IBM Stock: Warren Buffett Loves It, But You Might Want to Steer Clear (IBM)

Warren Buffett is arguably the most successful investor on the planet. So when the Oracle of Omaha makes a big investment-related move, the investing world takes note.

IBM Stock: Warren Buffett Loves It, But You Might Want to Steer Clear (IBM)The iconic, if somewhat maverick, investor has made yet another seemingly counterintuitive move by picking up an undisclosed number of shares of lumbering tech giant IBM (IBM) at a time when investors have been exiting IBM stock in droves. (IBM shares are down 9% over the past 12 months.)

So what’s this love affair between Warren Buffett and IBM stock?

Buffett’s Huge IBM Position

The legendary investor uses a tried-and-true investment strategy that encompasses only buying shares of companies he understands well, have ideal management, trade at a fair price and operate with safe margins. Buffett has favored investing in traditional sectors, such as oil and energy, and generally shunned the tech sector, dubbing it ‘‘too unpredictable.’’

This, however, changed during the winter season of 2011.

After reading Big Blue’s annual reports for 50 straight years while remaining on the sidelines, Buffett finally bit the bait and embarked on one of his biggest buying sprees in recent history by purchasing 45 million shares of IBM stock at $159.

Buffett continued buying IBM stock throughout the year picking up 64 million shares for $10.6 billion, good for a 5.5% stake in the company.

Buffett continued making sporadic purchases of IBM over the years, and as of the end of June, Berkshire Hathaway (BRK.A, BRK.B) held 79.5 million shares of IBM, worth about $11.6 billion at current prices, and good for a 7.9% stake in Big Blue.

IBM ranked as the third largest investment in Berkshire’s portfolio with a weighting of about 11.8%. The latest purchase might have taken Berkshire’s stake in IBM beyond the 8% mark.

So what does Buffett see in IBM that the rest of the investing universe is missing?

Revenue Tailspin

IBM has fallen out of favor with investors after racking up an unbroken 13 quarter streak of revenue declines, perhaps one of the worst records in the tech sector. It seems improbable that Buffett would be willing to stake such huge amounts of money on a perennial loser, unless of course he has developed a profound amount of faith in the company’s future.

To try and understand Buffett’s thinking about his IBM investment, sample this excerpt from his investment letter in 2011 when he started buying IBM stock:

”The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise.

You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply … In the end, the success of our IBM investment will be determined primarily by its future earnings.”

But even more revealing of Buffett’s state-of-mind when investing in Big Blue is the preceding piece of commentary:

”What should a long-term shareholder, such as Berkshire, cheer for during that period? I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years.

Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1.5 billion more than if the “high-price” repurchase scenario had taken place.”

You will notice that Buffett was remarkably prescient on some key points, yet missed on others.

Let’s start with the bad part. Buffet was apparently counting on IBM stock price to average $200 from 2011-2016, and for the company to continue its old policy of massive share repurchases as the primary means to create shareholder value. IBM stock price has, unfortunately, since then only crossed the $200 mark intermittently for brief periods, and the weighted stock price since the first purchase in 2011 is probably only $180 to $185.

Buffett was, however, quite right about using IBM’s share buybacks to build his stake in the company to 6.5% to 7% over a five-year timespan.

IBM has bought back about 20% of outstanding shares since then, which has increased Berkshire’s initial 5.5% stake to roughly 6.6%. The rest has come through Berkshire buying fresh IBM stock over time.

Has Warren Buffett lost money on his initial investment? At first glance, this appears to be the case since he bought IBM stock at an average price of $165.63 in 2011 whereas current price is around $145. But when you assume all dividends were reinvested (IBM stock yields 3.5%), and throw share buybacks into the mix, his initial investment remains solidly in the black.

Buffett is known to stick to his core holdings for what seems like an eternity. Assuming he plans to hold IBM stock for another five years, there is a very good chance that he might make good money on IBM if it manages to pull out of its revenue tailspin and returns to investors’ good books.

Not a Good Medium-Term Investment

But for the medium-term investor looking to hold IBM stock for two to three years, IBM remains a wildcard. IBM has slammed the brakes on its prolific share buybacks that have been propping Buffett’s investments. Big Blue dramatically reduced its share buybacks during the second quarter of 2014 as it looks to spend more money building on its cloud and Internet of Things investments.

IBM is counting on its cloud to pull the company out of its rut. IBM’s cloud game involved providing gilt-edged services with a price to match. IBM was among the last companies to join the cloud pricing wars, but did so in style when it finally jumped in. IBM slashed SoftLayer prices by 60% mid-last year, as it looked to keep up with AWS and Azure.

The dramatic cuts are probably what has been keeping IBM’s operating margins flat over the last couple of quarters after an impressive streak of expanding margins. This implies that IBM stock might remain in the doldrums longer than the average investor’s patience can be stretched.

As of this writing, Brian Wu did not own any of the aforementioned securities.

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