While the tech world anxiously awaits Microsoft’s (NasdaqGS: MSFT) selection of its next CEO, its stock price remains mired in the mid-$30s after a brief uptick following Steve Ballmer’s announced resignation five months ago.  There has been much speculation as to the future strategy its new leader will articulate for the tech giant, but we believe there really is only one correct path for the company to follow.

It is undeniably true that Microsoft has squandered the last decade, but all is not yet lost. We could place the blame on the outgoing CEO and his legacy mindset that Microsoft still had a growing PC market, when Microsoft was unable to capitalize on the major shifts taking place in the marketplace.  It was late to the game in smartphones and other forms of handheld computing, for which it has paid dearly in terms of lost opportunity cost.

However, it is difficult to blame any company which so dominates the engine that powers the first half of a long term technology wave. During the prior technology wave Henry Ford continued to build the Model T automobile long past the point it was considered leading edge or, more importantly, growing Ford’s market share. Even so, Ford survived being privately held to eventually successfully reinvent itself. It is extraordinarily difficult for an ultra-dominant company to navigate the process of creative destruction; the temptation is great to invest in products that could turn out to just be passing fads.

Microsoft followed the example set by Ford and opted to incrementally invest in new offerings as opposed to betting the company on a new innogration strategy. So instead of leading the market by creating entirely new products they chased the market by sticking with existing architecture that was not substantively changed in order not to threaten their existing revenue stream; a suboptimal strategy to say the least.  Microsoft has finally embarked on betting the company on where the market is headed, instead of chasing where it has been. Ballmer stepping down is clearly a move in the right direction. However, Microsoft really threw the gauntlet down when it released its second tablet offering – the Surface 2.

In order to make this tablet truly new and different Microsoft had to abandon its flagship PC operating system, Microsoft Windows, with its release of Windows 8.  Windows 8 is downright awful for use on PCs but works well on the tablet. But the PC market declined 10% this year while the tablet market has continued to grow unabated. Therefore this is the right move from a long term perspective, and has set Microsoft on a course for where the market is headed.  There is no looking back anymore.

The new Surface 2 tablet is a solid platform, much faster than Microsoft’s original tablet thanks to faster chips from Intel.  It is a bit pricey when dressed up with the hardware and software needed to work its way up to where it really can replace laptops as the platform of choice for personal and business users. But the right marketing strategy should be able to overcome that, just as Apple has been able to do with its higher priced product offerings.

The website Apple Insider did a review of the Surface 2 and admitted the tablet from Microsoft was indeed better than Apple’s tablet in some areas. The major shortcoming they identified was the size of Apple’s applications ecosystem which is five times larger than Microsoft’s tablet ecosystem. However, when they dressed out both tablet offerings they came to the conclusion that the Surface 2 was indeed good and less expensive than Apple’s tablet. They also correctly pointed out that no tablet can really replace a PC yet for power users, but it is now merely a only matter of time before tablets will completely replace PCs.

We can’t say that the future CEO will make all the right moves, but what we can say is that the cupboard is not nearly as bare as most people thought it was when Ballmer first announced his departure.  Fortunately, as Ballmer was heading out the door he laid the foundation for the Surface tablet while at the same time buying Nokia. When the new CEO arrives Microsoft will continue asking itself what are truly the best world class solutions required to compete? The answers to that question will lead them away from PCs and towards meaningful Smartphone and tablet entries. They have to continue to move in that direction or the company will no longer be relevant from an investor’s perspective.

So what should an investor do with Microsoft stock right now?

Microsoft is still pulling enormous cash flow from their enterprise software and also from PCs even as they continue their decline. The fact that Microsoft did not hire Alan Mulally as its new CEO suggests to us that its Board realizes how critical it is to have someone in that position with a demonstrated record of implementing innogration within the tech sector as opposed to hiring someone from outside the tech sector that is more process oriented.  If the new CEO is able to apply that excess cash flow to the correct innogration strategy, then it’s only a matter of time until this former market leader resumes its spot in the pantheon of tech innovators.

Social media stocks such as Twitter and Facebook are much more the media darlings but Microsoft is the better value play right now.  Trading at only 14 times TTM earnings while paying a 3% dividend yield, the downside risk is very limited. Microsoft finally has some fast horses in the starting gates – now we’re just waiting on the jockey to start riding them.  

Microsoft is a ‘buy’ up to $42 in our Investments Portfolio.