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.
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.
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.
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.
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.
Fool contributor Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway and International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.