Wednesday, May 6, 2015

Buffett and Munger on IBM

In an interview just prior to the start of 2015 Berkshire Hathaway (BRKa) shareholder meeting, Warren Buffett said that he purchased more shares of IBM (IBM) in the 1st quarter on 2015.

One thing to keep in mind is that IBM's stock dropped substantially during the 1st quarter. The stock currently sells at a higher price than what became available during the quarter.
(Though the shares are currently selling just below what was Berkshire's ~ $ 171/share cost basis at year-end 2014. )

We'll find out just how much additional buying occurred when the next 13F-HR is released later this month. The latest 10-Q shows that a bit more than $ 1.6 billion in equity purchases were made during the quarter.

So how much of these purchases was for IBM isn't known just yet.

According to the Wall Street Journal, Charlie Munger was asked at the meeting whether he considers IBM to be a "cigar butt." His response, essentially, was to say it's an enterprise that has mostly been able to adapt over the years and, importantly, they paid a "reasonable price."

Munger's comments were followed then by a noteworthy exchange with Buffett. From the Wall Street Journal's recap:*

Buffett jumps in to say that he never understands when people expect him to talk up Berkshire investments.

If we talked our book, he says, "we would say pessimistic things about all four of the biggest holdings we have" because all four are repurchasing their shares at the moment.

He asks Munger why people expect the opposite. Munger: "If people weren't often so wrong, we wouldn't be so rich."

Munger is usually good for some one liners.

This article offers some additional examples from the meeting.

Of course, Buffett previously explained in his 2011 letter -- in some detail -- that, for those with a long enough time horizon, it makes little sense to want well bought shares of a sound business to go higher in the near-term (or even longer). From the letter:

"When Berkshire buys stock in a company that is repurchasing shares, we hope...that the stock underperforms in the market for a long time as well."

Later he adds:

"'Talking our book' about a stock we own – were that to be effective – would actually be harmful to Berkshire, not helpful as commentators customarily assume."

A rising stock simply makes the buybacks less effective. A higher stock price simply means it's more costly to reduce the share count. That higher price paid, on a compounded basis, naturally hurts continuing owners. Yet Munger and Buffett understand this is usually a tough sell for those who are more interested in making speculative bets on near-term stock price action. More from the 2011 letter:

"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."

With this in mind, Munger's quip about the benefits of others being "often so wrong" is worth remembering.

At the meeting Buffett also said, when it comes to buybacks, "there's been more stupid stuff said and stupid stuff done" and emphasized that shares should only be bought back if selling below intrinsic value.

Seems obvious but, well, for some it's apparently not.

This past Monday on CNBC, Buffett once again talked about the importance of having the discipline to only buyback shares when they're selling below what they're intrinsically worth:**

"Buying in stock can be extremely dumb; it can be extremely smart. It was extremely smart for Henry Singleton at Teledyne, and I won't give you the names of people where it was extremely dumb. It all depends on whether your buying the stock for less than it's worth."

And he also said:

"...it's all case specific. We say that at Berkshire we'll buy our stock in -- and we'll buy it aggressively -- at 120% of book value. I know that at price the shareholders who stay are gaining on a per share basis because we are doing that. If we were to buy it in at 200% of book value our shareholders that were staying would be...penalized by that action."

What matters is if the shares were bought cheap against per share intrinsic value and compared to alternatives (opportunity costs). This is too often ignored by investors and managements alike. Some seem to think that if shares are repurchased then the stock proceeds to go lower prices it wasn't a smart buyback. That may be useful way of thinking for traders but it's the wrong way to think for long-term continuing shareholders.

CNBC Video - Buffett: We'll make 'considerable' money on IBM
CNBC Video - IBM's buybacks beneficial to shareholders: Buffett
CNBC Video - Why IBM and not Apple? Warren Buffett answers

I'd add that the estimate of intrinsic value should be calculated with conservative assumptions. Using more aggressive assumptions to justify estimated value is a recipe for insufficient margin of safety or worse. A satisfactory result shouldn't be dependent on great things happening.
(At least if risk and reward is being managed in a sound way. IBM may have been able to adapt in the past but that reveals little about the future.)

As a stock, IBM hasn't done much since Berkshire first bought it several years ago. Yet both Buffett and Munger still seem to consider it a sound investment. Time will tell whether they're correct in their judgment (mistakes are made by even the most capable investors), but it's not about what the stock does in the near or even intermediate term; it's whether IBM can maintain meaningful competitive advantages in a rapidly changing environment; it's whether IBM's core business economics will remain roughly intact and how excess capital will be allocated over the coming decades; it, ultimately, comes down to the price paid relative to per share intrinsic value and how that value changes over time.

