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

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