Will Owning IBM Stock Over The Long-Term Turn Out To Be A Mistake?

  • Warren Buffett recently warned investors that Berkshire Hathaway's IBM investment might turn out to be a mistake.
  • Berkshire has held IBM stock for nearly five years now and has racked up a huge paper loss.
  • Will owning IBM stock over the long-term turn out to be a mistake for retail investors?

In his latest annual shareholder letter, Warren Buffett talked about owning shares of lumbering tech giant IBM (NYSE:IBM). Mr. Buffett wrote that he thinks buying IBM stock was the right decision, but it could turn out to be a mistake:

"We've owned stocks that we've lost money in. If I'm wrong, you sell them out and take a big loss. We've done that on a few occasions with stocks and bonds over the years."

"What you pay for a stock doesn't mean anything. What means something is where the company's going to be in five to 10 years," Buffett said. "I think IBM will be worth more money but, like I said, I could be wrong but we'll accept that."

IBM stock is the fourth largest position held by Warren Buffett’s BRK.B (NYSE:BRK.B), representing 8.59% of Berkshire’s holdings as on 31st December 2015. Buffett bought the first lot of IBM stock back in 2011 and has gradually been buying more over the years. The maverick investor purchased the last lot of IBM stock in September 2015 during a time when the stock was down more than 20% YTD. Buffett’s first purchase was made at a time when IBM stock was trading around $159. The stock then rallied and crossed $200 two years later before tanking to the current level of $137.80

IBM 5-Year Share Returns

IBM stock chart
Source: IBM stock price chart by amigobulls.com

By the end of 2015, Berskshire Hathaway’s position in IBM represented a nominal loss of $2.6B and is one of the key reasons the fund badly underperformed the market in 2015.

Investing in IBM Stock

The fact that Buffett was willing to buy an undisclosed number of IBM shares in 2015 after the stock had been on a sustained decline for not less than two years tells you that he does not view the stock the way an ordinary investor would. Indeed, you can pick up some useful investment tidbits from Warren Buffett’s past shareholder letters. Buffett had this to say after buying IBM stock for the first time in 2011:

The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise.

You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.

In the end, the success of our IBM investment will be determined primarily by its future earnings.

So you can say that things have panned out the way Buffett had hoped for. However, he added this to that piece of commentary:

Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day:

What should a long-term shareholder, such as Berkshire, cheer for during that period?

I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years.

Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will
acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1 1⁄ 2 billion more than if the “high-price” repurchase scenario had taken place.

This second part of Buffett’s commentary appears to suggest that he had hoped for IBM stock to average $200 over the first five year period. But a look at IBM’s price chart tells you that the weighted price of IBM stock has been far lower than that, hence Berkshire’s huge paper loss.

So should we surmise that IBM is a bad long-term investment? The answer to that question depends on your investment timeframe. Buffett is known to hold equities for what seems like a lifetime, and has so far held IBM stock for less than five years. Assuming the company holds IBM stock for another 10 or more years, there is a good chance that Berskshire might end up making a good return on IBM stock. While the consensus is that IBM’s core server business is likely to continue shrinking over the next couple of quarters at the very least, IBM’s ‘‘Strategic Imperatives’’ segment consisting of the Cloud, Big Data & Analytics, Mobile, and Security is still growing at a healthy clip.

IBM recently reported FY15 revenue of $81.7B, down 12% Y/Y. The company’s Strategic Imperatives segment, however, posted a 17% increase in revenue to $28.9B, or 35% of IBM’s revenue. Cloud revenue was up 57% Y/Y to $10.2B while Business Analytics revenue was up 16% to $17.9B.

So it’s quite clear that some of IBM’s revenue segments are still growing at a healthy clip. There is a good chance that at some point growth in Strategic Imperatives will be enough to offset the weakness in IBM’s server business and help the company to eventually pull out of its tailspin.

I would, however, not recommend buying IBM stock at this point. Strategic Imperatives growth slowed down to 10% during Q4 2015, which is a worrying development. Investors with a really long investment timeframe on IBM stock should probably wait and see how this key segment performs during the current quarter before loading on the shares. Ultimately, holding IBM stock for a long-term investment timeframe like Buffett’s could prove rewarding for investors.

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  • I do not hold any positions in the stocks mentioned in this post and don't intend to initiate a position in the next 72 hours
  • I am not an investment advisor, and my opinion should not be treated as investment advice.
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  • I do not have any business relationship with the companies mentioned in this post.
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Comments on this article and IBM stock

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ray.saudlach
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Keep in mind Buffett's time horizon is so long (forever) that his logic may not apply to most investors.
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