Friday, October 11, 2013

Buffett's Purchase of IBM Revisited

In November of 2011, Warren Buffett revealed on CNBC for the first time that he had been buying shares of International Business Machines (IBM).

Buffett on IBM: Berkshire Buys Big Blue

He apparently began buying in the first quarter of that year and some will rightly note that the stock hasn't done much since then.

Certainly not, for example, compared to the S&P 500.

Berkshire Hathaway's (BRKa) cost basis in the stock is something like a little over $ 171 per share.

As I write this it is selling at roughly $ 185 per share (though, fortunately, earlier this week it went even lower).

So has it been a good investment for Berkshire?

It is, in fact, a very large and likely long-term position for the company. The stock hasn't done much but, as I'll get to below, earnings per share sure has.

Why Buffett Wants IBM's Shares "To Languish"

Here's how Buffett explained how he looks at IBM -- a company that's been repurchasing shares at a good clip for some time -- in the 2011 Berkshire Hathaway shareholder letter:

"When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well."

IBM has, in fact, been consistently repurchasing stock for quite some time.

If shares are selling at a plain discount to value, a temporarily even lower share price just increases the effectiveness of future repurchases for continuing shareholders.*

Buffett goes on to explain his thinking on IBM and their share repurchases this way:

 "....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."

This mostly comes down to the power of well executed share repurchases. They can work extremely well over the long haul when shares are bought nicely below intrinsic value, business prospects are at least solid (i.e. moat reinforcement/strengthening is not being neglected) and the company is in a comfortable financial position (a healthy balance sheet, lots of liquidity sources, along with robust even if fluctuating somewhat free cash flow).

Buffett walks through the math in the letter to further explain why he wants IBM's stock to "languish".**

The bulk of the IBM position for Berkshire was established in the 2nd and 3rd quarter of 2011. Buffett would have been able to see that IBM had earned $ 11.52 per share in its, at that time, most recently reported full fiscal year (2010).

Let's compare that to now. For 2013, earnings per share should come in at ~ $ 16.00 per share. That's obviously not such a bad increase in per share earnings power especially for what is a rather large company. Of course, there's certainly no guarantee that this earnings power will be persistent. That's only one of the many important judgments -- some easily quantifiable, many that are not -- any investor has to make.

Businesses -- even those that are, at least in my view, very much superior to IBM -- inevitably run into difficulties from time to time. The question becomes whether a particular business possesses -- and can further build -- enough advantages to produce attractive earnings over the longer haul.

The price paid should always represent a clear discount to the present value of conservatively estimated future earnings. There's some real ambiguity about what should be considered, within a range, IBM's normalized future earnings power. So the price paid should more than reflect such ambiguity. Otherwise, when a stock that's purchased at a plain discount to value temporarily goes to an even lower price -- especially if "temporarily" proves to be an extended period of time -- it's not at all a bad thing for the long-term owner.
(As long as the enterprise maintains an ongoing financial capacity to buyback shares.)

Berkshire has also been receiving a growing but still just decent annual dividend that now sits at roughly 2%; a nearly 50% increase in the dividend payment since early 2011.

Make some conservative assumptions on dividend growth (along with the impact of buybacks) going forward and that now modest payment seems likely to be rather a whole lot less modest 7-10 years out. Shares repurchased at attractive prices should, all else equal, eventually fuel earnings per share and, ultimately, dividends per share over the longer run. Over many years, especially if the stock remains low and the business performs at least reasonably well, the compounded impact of the share repurchases should be not inconsequential.

"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.

Charlie and I don't expect to win many of you over to our way of thinking – we've observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus."

So the key is the price compared to value and whether one thinks business prospects are likely to remain attractive (even if, as in the case of IBM, maybe a bit unexciting). The current valuation just doesn't demand spectacular business performance to achieve satisfactory risk-adjusted returns. Instead, it simply demands merely solid business performance and continued smart financial management. Price paid and, as Buffett points out in his 2011 letter, earnings performance "for a long time to come" will ultimately influence long-term investment results.
(Though not necessarily earnings performance in any given year or even over somewhat longer time frames. This is especially relevant when a business is going through some kind of transition or when macro factors come into play.)

