A Warren Buffett 'Mistake' That Has A Lot To Teach Us About Investing And IBM

| About: International Business (IBM)

In the first quarter of 2011, Warren Buffett began to build, on behalf of his company Berkshire Hathaway (BRK.A, BRK.B), a position in the shares of IBM (NYSE:IBM), the iconic technology company. And by the end of 2012, he had amassed a total of 67.5 million shares owning approximately 6% of the tech giant's shares.

I am a big fan of Mr. Buffett and he is my biggest role model from the investing world, but I believe that in this case he misjudged or ignored the deteriorating state of IBM's moat. As I will try to demonstrate below, I believe that IBM is a good business and that it offers a nice incentive for investors to bet that it will manage to conquer the challenging trends in its markets. However, it is not one of the "buy and hold forever" companies that are Mr. Buffett's stated investment target (and that's why I'm labeling this investment a "mistake" on his part).

The reason I'm saying this is that I believe that IBM's moat is eroding. This means that despite its iconic stature among professional IT executives and the mantra "No one got fired for outsourcing to IBM," IBM is slowly losing market share and the premium position it enjoyed in the minds of IT executives. For better or worse this isn't because IBM is doing anything wrong. It is because of new technologies that changed radically the way companies handle their IT infrastructure.

But before I speak about the way the industry is changing let's see what are the main products and services IBM offers to its customers:

  • IT outsourcing and infrastructure solutions: Effectively IBM builds and manages (if the client wants to) its clients' IT software and hardware.
  • Private cloud building: IBM offers businesses the ability to build and manage their own private clouds.
  • Business analytics and optimization solutions that help businesses manage effectively massive amounts of information.

Currently IBM is pressured in two of these main offerings: IT outsourcing and private cloud building. Due to public or semi-private cloud solutions, businesses have the ability to outsource their IT infrastructure at just a fraction of what in-house infrastructure would cost them. Behemoths like Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT) are major players in this space and both have the technical ability and the financing to take on IBM successfully, as they are currently doing.

Moreover, IBM's brand isn't invulnerable, and losing massive government contracts and other business to its competitors is hurting its public image even more. And while it has managed to do well over the last twenty years by staying ahead of various market changes, it is extremely difficult to maintain successfully this strategy in the long term.

And this is why I believe it is not a "buy and hold" investment. IBM doesn't have a long-lasting competitive advantage any more. Surely it will be alive and kicking in a decade or two but beyond that who knows? Its business situation doesn't have the same predictability that other Berkshire holdings have (like Coca-Cola, Wells Fargo or Procter & Gamble). However, Mr. Buffett didn't make his billions by being blindly optimistic. He made sure that he would have a good margin of safety in the case his IBM investment doesn't go as planned.

And that margin of safety is the company's massive cash flows, its dividend and its share buyback program. Despite the meager 2.5% average annual growth of its revenue over the last decade, IBM has grown its EPS at an average annual rate of 21%. The biggest part of this growth was because of margin expansion as IBM exited some of its low-margin hardware businesses to focus on more lucrative service oriented ones. However, 5% of this growth was due to IBM share buybacks, which IBM is committed to continue.

Furthermore, the company has a consistent dividend policy and has raised its dividend for 18 consecutive years, while during the last 10 years, it raised it by more than 10% every year. Now it pays out $3.8 per share which, at its current price of $183, is a 2% yield. Keep in mind also that currently IBM pays out only 25% of its earnings and thus has plenty of room to keep increasing its dividend at a double digit annual rate.

So even if IBM's bottom line stops to grow over the next decade or so, the value of its investment would more than double over this time period due to IBM's dividend and share repurchases. Pretty good for a "downside" scenario don't you think?

Nevertheless, I haven't written this article because I have a beef with Mr. Buffett but because there are two key lessons to take from the reasoning behind his investment in IBM.

The most important one is to always try to have a margin of safety in your investments. If priced right, a good investment opportunity should offer big returns in a "good case" scenario and small returns (not negative ones) in the case that things go awry. Of course no one can predict the future but if you invest following this principle then you'll certainly enjoy good investment results without risking any portion of your capital.

The second take is about IBM. Despite the fact that this company's future is uncertain, it offers a nice 7% value increase to investors willing to bet that it will manage to come on top of its changing markets. And it has two advantages as it tries to adapt to the new "cloudy" landscape.

  • The first advantage is its cash flow generation and its stellar balance sheet. IBM generates about $13.5/share (close to $5 billion) of free cash flow annually and has $10 billion in cash and a low level of debt (just 2 times its FCF). The company is in perfect shape to buy any technology or company necessary in order to adjust its products and services as fast as needed.
  • The second advantage is the relationship it has with its existing clientele. IBM's customers rely too much on IBM's products and services to change provider quickly. And this along with the feedback IBM gets from them give it the necessary tools to not only retain them but to offer new products and solutions perfectly suited to their needs.

These two advantages give IBM some "slack", and although it is currently losing market share, it has more than enough time to regroup and retaliate. So the question prospective investors must ask themselves before investing in IBM is this:

"Do you believe that IBM will manage to come on top of its industry's changes? And is a 7% annual value appreciation good enough for you to stay around to find out the answer?"

My answer to this question is that for my personal circumstances a 7% annual value increase isn't enough and thus I won't stay around to see.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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