What Can We Learn from IBM?

PS: I may not post the See’s Candies case study until tomorrow….backed up with work. Until then, tackle this:

Why did Buffett buy IBM?

IBM_VL    Don’t cheat! Look at the Value-Line and write what Buffett sees in IBM. (Disclosure: I own IBM along with BDX, BCR, CSCO, LXK, NVS, TESCO, ORI, etc. and I will not announce if and when I sell. I may be incorrect in the assessment of those businesses either in price paid or assessment of value.)

What do you think of IBM’s growth? Is this a good business? What might be driving returns for shareholders? How would you classify this company?  A rapid compounder? Value trap?

How can a company as well-known as IBM become mis-priced?

Hint: For those who wish to start your own fund….research the studies on horse track betting where favorites are SYSTEMATICALLY under-bet (under priced) while long shots are SYSTEMATICALLY over bet or over priced.

Notes:

Betting on Favorites

See research:Favorite_Longshot_Bias

http://www.gogerty.com/blogpersonal/2012/09/

One of the common criticisms I (Investor lecture at Columbia GBS) hear about this type of investing is that it is akin to betting on favorites at the race track. Once you have identified a company that is so obviously superior, how likely is it to be undervalued since the whole world will have perceived that it is an extraordinary company? The stock won’t have a margin of safety and may be persistently over-valued. The stock may be over-loved and overvalued.

Let me back up a second. As part of my misspent youth, I spent a lot of time in horse racing and handicapping. In fact, bettors in aggregate in pari-mutual betting are, in fact, very good at picking winners at the racetrack. Favorites do win races. But betting on favorites does not make you money; it loses you the least amount of money. Because there is a tremendous track take. So the horse racing/handicapping is a minus 20 percent on typical betting. If you just put money down on favorites as a mechanical system, the record shows that you will lose over time only 2%, 3% or 4%. If you bet on long shots, you will lose 20+% of your money.

Now in the case of the stock market over a long period of time, it has been a plus 9, plus 10, plus 11% game so it is very much more favorable business than horse betting. But betting on favorites, betting on quality as opposed to junk is a winning bet, as long as the valuation discipline is appropriate.

Prize awarded: Boom, Gloom, and Doom Report for the BEST reply.

Ok, now take a look at these articles: http://tech.fortune.cnn.com/2011/11/14/warren-buffett-ibm/

and  http://seekingalpha.com/article/510371-what-does-warren-buffett-see-in-ibm

Lessons learned?

If I can stress anything–and it took me TEN years to learn and I fall off the wagon occasionally–keep things simple!

15 responses to “What Can We Learn from IBM?

  1. What do you think of IBM’s growth?

    Suprisingly good for such a mature company!

    I applied my simple Graham test that I described in a previous post. EPS has at least doubled over a decade, with no more than 2 drops of 5% or more.
    Consistently high margins and amazing returns on equity, Share count going down.

    Straight off the bat I’d say that it would deserve a PE of 15, which is what it trades at. Looking at Google, I tried to calculate an EV/EBITDA value.
    I have a market cap of 227526m, and net debt of 19400 (11922-4159-4306-22857). So EV is 246926 (227526+19400).
    EBITDA is 21292 (21003 net income +289 depn/amort). That gives me an EV/EBITDA of 11.6.

    That seems quite high – perhaps I’ve missed something.

    I think Tesco looks a much better bet valuation-wise.

    I’m now starting to look for these kinds of things on a regular basis. With hindsight, I am reminded of one of my “crimes of omission” last year. That was in not buying Smith & Nephew – the artifical hips, keyhole surgical instrument and bandaging company – last year. It was pretty much “there” as a Buffett-type company, and I was busy sucking my thumb when it traded on an EV/EBITDA of a little over 6. Smith & Nephew should be worth comfortably more than that, and I missed my opportunity to make money on that one.

    One company I like the look of at the moment is London Stock Exchange. Perhaps you’ve heard of it 😉 EPS has more than quadrupled over the last decade. It has operating margins of 65%. Seems to have some kind of moat going on there, wouldn’t you say? And it’s trading for less than 10X free cashflow. Difficult to believe that these sorts of opportunities are out there, isn’t it?

    • Excellent points. The problem with EV/EBITDA is that is should be used for comparison purposes not necessarily for valuation except – perhaps-for evaluating realestate companies where Maintenance Capex is minimal.

      The value of any busness is the NPV of its FUTURE DISTRIBUTABLLE cash flows. What is the future and what cash is distributable. No wonder Buffett placed so much on stability and reasonable predicatability in many of his investments.

  2. The good/stable profitability & margins plus significant retirement of shares o/s has already been mentioned by McTurra.

    One thing I also noticed:
    The large increase in revenues and earnings has been driven by a significantly smaller increase of working capital as well as flat or declining need to reinvest in the business. It looks like cap’l spending per share is either flat or declining (plus shares o/s are also going down), while revenue and earnings has increased significantly.

  3. Pingback: Lottery stocks, horse races and the human love of the long shot. « Thinking in systems

  4. According to Valueline, IBM has 3 diversified revenue streams, two of which are currently experiencing revenue growth. Earnings growth at 16.5% over the last 5 years, and revenues increasing at 7% which tells me that there was likely margin expansion. (Also VL just shows increasing margins in the breakout to confirm that.) The dividend has increased by an awesome 24% per year for the last five years. Interestingly, book value has shrank over the last five years by 1.5%. This may be because of a product mix more slanted towards intangibles and software rather than hard assets and they took a big hit to BV in 2008.

