Those whose ears now respond only faintly to the suggestion that IBM stock continues to be unusually cheap are understandably soured on a company whose four-year performance of losing 3% annually coincides with a period of 13.5% annual gains in the S&P 500.
The financial media have been persistent in coming at IBM shareholders from every direction to narrate the Armonk firm’s woes–declining hardware sales, twelve consecutive quarters of shrinking revenues, earnings per share declines, a tumbling stock price, late entry into cloud technology, sluggish demand from the BRIC countries, and currency headwinds. Some have
regarded IBM’s performance as a thorn in the halo of Warren Buffett’s half-a-century track record due to the 28% decline in the price of IBM stock since Buffett began Berkshire’s accumulation of it.
Nodding to Mark Twain, however, there is reason to believe that the death of IBM has been greatly exaggerated. The analytics division is growing at 30% annually, suggesting that IBM is keeping up with the technology winds (it’s just that the lucrative wealth created by the hardware divisions has not yet been matched.)
And even then, when you look at what is exactly happening with the hardware divisions, the performance is not nearly as disappointing as the media makes it out to be. Because all online writing is incentivized to attract the maximum page views, it is in the financial interest of pundits to portray IBM as if it were destined for the ruins of Tel Megiddo. That is why you get headlines discussing 13% revenue declines. But once you adjust for divestitures, as well as the strength of the U.S. dollar against the currencies of the BRIC countries, the decline is barely 1%.
On Friday, we learned that Berkshire Hathaway has cumulatively lost $2 billion on its IBM investment so far, with Buffett taking the unusual step of providing explanatory information in the footnote: “IBM continues to be profitable and generate significant cash flows. We currently have no intention of disposing of our investment in IBM common stock. We expect that the fair value of our investment in IBM common stock will recover and ultimately exceed our cost.”
Then, on Monday, we learned that Berkshire bought 1.5 million additional shares of IBM in the past ninety days to boost the share count by an additional 2%. The average price of these additions was not disclosed, but if the price averaged $140 per share during this period, it is fair to guess that Buffett added an additional $210 million to the IBM holding.
I find Buffett’s move wise (even though only 2 of the 23 analysts currently covering IBM recommend the stock as a buy.) IBM is going to earn $14.25 per share this year. The current price of $133 is a P/E ratio of only 9.33. The stock has gotten so cheap that the buybacks are now eliminating 3% of the entire stock every quarter.
Graham didn’t just preach about margin of safety because he wanted to sound fashionably conservative to his intended audience. No, he knew it was a process that worked–when the rest of the world is taking a fish-eyed view of the stock, your financial house would best be served by taking the bird-eyed view. In 1993, IBM found itself in similar trouble with regular reports of revenue losses and a vague sensibility that it had lost its place in the burgeoning internet age. The stock got down to 11x earnings?
What happened to the investors that bought then? They would have 12.5% annual returns to this day. They would have beaten the S&P 500 by three points annually. It is the difference between turning $25,000 into $173,000 or turning $25,000 into $362,000. Over 22 years, those three points add up. And that is a comparison to IBM’s current low point. If you looked at the twenty-year period from 1993 through 2013, IBM’s compounding rate would be 15.5%. That $25,000 would have given you $469,000. I mention both figures to point out that margin-of-safety investing not only gives you good returns when things don’t always go as planned, but also turbocharge returns when favorable days arrive.
IBM’s balance sheet is in stronger position than most people think. Some of the 5% debt has been removed from the balance sheet, bringing it down from $41 billion to $38 billion. The pension obligations are $112 billion while the pension assets are $147 billion (putting erstwhile IBM employees in the position of knowing that the financial promises of yesterday are on pace to be honored). There is almost $10 billion in cash on hand. The share count is rapidly shrinking.
People say, “Oh, IBM’s just buybacks. It hasn’t done anything to actually grow the business in a while.” That’s just not true. If you look at 2007, it was making $10.4 billion in annual profits. Now, it is making $14 billion in annual profits. Keep this in mind: Coca-Cola, with 500+ drinks in over 210 countries, hasn’t even hit $10 billion in annual profits yet. I don’t think people realize how mammoth this operation is. The share buybacks have catapulted the earnings per share from $7 to over $14 per share during this time period, but that is a legitimate way of using excess cash since the dividend payout ratio is only in the low 30% range.
This nearly 4% dividend yield is something that people will look back years later and wonder how they missed it. But headline risk always accompanies good opportunities. Back in 2008-2010, the headlines about General Electric, Wells Fargo, and American Express weren’t pretty. That is when they were great investments. The past year or so, oil stocks have found themselves in the same position. People will look back upon Chevron at $70 in 2015 and wonder how they missed it.
With the benefit of hindsight years from now, IBM will prove its belonging on that list. When you are collecting 4% dividends, are trading at 9x earnings, and retiring nearly 10% of the stock per year, you can create decent wealth even if IBM stagnates indefinitely. And if it achieves even moderate, low single digit revenue growth? Then you will beat the market. IBM is a very attractive value investment at this price, and it doesn’t require nearly as much courage to buy if you study the forms of safety that are inherent in the $133 market quotation.