Friday, June 20, 2014

What Attracted Warren Buffett to IBM?

Back in 2011, Warren Buffett invested billions of dollars in IBM. This move by the Oracle of Omaha surprised many, since he is widely known to avoid technology stocks. Of course, these people do not know that Buffett made millions investing in a tech start-up in the 1950s. Currently, his company Berkshire Hathaway (BRK.B) holds a 6.30% stake in IBM.

Buffett and his partner Charlie Munger acquire businesses that are (1) Easy to understand (2) Have durable moat (3) Run by able and honest management and (4) Fairly priced.

The business of IBM is relatively simple to understand. It provides IT support services to companies on a global scale. Over half of revenues are recurring. The company is divided in five segments: Global Technology Services, Global Business Services, Systems and Technology, Software and Global Financing. International operations generate almost two-thirds of revenues.

Per Buffett’s comments, it is tough for companies to change auditors, lawyers and IT consulting firms like IBM. Once you have established the relationship, you will keep using their services for many years.

The business is managed by honest and able managers, who are setting up goals, and executing their strategy accordingly. One of the reasons why Buffett invested in IBM in the first place was the fact that management had outlined their plan to earn $20/share by 2015. In that plan, it is evident how exactly they would achieve that. In addition, the management was able to transform IBM from a company focused on hardware, into a firm that focuses on software, services like consulting and IT solutions.

The thing that appeals to me is the fact that management returns a lot of excess cash to shareholders in the form of dividends and share buybacks. IBM is a dividend achiever which has rewarded long term investors with an increase for 19 years in a row. In addition, IBM has managed to consistently buy back stock, through thick and thin, unlike other corporate boards. The company has managed to retire a significant chunk of outstanding shares over the past 20 years, and has managed to accomplish that at pretty attractive valuations as well.

The main concern investors have is about flat or declining total sales. This could be an issue, since you can only cut costs and streamline so much out of your bottom line. Of course, if the company can manage to get rid of businesses that generate revenues but do not have solid margins like hardware, and focuses more on software and services, which have much higher margins, this could translate into a win for the bottom line. While revenue growth is important, it is equally important to actually improve the profits, which is where dividends are paid from. Mindless acquisitions or chasing revenue is usually not a good strategy, although at some point in time revenues at IBM do need to start picking up.

The stock is trading at a pretty low P/E ratio of 10.20 forward earnings, which is the lowest in over a decade. In addition, IBM is spotting its highest yield in years at 2.40%. I own a little of the stock, and plan on adding to my position in my Roth IRA in 2014. Obviously, many investors have low expectations for the company, which explains the depressed stock price. Hence, this could provide some nice returns to contrarian investors. However, I also like Accenture (ACN), since it has much better cash flow generation capabilities and revenue growth that IBM lacks. Accenture is selling at 18.30 times forward earnings and yields 2.20%.

Full Disclosure: Long IBM and ACN

Relevant Articles:

Should you follow Buffett’s latest investments?
Four dividend paying companies with long term growth plans
Five Dividend Paying Companies with Consistent Share Buybacks
Accenture PLC (ACN) Dividend Stock Analysis
IBM (IBM) Dividend Stock Analysis

10 comments:

  1. Accenture is a cash cow. Their USA consultants work onsite (20%) or overseas (80%) so the company has little overhead. Generous contract rates are achieved with the same sticky relationships used by IBM and other good companies. Accenture is the new ObamaCare website contractor and will receive high profits to get that disaster working.

    Long ACN, both wife and I are former employees.

    ReplyDelete
    Replies
    1. Hi Anonymous,

      Thank you for stopping by, and providing your input on ACN.

      Best Regards,

      DGI

      Delete
  2. DGI,
    Since you didn't include the normal charts in this article, I followed the links to your analysis of both IBM and ACN from last year. I see that you initiated small (less than 1% of your portfolio) positions in both companies even though the articles seem to indicate that you didn't consider them buys at the time you analyzed them. In the case of IBM in particular, did you relax your 2.5% dividend yield criteria? Or did you buy when the price dropped below $176 recently? Can you tell us how many stocks on on your watch list?

    Personally, I don't own IBM. I have been considering picking up shares since they appear to be a value play in a market that seems to be over valued. Thanks for another look at an iconic company.
    KeithX

    ReplyDelete
    Replies
    1. Hi Keith,

      I sometimes buy positions in stocks that have yields lower than 2.50%, but sell for less than 20 times earnings. However, I tend to put less money in those - say I put a half a lot ( half the amount I would usually invest in a company like an Aflac). Many of those lower yielding ideas however have high growth expectations in EPS and DPS, which can potentially translate into pretty nice yields on cost and high capital gains. I have a somewhat layered dividend growth portfolio, with a lot of companies in the sweet spot, a few with a high yield, and a bunch of small stakes in those I feel have good growth prospects.

      Check this article I wrote in 2010, for more information on what I am doing: http://www.dividendgrowthinvestor.com/2010/03/four-percent-rule-for-dividend.html

      I agree on IBM being a value play today. I bought ACN on a dip a few months ago, but haven't put anything there, as the price has started going up, up and up. If it doesn't go down by the time I have my money, I might not add $$$ there. I actually like ACN better, but that could be because I have had personal interaction with ACN employees, and not much with IBM (although I have used their web analytics software, tealef and it is pretty neat)

      Best Regards,

      Dividend Growth Investor

      Delete
  3. Well this makes me feel better about the fact that I purchased a chunk of this stock yesterday :)

    ReplyDelete
    Replies
    1. Hi Kyle,

      Thanks for stopping by. Good luck in your investing journey!

      DGI

      Delete
  4. Interesting post! I have not been that excited about IBM. I use their products in my day job as a software engineer. Licensing is expensive and we are doing the best we can to minimize our exposure their products. Doing this will save us several 100 thousand dollars a year (just for my small program), a good chunk of my company is moving toward this. I suspect this will reduce expenses by 5-10 mil per year for my facility. We are replacing with with Open Source tools and judging by what companies are looking for in a skill set they are too.

    I do like ACN though. They have done a good job building relationships with the customers and once entrenched that relationship stays for a long time. Plus, they have a very nice balance sheet.

    Take care!

    ReplyDelete
    Replies
    1. I have more experience with ACN than IBM, although ACN is more expensive than IBM today. I am afraid I am more biased towards ACN because of the personal experience with ACN, which might be costly because objectively speaking IBM is cheaper. IBM does offer a lot of options, and to a variety of customers worldwide, which is why I would be hesitant to focus only on my personal experiences. That being said, if you are a software engineer, chances are you might know more about IBM than I do. I do like the cheap valuation, the EPS targets, and the fact that everyone seems to hate IBM these days. This sounds like a recipe for very good returns going forward. Let's wait and see how this works out.

      Delete
  5. I was at a recent conference for my field and spoke with IBM at their booth. They are definitely moving towards software and services. Not one word was mentioned about hardware to me. I might look into them as well as I need a few more tech companies in my portfolio. Good analysis. Thanks!

    ReplyDelete
    Replies
    1. IBM is that blue chip behemoth, which has managed to reinvent itself in the 1990s, and now it seems to be still reinventing itself. Actually, this tech company has been around for over 100 years. I think that deep in their corporate culture, they have it that they need to keep staying current, which has allowed them to continue for so long.

      Thanks for stopping by!

      DGI

      Delete

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