(Reuters) - Microsoft Corp's chief executive tried to persuade skeptical investors on Thursday that its 10-year Web search partnership with Yahoo Inc is good for both companies.

Shares of Yahoo slumped 12 percent after the long-expected deal was announced on Wednesday, and fell more than 3 percent on Thursday. Microsoft shares rose only slightly, puzzling CEO Steve Ballmer.

"I was myself kind of surprised by the market reaction," Ballmer told a meeting for financial analysts at Microsoft's headquarters near Seattle. "Nobody gets it. It's a little bit complicated."

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Under the deal, aimed at creating a stronger competitor to Google Inc, Microsoft's Bing search engine will power queries on Yahoo's sites. In return, Microsoft will pay Yahoo 88 percent of revenue from advertisements generated from these sites.

In theory, that means Microsoft gets more traffic to refine its search technology and build up its ad base, while Yahoo gets revenue from search ads without the expense of managing its own search engine.

The deal appears to end a long saga between the companies, after Yahoo rebuffed Microsoft's $47.5 billion takeover bid last year.

"Nothing got sold yesterday and nothing got bought yesterday," Ballmer told the meeting, in an attempt to explain the deal. "It's a win-win deal from my perspective."

Yahoo's share of search ad revenue is a "big number," said Ballmer, considering the company will have to lay out no money to obtain the revenue.

"On the Yahoo side -- this is the one that stuns me that people haven't figured it out -- Yahoo gets 88 percent of the search revenue they have today. They have zero percent COGS (cost of goods sold) and they have no R&D (research and development) expense and no ongoing capex (capital expenditure)," said Ballmer. "It's sort of unbelievable."

For Microsoft, he said the deal means it gets more Internet traffic, enabling it to refine its search technology, which should lead to more interest from ad buyers and hence better prices for its ads.

"The more queries you see, the more you can tune your product. The more scale you have, the more advertisers advertise on your system, and the more relevant they make their ads for your users," said Ballmer. "Because we have more bidders in our advertising marketplace, we will get higher bid prices, probably, and more liquidity in the marketplace. That will improve monetization."

Yahoo shares closed down 3.6 percent at $14.60 on Nasdaq. Microsoft shares closed up 1 cent at $23.81.

(Reporting by Bill Rigby; Editing by Tiffany Wu, Leslie Gevirtz)