Pruning Realty Income And Buying More Shares Of IBM

About: International Business Machines Corporation (IBM), O
by: Investment Pancake

IBM's financial performance is impressive when you look at the company's shareholder equity and dividend growth.

Realty Income is a lovely company, but at the moment, it does not seem to be as cheap a bargain as IBM.

Since Realty Income is a very large position for me, and IBM is a very small position, I'm going to rebalance capital to gain diversification and to increase portfolio income.

What do you see when you glance at the corporate balance sheet for IBM (IBM)? (Screenshot from CNBC.Com)

I'm calling your attention to two lines: common equity and common shares outstanding. As we can see, the common equity for IBM has been surging, while the share count has been picked over and whittled down like a plate of homemade cookies. Equity per share stood at $11.98 per share in 2014. As of September, 2018, the equity per share has leapt to $21.76. This is an excellent measure of how much the company's intrinsic value has grown over recent years. (Screenshot from CNBC.Com)

On its own, rising common equity per share is an incomplete measure of how much value the company has put into the pockets of its shareholders. During the same 5 year period, IBM paid it's shareholders an average annual dividend of $5.50 per share. (Screenshot from

I calculate this staggering return to shareholders at 52% per year.

Looking at the balance sheet gives you a slightly different perspective than the income statement or cash flow statement. How has IBM's strategic turnaround been going? If you just look at the cash flow, you'd conclude that progress has been slow to nonexistent - which seems to be mostly what you read about when it comes to IBM. (Screenshot from CNBC.Com)

Perhaps lousy revenue and cash flow growth accounts for the malodorous share price action that shareholder have enjoyed these last few years?

The balance sheet for IBM tells a rather different story about the financial health of the business - which appears excellent. As far as past performance goes, the key seems to have been the falling share count which has had a salutary impact on the rising equity per share and fueled dividend growth even in the face of stagnant overall corporate cash flow. But what about moving forward? The answer is based on how to value IBM's business transition to cloud, AI and other strategic initiatives. What strikes me is that the value of these business transitions is, in essence, a call option that may or may not expire in the money. The likelihood of financial success with these initiatives is unchanged by IBM's share count. However, when IBM reduces the number of outstanding shares, it is functionally the same thing as lowering the strike price on the call option that remaining shareholders have on the future growth from IBM's strategic initiatives (which dramatically increases the value of the call option in the hands of whomever owns it).

Shareholders will benefit exponentially if from IBM's falling share count if the increases in the company's cash flow from its strategic initiatives continues to overtake decreased cash flow from some of the company's legacy businesses. To existing shareholders, the value of these nascent business opportunities has increased significantly since there are fewer other shareholders to divide up the future profits. This fact does not seem to be reflected in the company's stock price. Frankly, the stock seems very cheap. Average the earnings for the past 4 years, and the PE ratio comes in at around 10. (Screenshot from CNBC.Com)

As it happens, I own a modest investment in IBM in my portfolio - currently, about .64% of my portfolio consists of IBM shares. Not much of a position, in fact.

Whereas... I currently hold nearly a 2% position in Realty Income (O), which is a fine company and one of the highest quality REITs in America. In fact, I recently wrote an article extolling the many virtues of this company. Cheapskate's Guide to Real Estate Investing. Realty Income has had a very good year compared to the overall stock market.... to say the least. (Screenshot from CNBC.Com). It's one reason why my portfolio held up reasonably well against the onslaught of depressing market news last year and early this year.

On their own, rising stock prices are not a negative thing per se, but what about the valuation of the stock? Let's look at the company's most recent estimates for its adjusted funds from operations (AFFO). Source: Realty Income 3rd Quarter Earnings Release.

Going by the midpoint of the company's guidance, the company is trading at a multiple of about 19. This measure alone tells us little about whether a company is fairly valued - to make that determination, we need to see how the company has grown shareholder wealth. So what does the balance sheet show us? (Screenshot from CNBC.Com)

In a nutshell, the company's equity per share has grown from $23.19 per share in 2014 to $26 per share as of September. Including average monthly dividends of roughly $.21, this represents a total shareholder return of 12% per year.

Not bad. Not bad at all. A price to AFFO ratio of 19 verses equity growth and dividends per share at an annual growth rate of 12% is a very fair and reasonable.

But not like IBM, which is just plain cheap and unloved for all the wrong reasons.

It happens that I own shares of O in a ROTH IRA (in addition to many more shares that I hold in a taxable account). The price for O has risen by over 100% since I first bought it in 2010, which is one of the reasons why I hold a relatively large portfolio allocation into this business. So today, in the interests of diversification, I decided to reduce my position in O in my ROTH IRA by 50% and reinvest the proceeds into more shares of IBM. In essence, I'm withdrawing and reallocating my original capital, but retaining the remaining shares of as a free gift from Mr. Market. In the process, I will receive an immediate boost to my portfolio dividend income, and also a bump in my portfolio's average earnings per share. The one-time capital gain, the increased earnings per share and the higher dividend yield; all of it will be income tax-free forever. You can't beat a free gift from both Uncle Sam and Uncle Mr. Market working together like tag-team WWF wrestlers. I'm going to keep my O shares in my taxable accounts, though - the built in gains would make it prohibitively expensive to sell those absent an overwhelming reason to do so.

And it turns out that I have a few hundred bucks here and there scattered around my IRAs and ROTH IRAs. No harm reinvesting those dollars into some commission-free shares of ETFs such as the Schwab US Dividend Equity ETF (SCHD) or Ishares MSCI ETF (EFA). Modest investments, to be sure, but it's the financial equivalent of leaving a cereal bowl in the sink under an annoyingly leaky faucet. Drip. Drip. Drip. Sooner or later, you realize that you've filled an entire bathtub without even realizing it.

After today's financial foibles, the portfolio allocations will stand thusly:

Income growth will rise from 12.9% to 13.18%, and annual dividend growth will rise from 13.4% to 13.53%. It's modest improvement we're talking about, but if you keep doing this sort of thing over and over, year after year, even minor dividend reinvestments and earnings/ dividend boosts start to add up the way that a teenager blithely stacks filthy dishes in the sink (uncritically assuming that his or her parents will clean them up, seemingly oblivious to the fact that the parents have repeatedly assured said teenager to the contrary).

Disclosure: I am/we are long IBM, O. 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.

Additional disclosure: Nothing in this article is investment advice, and I am not an investment advisor. Nobody can rely on anything in this article, any facts or even any analysis, for any reason whatsoever besides entertainment purposes. I am long all of the positions shown in the attached spreadsheet.