Source: IBM
Warren Buffett took a big position in IBM (IBM -0.89%) back in 2011, and he bought more IBM stock at lower prices during the fourth quarter in 2014. The Oracle of Omaha is arguably the best investor ever alive, and he seems to be quite convinced about his investment in IBM, so maybe the stock deserves some serious consideration. Should you follow Warren Buffett into IBM stock?
A high conviction pick
IBM is among Berkshire Hathaway's (BRK.A 0.64%) (BRK.B 0.54%) "big four" investments, an honor it shares with classic Warren Buffett stocks such as Coca-Cola, Wells Fargo, and American Express. Berkshire increased its ownership in each of its big four positions last year, however, Warren Buffett only allocated fresh capital to IBM, the ownership increase in Coca-Cola, Wells Fargo, and American Express was solely due to share repurchases from these companies.
Berkshire Hathaway owns 76.9 million IBM shares as of the end of the fourth quarter, for a market value of more than $12.3 billion and a company ownership of 7.8%. Warren Buffett does not make investment decisions lightly, IBM is a big position for Berkshire, and Buffett is buying more IBM stock at current prices, so he must have strong reasons to do so.
This is a particularly interesting case, since IBM stock has delivered dismal returns over the last three years, declining by 18.8% versus a big increase of 54.4% for the S&P 500 Index over the same period.
No surprises
One of the main reasons for the decline in IBM stock price is that revenues are falling, which is something that is spooking investors and Wall Street analysts away. The company is divesting its low margin businesses in order to better focus on its most profitable divisions with superior strategic value, and currency fluctuations are also a considerable drag on performance.
In this context, IBM reported a 6% decline in revenue from continuing operations during 2014. When adjusting for divested businesses and currency fluctuations, the decline was a much more moderate 1%, but sales are still moving in the wrong direction. Non-GAAP operating earnings per share fell 1% during the year.
In an interview with CNBC on Monday, Buffett said that there have been no surprises regarding IBM and its stagnant revenues over the last few years. Transformations take time to produce results, and the Oracle of Omaha is all about patience and investing for the long term.
In fact, Buffett said in the interview that he is feeling quite happy with the decline in IBM's stock price, as this allows the company to repurchase more stock at convenient prices. This is not an excuse the Oracle of Omaha is making because of the disappointing returns Berkshire is getting from IBM. In his 2011 letter to Berkshire investors, Warren Buffett wrote:
Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company's earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: 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.
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.
The bullish case for IBM
Share buybacks are one of the main reasons why Buffett is invested in IBM, and what the company is achieving in that department is nothing short of amazing. IBM has reduced its average diluted share count by more than 40% in the last decade; in addition, IBM has raised dividends per share by 450% through that period.
IBM Average Diluted Shares Outstanding (Quarterly) data by YCharts
While overall revenues remain stagnant, sales from the segments that management has identified as "strategic imperatives" -- meaning cloud, analytics, mobile, social, and security technologies -- are doing remarkably well. Sales in these divisions grew 16% in 2014, and that was in spite of strong currency headwinds. Together, these businesses account for 27% of total revenues, since they will most likely continue outgrowing the rest of the company in the coming years, their contribution to overall growth rates should continue increasing over time.
Valuation is also compelling, IBM trades at a forward P/E ratio of 9.6, nearly half the average valuation for companies in the S&P 500 Index. If the company's transformation generates accelerating growth in the coming years, then IBM stock offers considerable upside potential from current levels.
Investors should never blindly follow the decisions of others, not even when it comes to an investing superstar like Warren Buffett. However, considering IBM's massive capital distributions, opportunities to accelerate growth in the future, and attractive valuation, there are solid reasons to give IBM some serious consideration.
