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Why Warren Buffett Bought IBM

February 13, 2012 | About:
Warren Buffett surprised everyone when he announced that Berkshire (BRK.A) (BRK.B) bought 5.5% shares of IBM (IBM) last November. No matter how bizarre it looks, there was sound logic behind Buffett’s decision, as he explained in his interview with CNN.

Instead of a tech company, IBM is more a service company and has sticky businessIBM’s share is the best choice in this low interest, low growth environment; not only for him, but for everyone elseIBM’s senior management team is shareholder-friendly.

Buffett knows IBM and its leading position among tech companies well. He had been reading IBM’s earnings reports for about 50 years. But last November, he “read it through a different lens.” Although Buffett didn’t spell out all the details, he did mention some clues in pieces. When we connect all the dots, the whole picture emerges.

Buffett mentioned a couple of things in his interview:

The book by IBM’s former CEO, Lou Gerstner, “Who Said Elephants Can't Dance?”

Buffett went around Berkshire to understand how IT departments work.

IT service is sticky. Or in Buffett’s own words: “There's a lot of continuity to it.”

“Who Said Elephants Can’t Dance?” is a superior management book. Among all the gems embedded in the book, there are two keywords which, I believe, changed Buffett’s view about IBM. The two keywords are “services” and “portfolio.”

Technology is disruptive. It changes everyone’s daily life. But it also may cause unpleasant financial consequences to investors. Technology brings dramatic economic growth which is, unfortunately, less predictable. In Buffett’s own words when asked in the interview if he would buy other tech companies: “I look at everything but most things I decide I can't figure out their future.” For some examples, just look at Research In Motion (RIMM) versus Apple (AAPL), Yahoo! (YHOO) versus Google (GOOG), and Kodak versus all the other digital camera makers. The last one is especially ironic because it is Kodak that invented the digital camera in the first place.

But IBM’s business is different from others. It is the first keywords we mentioned above, “services.” Service is a bridge between technologies that are often for general purposes and customers' specific needs.

Think about the iPhone. It is loaded with fascinating technologies but all of them are for general purposes. You can use it to make phone calls, shoot photos or type messages. What if a business owner wants to use iPhones to process credit cards? It is a legitimate need but Apple won’t sell an iPhone with a card reader attached to it, simply because 99% of people don’t need it.

Yes there are third-party card readers for iPhone. Probably for every business need, customers can find a third-party vendor for it. But then the customer will fall into the nightmare named integration. Because all those products are from different vendors, their interfaces are often incompatible and data cannot flow freely among them. Remember that theTower ofBabel failed because people speak different languages.

There are generally two options to solve the problem: Build an in-house team to do the job or hire a service company.

Although many tech companies have an in-house IT team, it is often not cost-effective for all the rest. Companies that want to have a try will soon find out that they need to hire a lot of people.

First there has to be a team of developers to write the code. Then there has to be a validation team to test the code. Now you need to have three separate environments, the development, the testing (or integration) and the production environment. Hence, there has to be an infrastructure team (to manage the hardware, network, power, disk array, security patches, etc.) to support those environments. And because parts are from different vendors, there has to be a supplier management team. On top of that, there has to be a change control team to manage the overall schedule. A CEO of a retail company will soon wonder: Why do I have so many IT guys fooling around here? Am I another Amazon (AMZN)?

A service company will do all the dirty work for you and save you a lot of trouble and budget. Buffett must have learned this by going around his IT departments. He must have also learned another thing — service is sticky.

Service is sticky because it is hard to transfer knowledge and experience among people. It’s common for a big company to have thousands of computers, linked together by networks cables, sometimes fibers. Each of them has different pieces of software installed. Each piece of software consists of thousands of lines of code. The entire system could be built over a span of five years or even longer. During the period, engineers created zillions of artifacts and learned zillions of hard-lessons. The knowledge and experience could be totally unstructured since most of the time the system is built out piece by piece and without a master plan. Dare you hire another service company to support it? Give the new-comer one year and they are a genius if they could ever figure out what’s going on.

Stickiness is good but a service company also needs an edge over competitors to sign up new customers. IBM’s advantages are its brand name, economic scale, market share, and portfolio, where “portfolio” is the second keyword I mentioned before. Customers want to subscribe to “proven technologies” to reduce risks. IBM can satisfy this by its huge portfolio of technologies, probably the largest in the world. Moreover, it keeps growing the portfolio by continuous M&A activities.

Buffett also mentioned that IBM is a good choice for him because he can put a big chunk of cash to work.

