Following Warren Buffett Into IBM Could Be a Great Strategy

Legendary investor Warren Buffett began buying shares of technology giant IBM (NYSE: IBM  ) in early 2011 due its impressive turnaround under former CEOs Lou Gerstner and Sam Palmisano. Buffett also heralded the company's smart financial management, which has generated additional value for shareholders.

Indeed, IBM is now the third-largest holding for Berkshire Hathaway (NYSE: BRK-B  ) . However, so far the investment has underperformed. While the market has been rising since Buffett began buying, IBM shares recently dropped below the average price he paid, following IBM's disappointing Q3 earnings report.

Warren Buffett speaks to reporters.

This has given investors a rare opportunity to follow Berkshire Hathaway into a major investment without paying a premium to what Buffett paid. This seems like a smart strategy. While IBM has hit some bumps recently, the company has a strong franchise and there are good reasons to expect fairly swift improvement. This creates a very favorable risk/reward trade-off today.

Rare decline
The recent earnings-driven drop in IBM's stock price has left the stock nearly 20% below the all-time high it set earlier this year. Up until now, IBM has generated extremely consistent share price appreciation since closing the sale of its PC unit to Lenovo in 2005.

IBM Chart

IBM 10 Year Stock Chart. Data by YCharts.

Aside from a roughly 40% drop in 2008 due to the Great Recession, IBM shares have not experienced a 20% decline since 2005. In other words, IBM is a business that has historically been a reliable performer. If IBM's weaker-than-expected results are a sign of secular decline, then the stock could be in for continued trouble, but otherwise the recent price drop represents an historic opportunity.

IBM can bounce back
Fortunately, IBM's recent struggles are unlikely to continue. While revenue declined 4% year-over-year, half of that decline was attributable to currency fluctuations. Management blamed most of the remaining shortfall on delayed hardware purchases in China, where public sector spending has ground to a halt in anticipation of new economic reforms that could be announced as early as next month.

The bottom line for investors is that IBM expects both of these factors to diminish over the next two quarters and then turn into a tailwind thereafter. IBM also experienced weak growth in software last quarter, but management expects a strong rebound in the current quarter. As a result, executives repeatedly affirmed during IBM's earnings call that IBM is on track to meet is long-term guidance, which calls for EPS of $20 by 2015.

One key data point supporting that forecast is that IBM's services backlog continues to grow. It reached $141 billion at the end of last quarter, up 2% in dollar terms and up 6% in constant currency. This is a sure sign that IBM's largest business unit (accounting for more than half of company revenue) will return to growth soon.

Foolish conclusion
IBM may have dragged down Berkshire Hathaway's stock portfolio last week, but don't expect Warren Buffett to sell. In fact, he's more likely to take advantage of the "fire sale" at IBM to scoop up even more stock.

IBM stock is particularly attractive because while the market's earnings multiple continues to expand, IBM now trades for less than 10 times expected 2014 earnings. The company's recent stumble does not seem to be indicative of long-term decline. Meanwhile, IBM has been consistently repurchasing more than $10 billion of stock each year, thus building shareholder value.

As a result, I think IBM will be a long-term winner for Warren Buffett and Berkshire Hathaway. Best of all, individual investors now have a chance to buy IBM at the same price Buffett paid back in 2011 and share in Buffett's future gains.

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Read/Post Comments (8) | Recommend This Article (21)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 23, 2013, at 6:46 PM, sh4unz0r wrote:

    Sal Palmisano?

  • Report this Comment On October 24, 2013, at 4:01 AM, dgmennie wrote:

    "If you're an investor, you probably admire Warren Buffett. He's made billions through his investing with simple strategies that anybody can understand."

    So where are the legions of investors who have comfortably made a few million using Buffett wisdom? There has got to me more to it than that, otherwise plenty of reasonably intelligent folks would now be retiring fat and happy. Yet they are not. Buffett has billions. The masses have squat.

    Go figure.

  • Report this Comment On October 24, 2013, at 7:41 AM, dbtheonly wrote:

    @dgmennie

    Buffett buys millions of shares. I buy hundreds. He makes millions. I make hundreds. As the Musician said, It's the scale.

    I'm not retiring yet but my plan is to sell one share of Brk-b per month to supplement my dividend income.

  • Report this Comment On October 24, 2013, at 12:37 PM, Mathman6577 wrote:

    Buffett started out with the same amount as most investors -- zero. He makes his money because he refuses to sell (or even buys) in the face of a panic while most others sell.

  • Report this Comment On October 28, 2013, at 11:00 PM, TerryHogan wrote:

    @Mathman6577

    I wouldn't say that Buffett started out with the same as most investors, unless most investors are sons of a congressman who also owns a stock brokerage.

    Don't get me wrong, he's a great investor, but he didn't get to be a billionaire by simple compounding of his newspaper route money. He earned a lot of money early on as basically a hedge-fund manager.

    @dgmennie

    There are lots of investors who made millions using Buffett methods. Look at the people in his early partnerships, and long-term investors in Berkshire.

    Of course you can't just read a book on Ben Hogan and be a great golfer, or study video of Tiger Woods, you still have to put in the same amount of work. You can read all of Buffett's annual reports, all his books, and all the Graham and Dodd books, but you still won't have the years of experience and mistakes, and the years of Wall St. Journals and annual reports that are buried in his head.

    No denying that he also gets deals that others wouldn't get (See Goldman and GE sweetheart deals) but the meat of his work is the continual reading, reading, reading, and then the patience, patience, patience. Most people aren't willing or don't have the time to do the same amount of research in the same way.

    He can say what he wants, as can the board of Berkshire, but he's irreplaceable, you can't replace the experiences in his head, and the reputation he has. When he dies, if accounting reflected reality, they should take a writedown of about $100 billion in intangibles.

  • Report this Comment On October 29, 2013, at 7:38 AM, sagitarius84 wrote:

    IBM is a great company that has a moat around client relationships. It has managed to increase dividends for 18 years in a row, and repurchases stock consistently.

    The stock is really cheap at 10.30 forward earnings.

    http://www.dividendgrowthinvestor.com/2013/03/ibm-ibm-divide...

  • Report this Comment On October 30, 2013, at 12:26 AM, Fabin81 wrote:

    Purchase shares this morning. Thanks for the tip guys. This one will be a nice buy and hold.

  • Report this Comment On November 07, 2013, at 11:02 AM, Callum wrote:

    I agree with most the comments posted here. Howerver, I have a little problem with the general premise of this article. If the author of this article knew anything about investing, he would soon realise that the share price dropping a few percentage points a). problably doesn't mean much to Berkshire, and b). Berkshire is primarily responsible for driving up the share price, simply due to the volume they had to purchase. Investing at the scale which Berkshire does, the capital gains aren't as important as cash-flow through dividents. If IBM hand't paid dividends, i'm certain Berkshire wouldn't have bought any shares. Prices will go higher, ref: inflation. But cash-flow is king, if you want compound wealth.

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