    Also, working capital has been a little lumpy, but overall has been pretty consistent. I know that Buffett likes a business that does not have to continually reinvest in new equipment, inventory etc with rising capex. You have a business here growing earnings at 16.5% with capex relatively stable.

    You also see a steady and significant drop in shares outstanding. If IBM’s stock price simply stands still for 5 years and they continue to buy back stock at this pace, that will be better for Berkshire than if the stock appreciated and IBM continued to buy back stock.

    I think Buffett also likes that IBM has laid out a clear road map about how IBM plans to get where they want to go. He is quoted as saying the CEO since 2002 has “delivered, big-time.”

    The VL description of IBM calls it a “worldwide supplier of advanced information processing technology, communication systems…” The planet is drowning in information and data and the amount of data is only growing by the day. Not all data is not information, just as not all information is knowledge. IBM is positioned to be a bottleneck in helping businesses make sensible use of the data, thus transforming it into usable information.

    Moat-wise, I think a major factor is switching costs. I honestly don’t know a ton about major business IT, but I have worked with small cap IT guys and to switch out the data infrastructure of a business is a major ordeal.
    There is also a brand component, bc if you are dealing with highly sensitive data on servers that needs to be secure, you don’t want to tell your clients your skimped and with with a ‘B’ player – much like telling your Valentine
    you sprung for the cheaper chocolates.

    Things that aren’t mentioned in the Value Line is the IBM smart grid technology and being able to shift power to parts of the grid that need it. I think about this in conjunction with Buffett’s wholly owned Mid-American energy which is a huge player in the utility market and also Buffett’s 10% purchase of BYD which is a major producer of electric cars that recently opened a Los Angeles office. Obviously there could be a lot of synergy between the three.

    Risks – There will be a new CEO at the end of the year. I don’t know much about her, but I’m sure Warren does. Also, Buffett (or is it Munger?) is noted as saying “when managers have to make the numbers, they will at some point be tempted to make up the numbers.” That could be the case with IBM so publicly pronouncing $20 per share by 2015.

    • I’m just hypothesizing here and based on my limited interaction with IT, but if it’s difficult to switch at a small cap it’s going to by much harder at a bigger firm with more to lose if you get things wrong. Also, the phrase “nobody gets fired for choosing IBM” comes to mind so even if there are cheaper options from smaller firms there may be disincentive (career risk) for people to switch to an unproven platform.

      Hopefully someone with IT experience can shed some light on this topic.

    • You are right about huge customer captivity/high switching costs. IBM is embedded in the operations of many of their clients.

      A great read is Gerstner’s book–mentioned up above.

  5. Additonal comment: let’s look at it from a bond perspective.

    Operator earnings are about £13.63 per share (cashflow per share 17.77 less depreciation 4815/1163). I’m assuming that depreciation is a good proxy for maintenance capital.

    At a share price of $200 per share, investors are getting an operator earnings yield of 6.8% (13.63/200). I don’t know what the market is yielding, but having some scratchings around elsewhere, I figure that it’s around average.

    So, as a bond, Buffett would get a 6.8% “yield” which should grow in the range of 6-12% pa “for some time”. OR, he could buy a AAA corporate bond, which would get him about 3.4%. Clearly, the former option is much more attractive – although that figure is not guaranteed, of course.

    BTW, I applied the same idea on Tesco, and came up with a yield of 10.8%.

    • Don’t you have to also subtract the interest expense? This is a company that has debt so we can’t just ignore it, right?

      • You should not ignore debt. Add net debt (gross debt including unfunded liabilities, etc. minus EXCESS or non-operational cash) to mkt. cap to determine the price of the whole business.

        EBIT is before interest expense because you want to know the pre-debt earnings power.

        • Ok, so in this case:

          EV = 241,000 (mcap) + 31,320 (debt) + 13,200 (pension obligations) – 11,922 (cash) = 273,598

          EV/share = 273,598 / 1163,2 = 235,21

          FCF Yield = 13,63 (as above) / 235,21 = 5,8%

          Is that correct? We should not use mcap/share but EV/share?

  6. If you can earn 10.8% a year in a world of 2.5% on 10-yr govt. bonds, then good for you. We live in financial repression.

  7. John,

    I thought you might like to see an article that’s actually diammetrically opposite: “Black Swan Farming”.
    http://paulgraham.com/swan.html
    It was written by a guy called Paul Graham, who is well known in Lisp programming circles. He created a startup based on programming in Lisp, and made his fortune when he sold it to Yahoo as Yahoo Stores. His financial success led him to create Y-Combinatior, named after a “fixed-point combinators in untyped lambda calculus” – actually a Venture Capital Fund for internet startups.

    It also got me to thinking about Buffett’s poker tournament, and how he usually got knocked out fairly early. An observer expressed the opinion that longer-term investors usually don’t make good traders, and that traders make good poker players. He said that traders must often decide quickly whether to exploit or reject a situation.

    I don’t play poker, and I know virtually nothing about it, but one thing that happens is that as time goes on, the players thin out, and the antes get higher. Players have to make very good assessments of the situations. What’s different from investing is that if you play too conservatively, you’ll just be anted away. Apparently, in Vegas, there are people called “rocks”. “Rocks” is a poker term for people who play solidly, basically, and have a good understanding as to how to play the odds. Locals to Vegas can reach a very high amateur status, and make some money playing against novice tourists. But the pro said that these amateurs would never be able to take on pros.

    It reminds me of an episode of Star Trek Next Generation, where they had a poker game. They were sitting around the table, and Riker put a bet, and Data folded because he didn’t have good odds. They discussed the hand afterwards, and Data basically said that Riker’s actions were illogical, and he shouldn’t have won. To which Riker responded: “But I did win!”

    More food for thought.

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