The recent semi scandal over how some Fidelity analysts apparently found a way to rig in their favor the chances to get some questions asked at Berkshire’s (BRK.A) Annual Shareholding Meeting gave us the opportunity to re-read some questions they asked. Apparently, they were the ones that submitted a question asking Buffett what he would do differently if he were just starting to invest in this day and age. His answer was that he would try to understand technology better, and increase his circle of competence in that direction. That was probably one of the strongest clues that he was starting to consider more seriously making investments in that sector. As most Buffett followers now know, he invested during 2011 almost eleven billion dollars in IBM (IBM), the largest stock market investment he has ever made!
This should make us pause for a moment and ponder if there are some lessons to be learned here. We have first to remember that Warren has systematically avoided technology companies, even passing on what could have been one of the best investments in his career (he had the opportunity to be one of the first investors of Intel (INTC)). So what made him change his mind?
The problem with most technology companies from a business perspective is that their moats, or competitive advantages, are not always very sustainable. They can be very wide, resulting in huge market shares and profitability, but are also at risk of a better technology disrupting them. Charlie Munger, Buffett’s business partner, even remarked that Google (GOOG) was probably the company with the biggest moat he had ever seen. The risk obviously is that someone comes along and develops a much improved algorithm for ranking websites and does to them what they did to Yahoo! (YHOO). That risk has been somewhat mitigated by their scale and brand recognition, and to a lesser degree to their diversification efforts, but a significant risk remains. The other issue with technology companies from an investment perspective is that they usually command higher valuations. Many times the premium valuations are justified, since they usually have better growth and profitability prospects. So how and why did Buffett’s largest stock market investment ever turn out to be in a sector he supposedly avoided?
To answer that question we might have to take a step back and take a brief look at the pharmaceutical sector. Buffett was once asked if before investing billions into Johnson & Johnson (JNJ) and Sanofi Aventis (SNY) if he had analyzed the prospects of their drug pipelines. His answer was that he did not really know or understand the drug pipelines of his pharmaceutical investments and that he simply looked at the historical performance of the company and concluded that some new products would be successes and others would fail, but that on average they should continue to do very well. The lesson here being that Buffett sometimes simplifies things by taking a statistical approach based on previous results. Maybe IBM’s cloud computing bets will pay off big time, maybe Watson was just a huge waste of R&D dollars, or maybe it will turn out to be the other way around.
The moral of the story is that Buffett is not betting on any specific technology IBM has or is developing, but that he has taken a statistical approach to past results and feels comfortable knowing that it is a company with significant diversification (geographical and technology wise), has a valuable brand, good management, and that there are very high switching costs for their customers. In fact he remarked in a CNBC interview that the high switching costs were one of the reasons he made the investment in IBM:
The IT departments, I—you know, we've got dozens and dozens of IT departments at Berkshire. I don't know how they run. I mean, but we went around and asked them and you find out that there's—they very much get working hand in glove with suppliers. And that doesn't—that doesn't mean things won't change but it does mean that there's a lot of continuity to it..
From a recent IBM investor presentation we learn several interesting facts:
- Huge geographical diversification (roughly 30% USA, 30% EMEA, 30% Asia, 10% Canada & Latin America), presence in more than 170 countries.
- They met their 2007 roadmap to achieve $10-$11 of earnings per share by 2010.
- They significantly outperformed the S&P500 in the last five years.
- The new goal is to exceed $20 dollars of operating earnings per share by 2015.
- Most of the revenue growth is expected for 4 areas (emerging markets, the smarter planet initiative, cloud computing, and business analytics).
- Margins are expected to expand as revenue shifts to higher value offerings (mainly more software revenues and less hardware/financing). As well as some productivity initiatives that should generate more savings.
- They offer a remarkably detailed plan for their free cash flow for the next five years, where they allocate $50 billion for share buybacks, $20 billion for dividends, $20 billion for acquisitions, and $25 billion for capital expenditures.
So what can we conclude from all this information? It gives us confidence in management. If they met the previous 5 year plan they probably have a decent chance of doing it again. Also, it shows they are committed to their shareholders by returning excess cash in the form of buybacks and dividends. Very interestingly, it can also help us estimate the return we could expect from an investment in IBM for the next few years. Assuming the price earnings ratio remains the same (which is currently around 14) and the 2015 plan is met, the market capitalization should increase by roughly 50% ($20 operating EPS target for 2015 divided by $13.25 operating EPS estimated for 2011). The dividends would add about 10% more. The result would approximate a 60% gain in 4 years, or a CAGR of 12.46% per year. Not bad considering what Treasuries are yielding, and that IBM is one of the premier blue chip companies in the world.
Disclosure: I am long BRK.B.