 7/23/12): Western Asset High Income Opportunity Fund (HIO) and Hatteras Financial (HTS).

 In today's mailbag... one reader cheers Porter's Friday Digests and his quixotic attempt to teach the lessons he'd want if he were a subscriber. Send your messages to feedback@stansberryresearch.com.

 "I enjoyed your article on regression analysis. Tell your copy editor that some of the dummies out here like to learn this stuff. They are not helping when they censor you.

"I also enjoyed your revelations regarding your personal asset allocation strategy." – Paid-up subscriber O. Donn Grace

Ferris comment: Thanks for your comment. We'll let them know.

Regards,

Dan Ferris and Sean Goldsmith

Medford, Oregon and New York, New York

July 24, 2012