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Warren Buffett announced on CNBC on Monday of last week that he has invested $10.7B into IBM (NYSE:IBM). Buffett has also recently invested an amount of money in Intel (NASDAQ:INTC). Let’s look at what Buffett sees in IBM in particular.

In 2007, IBM laid out a roadmap to achieve $10-$11 of earnings per share by 2010. At that time the EPS was $6.11 for 2006. In 2010 IBM achieved an impressive EPS of $11.53, thereby exceeding their target. Now, in 2011, IBM has laid out a roadmap for 2015 of $20 per share. If they achieve this target, their EPS would increase by a compounded annual growth rate of 11.6%. This target is based on a conservative base revenue growth of 2%, plus revenue growth achieved through strategies such as shifting to a faster growing business mix, further growth through acquisitions, and their EPS values will enhance through continued large share repurchases.

IBM is buying back a lot of shares which adds value to shareholders. The repurchases make its shareholders equity smaller and hence return on equity higher.

As Buffett touched on in the interview, IBM’s competitive advantage lies in the switching costs of its customers. Even ignoring the expense, it is too much of a hassle for large companies to change over their IT service provider. Buffett also mentioned in his interview on CNBC that IBM recorded double digit growth in 40 countries in 2010. IBM is positioning itself well to take advantage of the development of emerging economies, and the majority of IBM’s organic growth will be achieved in that area. IBM has reinvented itself a number of times throughout its 100+ year journey which has enabled it to continue to grow into the huge company that it has become. IBM's performance has been remarkable over such a long period of time, and the reason for its success over many generations is without a doubt its culture of innovation. Its employees, often called IBMers, have garnered a myriad of awards including 5 Nobel Prizes. IBM holds more patents than any other U.S. technology company.

Quality Rating

IBM QR
(Click to enlarge)
Source: usastockvaluation.com

IBM’s quality rating is not as great as one might expect. The reason is perhaps due to the fact that IBM is so big, and hence growth rates are not as high as a smaller company. Having said that, other big tech companies such as Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) and Microsoft (NASDAQ:MSFT) enjoy much higher quality ratings. The other reason is IBM’s persistently high net debt to equity ratio – though as mentioned above, IBM’s reported shareholders’ equity is low due to share repurchases, resulting in a perhaps misleadingly high net debt to equity ratio.

Intrinsic Value

IBM IV
(Click to enlarge)
Source: usastockvaluation.com

A reasonable margin of safety exists at the moment for IBM. For a big strong company such as IBM, an investor will almost never see a really large margin of safety, and so apart from exceptional circumstances (such as March 2009), the current margin of safety is around about as big as it gets.

IBM IV Graph
(Click to enlarge)

We recently analyzed Microsoft and it had a similar looking graph to IBM. During the dot com bubble all tech stocks became well overvalued, and once the bubble burst some of the bigger and better companies such as MSFT and IBM were spared in the slaughter, relatively speaking. So as a result, their share-price remained overvalued. Since then the share-price has gone sideways while intrinsic value catches up. As can be seen from the above graph, it didn’t take long for IBM’s intrinsic value to catch up to its share-price, and over the last 7 years or so the intrinsic value has stormed ahead and left IBM’s share-price in its wake. Now does look to be a fantastic opportunity to buy into a big strong 100 year old company. From a value point of view, Buffett looks to have nailed this one on the head. But how could a company trading at around 52 week highs be “in value”? The answer?: 52 week highs and lows tell you absolutely nothing about a company’s business performance relative to its share-price.

Investment Grade Score

With a margin of safety of 30, and a quality rating of 59, IBM achieves an investment grade score of 18 which places it at number 104 in our investment grade table. By multiplying the margin of safety by the quality rating (then dividing by 100), only those companies with a good combination of quality and value make the upper echelons of the investment grade table.

Conclusion

Warren Buffett in his role at Berkshire Hathaway (BRK) has to invest huge amounts of money. In 2010, BRK generated an average of $1B per month in free cash flow and that is $1B per month that Buffett has to find a home for. Buffett only investigates huge companies because it is only huge companies that have enough market capitalization to be able to absorb the huge dollars that Buffett has to invest. The average investor such as you and I have a massive advantage over Buffett in this case. We can invest in young up and coming companies with wonderful growth prospects [one that springs to mind immediately is Medifast (NYSE:MED)], whereas Buffett can’t. In terms of percentage returns, this gives us an extraordinary advantage over Buffett. Because he has to invest large amounts of money, it is impossible for Buffett to earn the sort of percentage gains that he enjoyed 30 or 40 years ago. Buffett has to invest in the best of the big companies, whereas we can invest in any listed company.

For you and I, we can analyze medium cap and small cap stocks to find companies with wonderful long term growth prospects. Companies that are yet to be covered by mainstream analysts, and hence yet to be recognized by the market. We like to see portfolios focused on investing over the long term (5-10 years) in these young up and coming companies (just a Buffett did 30+ years ago). Extraordinary long term wealth can be generated this way. But the idea of portfolios holding one or two “stalwarts” in there as well so as to smooth out volatility has merit also. There are plenty of other more attractive investment opportunities available at the moment to the average investor, but an investor who is looking to add a big, high quality “stalwart” to their portfolio may like what they see in IBM at current prices. For Buffett, who can only invest in large cap companies, IBM looks to be a great choice. The master is back in form.

Intel

And just a few quick notes on Intel – it has zero net debt, our quality rating of 69/100, a current intrinsic value of $23.39 (vs. a share price of around $24.30) rising to $25.62 next year and $28.37 in 2013. It’s NROE for 2010 was an excellent 25%. Without conducting further analysis, it is hard to see what entices Warren Buffett to invest in Intel given the lack of margin of safety. Back in August and September (which is perhaps when Buffett bought into it?) it was around $20 which was better value than the current share-price.

Source: Analysis On Buffett's IBM Investment