Under the right circumstances -- primarily when shares sell at a nice discount and the business can easily afford it -- repurchases can end up being, all else equal, incrementally beneficial to per share intrinsic value.***

Those who speculate on price action, even if in a very skilled manner, are mostly involved in an entirely different game.

Adam

Long position in BRKb established at much lower than recent market prices. Also, long position in IBM established at slightly lower than recent prices. (In both cases compared to average cost basis.)

Related posts:
The P/E Illusion
The Benefits of a Declining Stock
Buffett's Purchase of IBM Revisited
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
Buffett: Indebted to Academics
Buy a Stock...Hope the Price Drops?

* Also see The New York Times coverage of the meeting.
** From the 2011 letter: "Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company's intrinsic business value, conservatively calculated."
*** Keep in mind that overall business value can change much more modestly than per share value over time or, actually, even not at all. For example: if share count is cut in half through share repurchases and the earnings of a business remains constant in perpetuity over time, then the per share value, assuming for simplicity that all other elements of value are equal, doubles while overall business value does not; the same earnings divided by half as many shares outstanding will naturally double earning per share. If the doubled price -- to simply reflect the doubling of per share earnings -- is multiplied by one half as many shares outstanding, the market value will be the same overall even though each owner who hangs in there owns something roughly twice as valuable on a per share basis. If one assumes durable earnings are 100% used for buybacks, and shares are bought back, on average, at a high single digit multiple of earnings, then share count is comfortably more than cut in half over 7-10 years (even accounting for the likely repurchase price increase over time as per share earnings rises due to share count reduction). Instead of growth it's the high earnings yield (inverse of price-to-earnings), over a long enough time horizon, that increasingly becomes the dominant factor when it comes to producing returns. This works for even the largest enterprise. The so-called law of large numbers can distract from this possibility. Individual owners can do just fine when a business -- large or small -- is able to reduce its share count at attractive prices with modest or even no growth. Now, there's no guarantee the market price will fully reflect the increase in per share value but, in the long run, if earnings per share is increasing (while, once again, overall business value hardly changes if at all) at a satisfactory rate, good things seem likely to happen for those who stick around. In other words nothing spectacular has to happen to get a satisfactory or better result. It's possible that the future multiple of earnings investors are willing to pay contracts further but, in fact, that would simply create an additional earnings yield tailwind over the longer run. The compounded effects of this over many years is at times underestimated. What's most important, at least for me, is the implications of this when it comes to balancing risk and reward. Not insignificant. No one complains when a stock rises after purchase, of course, but the opposite can work out more than just fine under the correct circumstances. So, mo matter what direction the stock goes soon after purchase, it can be heads I win...tails I win more for someone able to judge growth-challenged/turnaround situations reliably well enough. The same effect is not meaningful for a stock that sells at 100 times earnings because the earnings yield, and incremental earnings yield as the market price drops, is just not substantial enough to matter. For the high multiple stock, growth then necessarily becomes the dominant factor with the downside usually being not small if growth prospects don't quite materialize. Consider two scenarios where a stock suddenly drops 50%: 1) A stock selling for 100 times earnings that drops to 50 times earnings turns a 1% earnings yield into a 2% earnings yield -- incrementally, a 1% increase in yield for every future incremental purchase/share repurchase. 2) A stock that goes from 10 times earnings to 5 times earnings turns a 10% earnings yield into a 20% earnings yield -- incrementally, a 10% increase in yield for every future incremental purchase/share repurchase. If the multiple stays low long enough and the investor hangs in there long enough that substantial yield becomes the main driver of returns. The high multiple stock can't put a meaningful dent in share count over 7-10 years with a 1-2% earnings yield; the low multiple stock certainly can. If nothing else it's worth remembering that the math is such that growth is not necessarily required when the multiple is low enough and the earnings prove durable enoughThis way of thinking may be of little use to those who mostly make bets on near-term price action, but matters a great deal for those who tend to invest in shares with a decade or two in mind. Growth often comes at too high a price. A premium price should only be welcome when it comes time to sell. Multiple expansion is overrated for the owner who truly has no intent to sell for many years; it matters a great deal to those who place short and intermediate term bets. Selling is almost always imminent for the speculator; less so for the investor. The challenging part, of course, is gauging whether earnings power will prove persistent roughly near current levels. Most businesses that sell for a single digit multiple of earnings have the kind of fundamental difficulties ahead that make figuring out what normalized earning power really is not at all straightforward. More specifically, that's what makes IBM's longer term prospects so tough to judge. The earnings may in fact keep going down down down. Permanently and meaningfully impaired earnings is a real problem. A temporarily reduced stock price, even if it persists for years, is certainly not. The job of a long-term investor, while never easy, in fact becomes at least somewhat easier when a stock already bought at a nice discount to conservatively estimated value drops even further.
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