“Well, but it also means that some great big strong American companies look very cheap compared to investment alternatives. I mean, in the end, you know, you're sitting with money in your pocket. Do you leave it in your pocket, you get zero on, do you put it in a money market fund, you still get zero on it, do you buy 10-year Treasuries and get 2 percent, or do you buy American businesses that are earning very good money, that have high returns on equity, have high returns on incremental capital, are buying in their stock at a rapid rate so that your ownership in the business increases significantly? I love all those things. Now, you measure one vs. the other. But in the end, you have — you know, you do something. Doing nothing is doing something.”

At the first glance Buffett was talking about himself. But if you think about it, he is talking about every investor.

We are at a time that is marked by low interest rates and low growth. The bad thing is that we probably will get stuck in this situation for much longer. Because of the huge debt both in the public and private sector, growth will be scarce. And we have this determined Fed to keep interest rates at rock bottom to spur growth. But the last two to three years already told us that low interest rates only alleviate the symptoms, not cure the disease. The outcome is low growth coupled by a high unemployment rate — a less painful deleveraging process.

So for investors, there are really not many good investment opportunities in our time. I would imagine most sensible investors face the same problem Buffett is facing. And their logical decision would be the same with Buffett, to avoid money markets and bonds, and buy and hold mega-cap, multi-nation cash cows like IBM, which is safe and will continuously generate returns.

And this is especially a good thing for IBM as it conducts a lot of M&A activities. Investors chase IBM’s stock. IBM’s stock increases in value. IBM uses its stock as a richly valued currency to buy other companies. IBM’s revenue and profit grow and it attracts more investors. This is a typical positive feedback loop that benefits every shareholder, including Buffett.

A trustworthy management team is also a trait Buffett normally looks for when making investment decisions. In the interview, Buffett named the following pieces of evidence to further support his decision.

“The other thing I would say about IBM, too, is that a few years back, they had 240 million options outstanding. Now they probably are down to about 30 million. They treat their stock with reverence which I find is unusual among big companies. Or they really — they are thinking about the shareholder.”

“And if you read their reports — if you read what they wrote five years ago they were going to do and the next five years, they've done it, you know, and now they tell you what they're going to do in the next five years, and as I say, they have this terrific reverence for the shareholder, which I think is very, very important.”

About the author:

Trustamind
Author of ETF Ranking Newsletter.

An amateur trader / investor that tried many methods including buy and hold, technical analysis, quantitative analysis, day trading with pattern, and finally settled with fundamental analysis to discover undervalued quality stocks.

Visit Trustamind's Website


Rating: 4.4/5 (55 votes)

Comments

Moneymaker5o1
Moneymaker5o1 - 2 years ago


Excellent article! i've added the idea of looking into the trends of stock options into my checklist now
stevenramsey
Stevenramsey - 2 years ago


Great input here on IBM. After reading the last five years of reports(10% of Buffett's reading-oops), I was totally fascinated by it. The company does have some big tailwinds, some from economic evolution, and from the management's shareholder orientation and execution.

The "on-the-ground" research by Buffett is interesting too. The company is doing an overall engineering of growth for shareholders by increasing Free Cash Flow through operations, using the cash to pay dividends, by back stock, and make good acquisitions. All of this is being done using a conservative amount of debt and with the thought: the shareholders own IBM, as management we are stewards.

And on the above comment, "stock-option trends" is something to keep an eye out for, I'm glad you pointed this out.
Sivaram
Sivaram - 2 years ago
I kind of disagree with you. I don't think IBM's moat is as strong as you imply. Yes, service companies that become dominant tend to have stickiness. Good examples are major accounting firms and investment banks.

But, in this case, I'm not really sure what IBM's competitive advantage is, other than its brand and ability to source large amounts of capital (for M&A if needed). IBM services, from what little I know of them, are very expensive, so what's to stop someone else from undercutting them, either at a cheaper rate, or minimizing IT services (e.g. using cloud services that need less IT service work)?

The other thing with this purchase is that Buffett is buying it near all-time peak -- definitely not attractive from a contrarian point of view. Yes, being contrarian for the sake of contrarian can be disastrous but I just wonder. You are basically buying IBM when it is firing on all cyclinders and forecasts are rosy.
Sivaram
Sivaram - 2 years ago
Having said all that, Buffett could be making a min-macro bet on emerging markets, where IBM is gaining business and has very strong reputation. In undeveloped and developing countries, computer services, like what IBM is selling, is likely sold on brand name.

I'm just not sold on this buy by Warren Buffett. Then again, I wasn't and still am not sold on Buffett's purchase of Burlington Northern Santa Fe either.
joe_litehorse
Joe_litehorse - 2 years ago
Until you look at the "Buffet" purchases through the eyes of BRK, you will never understand.
william111
William111 - 2 years ago
I guess it was buffet who killed the oil pipe line from Canada to the us. He is a major winner with his Rail road company. Good for him and bad for the country. Nice to have inside information. Just like the great one George Soros Obama's string puller.

Good Luck America

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