Monday, November 14, 2011

Buffett on IBM: Berkshire Buys "Big Blue"

This morning on CNBC, Warren Buffett revealed that Berkshire Hathaway (BRKa) had accumulated a large stake in IBM (IBM).

The sheer size of the purchase is, in itself, news. That Buffett is buying a technology company at some scale even more so.

How things seem to have changed.

It's clear that the valuation landscape of some larger capitalization technology franchises is nothing like a decade ago.

Many these days are very inexpensive with quite a few even selling at price to earnings ratios in the single digits.

According to Buffett, the number of shares of IBM bought by Berkshire was around 64 million at an average price of ~$ 170/share.

So the actual amount invested in IBM looks to be somewhat less than $ 11 billion.

As of Friday's close, the share price of IBM was $ 187.38/share meaning, at this time, the shares are now worth more like $ 12 billion.

Even considering Berkshire's size, this is certainly not at all a small stock purchase.

To put it in perspective, at Friday's closing price here is how the new stake in IBM compares to the size of Berkshire's three other large holdings*:

Coca-Cola (KO): $ 13.6 Billion
IBM (IBM): $ 12.0 Billion
Wells Fargo (WFC): $ 9.0 Billion
American Express (AXP): $ 7.6 Billion

Those 4 stocks now make up roughly two thirds of the entire $ 60 billion plus Berkshire Hathaway domestic equity portfolio.

It will be interesting to learn over time what Buffett views as IBM's durable competitive advantage(s).

Historically, Buffett has made it clear why he avoids things like technology businesses. His preference is for businesses and industries with little change.

On many past occasions, Buffett has explained how difficult he finds it to gauge the economic durability of any business that is in a fast-changing industry. An example:

"...you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek." - Warren Buffett in the 1996 Berkshire Hathaway Shareholder Letter

What's the economic moat? What is it going to look like in ten years or so? Will it grow or shrink? By their nature, tech businesses often reside in a rapidly changing and competitive industry environment so it is hard to gauge these things.

Now, the IBM of today is nothing like old-school IBM. The company's business model today places more emphasis on providing higher margin software and service to IT departments, less on the brutally competitive lower margin hardware business of its past.

Their current way of doing business would seem to offer more flexibility, utilizing IBM's expertise to adapt to changes in the technology landscape. Quite a bit less vulnerable to technology shifts, more about being a trusted source that helps IT departments do their job better.

In the CNBC interview, Buffett did say "I've probably read the annual report of IBM every year for 50 years" and that this year he "got a different slant on it."

Buffett also said he checked with the IT departments of the company's Berkshire owns:

"...to see how their IT departments functioned and why they made the decisions they made. I just came away with a different view of the position that IBM holds within IT departments and why they hold it and the stickiness and a whole bunch of things."

So there is some form of a durable moat at work here. Hearing a more comprehensive explanation at some point of how Buffett sees IBM meeting the "certainty we seek" threshold noted above will be of some interest.

He was also complimentary of IBM's shareholder friendliness. As an example, the company has reduced share count substantially since the end of 2006. Shares outstanding was lowered from over 1.5 billion to 1.2 billion since the end of that year.

IBM currently sells for slightly more than 14x earnings so, while not expensive, not nearly as cheap as some other large cap technology companies.

During the interview, he was questioned by Joe Kernen of CNBC on why the purchase of shares in IBM was at what at least seemed a higher price. In other words, not expensive but not really a bargain, either. There were, in fact, many chances to buy it much cheaper not long ago. His response:

"We bought railroads on highs..."

and

"...I bought control of GEICO at its all-time high."

As investments, in both cases, these two examples worked out more than okay for Berkshire's investors.

To an extent, Buffett did equate coming to the IBM party late, so to speak, with how his views changed on the railroads. He said that railroads "were something I should have spotted years earlier" that finally "just hit me between the eyes and it was there."

The impression, somewhat understandably, seems to be that Buffett has some unique ability to buy things when they are hitting at or near new lows or that he is often shrewd about getting exposed to an idea early. A quick check of history reveals otherwise.

Sound judgement of value**, how it may change over time, and the discipline to buy shares of a good business when selling at a comfortable discount is what has been and always will be what is crucial.

Being early on a good idea and/or buying something near all-time lows is tough to do consistently, even if a nice bonus when it happens, but fortunately is also not a required skill to produce above average long-term returns.

The aforementioned sound judgment of value and buying discipline certainly is required.

The difficult part, at least for many, is the ability to deal with short or medium term losses on paper. Now, if value has been judged too high or too much was paid, there's probably nothing "paper" about those losses.

Unless luck intervenes odds are they're real and permanent.

It's not at all unlikely that a cheap stock will at least temporarily even get cheaper. So sometimes those paper losses will persist for quite a while. Yet, as long as current value and likely increases to value has been judged reasonably well, that stubbornly low price is actually a net benefit to long-term owners.

The reason? Some shareholders, likely those with less patience or conviction annoyed by the lousy stock price action, end up selling shares below their intrinsic value (whether a loss to them individually or not) so they can move on to something they feel has a quicker and certainly more near-term explicit upside. For some, the game is first and foremost price action not price versus value.

A time horizon that is less than 3 to 5 years, never mind 3 to 5 minutes, doesn't work. The process plays out over many years, preferably a decade or more, and in a hyperactive-attention-deficit oriented market, this whole approach probably seems to make little sense.

Seems being the operative word because the pure long run arithmetic involved here is actually relatively simple to understand.

The shares being sold below intrinsic value, mostly by the impatient and annoyed, end up either repurchased (if management is doing its job), in the hands of new value-oriented buyers, or in the hands of long-term holders who'd like to accumulate more of the business while still cheap. The portion of profits sold for less than full value ends up directly benefiting long-term owners, of course.

That benefit, on a compounded basis over a long enough time horizon is not small.

Of course, substantially misjudge the value, how that value may change over time, or pay a large premium to value and the outcome will probably be much less favorable. Permanent capital loss becomes more likely when value is misjudged and/or an investor pays too much.

Buffett began to buy IBM's shares back in March of this year but, since sometimes the SEC allows Berkshire's buying to be kept confidential, the position wasn't known until it was disclosed today. Permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.

Adam

With the exception of IBM, I am long each of the stocks in this post.

Related posts:

Technology Stocks
Bufett: Severe Change, Exceptional Returns Don't Mix
Buffett on Competitive Dynamics
Buffett on Space Exploration

* Based upon the 2nd Quarter Berkshire Hathaway 13F-HR (the latest available equity portfolio snapshot). The 3rd Quarter 13F-HR should be released later today. 

** Value driven by the size of the economic moat/sustainability of its competitive advantage, high return on capital, a management culture that tends to allocate capital wisely etc.
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