Unfortunately, with some public companies, share repurchases are done at unattractive valuations and for the wrong reasons (e.g. to prop up the stock or to offset dilution from stock options).

It's when a stock sells for a plain discount to conservatively estimated per share intrinsic value, and the company can comfortably afford it, that a buyback makes sense.

I don't doubt that market participants primarily in the business of betting on price action will maintain this was not such a great investment. That view may even prove correct. Those looking for quick speculative gains will likely find IBM to be a mostly uninteresting place to put their money at risk. If nothing else, IBM is the sort of investment that's almost certain to not make someone quick and substantial returns.

Some will correctly point out the lack of revenue growth prospects; IBM's organic revenue growth has been pretty much nonexistent (or worse) for some time.

That's likely to continue.

While revenue growth can be a fine thing, it can't be viewed in a vacuum; not all incremental revenue is of the high return variety. Some opportunities produce growth without producing attractive returns on capital.

Excess capital should be returned to shareholders when it can't be put to good use elsewhere (i.e. when only subpar or worse investment alternatives exist). Well, in too many cases, that's just not what happens.

Of course, some might view IBM's share repurchases as just an attempt to prop up earnings. No doubt some companies do just that. I happen to think this doesn't apply to IBM when you consider how they've handled their financial management responsibilities over time.
(Buffett does highlight the quality of IBM's financial management in the 2011 letter.)

The specific context matters when it comes to share repurchases.

Among other things:

- How price paid compares to a conservative estimate of intrinsic value

- The attractiveness of investment alternatives

- The durability of the core business franchise

- Inherent capital intensiveness

- Financial health (balance sheet and free cash flow)

IBM is ultimately a technology business.

That's the bad news.

For that reason alone the company's stock will never be a favorite.

Naturally not all technology and technology-related businesses possess similar inherent risks; some new tech startup, for example, has very different specific risks associated with it compared to IBM. Up to a point it's true that the price paid can minimize the risk of permanent capital loss, but only up to a point.

Sometimes the risks of a business are so difficult to gauge that no price is low enough to provide sufficient margin of safety.

At some point the right answer is to just avoid.

For me, that's often the right answer with shares of technology businesses.***

From earlier in the 2011 letter:

"The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another."

There are certainly far better businesses out there but, once the inherent risks and opportunities are understood well enough that it gets beyond the go/no go decision, the investment process always comes down to price.

Adam

Long position in BRKb established long ago at much lower than recent prices. Recently added a small IBM position for the first time at somewhat lower than current prices.

Related posts:
Buffett on Buybacks, Book Value, and Intrinsic Value
Buffett on Teledyne's Henry Singleton
Why Buffett Wants IBM's Shares "To Languish"
Buffett on IBM: Berkshire Buys Big Blue
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Technology Stocks
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Buy a Stock...Hope the Price Drops?

* Share repurchases may happen going forward but will only make sense if the shares remain cheap enough. In other words, nicely below per share intrinsic value. Repurchases that are executed above approximate per share intrinsic value is generally poor use of capital. Since estimated per share value is best case an imprecise range, there should be a plain margin of safety. The discount to value should be obvious. Share count reduction needs to accomplished in am economically sound manner. This should be something an investor can count on but, unfortunately, that's not the case.

** In the letter, Buffett explains the relatively simple yet important repurchase math. Essentially, he points out that if IBM's stock price were to average something like $ 200 during a given period the company would acquire 250 million shares for its $ 50 billion. If the stock instead sold for $ 300 on average during the five-year period IBM will acquire only 167 million shares. He says that, over the five years, Berkshire's share of those earnings would be a full $ 100 million more in this "'disappointing' scenario". Also, if the stock were to fluctuate near current prices -- which are now even lower than the "'disappointing' scenario" -- it would work out even better. In the very long run the "weighing machine" will reflect roughly the additional per share value of those incremental earnings.
*** I realize some others may feel more comfortable with tech stocks but, with investments, buying only what one knows well is essential. That is necessarily unique to each investor. Gauging the future prospects of most tech businesses is tricky at best. At least it is for me. 
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