IBM: From Best to Good

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Oct 22, 2014
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A while ago, I wrote an article about IBM (IBM, Financial), which you can find here. In that article, I laid out a simple case for IBM if you have a 5-year+ investing horizon. Since then, we have seen another lackluster quarter, which had the effect of chopping off the price of “the Big Blue” by a good amount. As one of Warren Buffett’s largest holdings, IBM has certainly attracted a lot of attention, especially with the recent price drop. In this article, I want to briefly touch on the point that IBM has gone from the very best business to a good business since Buffett’s initial purchase during the first quarter of 2011.

In a recent interview with Carol Loomis (see link here), Buffett explains the difference between a good business and the best business:

“A good business is one that earns high return on tangible assets. That’s pretty simple. The very best businesses are the ones that earn a high return on tangible assets and grow. Even if the ones that don’t grow, if they earn a high a return on tangible assets and if you don’t pay too much, they could be a good investment. They are good investment to start with by the high returns.”

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Before Buffett initiated a position in IBM, IBM has had a few consecutive quarters of revenue growth. Since IBM also earns a very high return on tangible asset, combining with the growth factor, IBM qualifies as one of the best businesses according to Buffett’s definition.

Unfortunately, the growth factor almost immediately turned south after Buffett's purchase. As we could tell from the quarterly revenue growth table, IBM has had 10 consecutive quarters of revenue decline, which took the company out of the best business category and into the good business category. IBM still earns very high returns on tangible assets, but without the growth it had experienced prior to Berkshire’s big position, the market factor started to work unfavorably.

I don’t know whether Buffett saw this coming before he made his decision in pulling the elephant gun trigger on IBM. However, like Buffett said, it can still be a good investment if you don’t pay too much for a business that earns high return on tangible assets. At least Buffett hasn’t lost any money on IBM if we factor in the dividends. Berkshire's ownership percentage of IBM has also been growing due to the IBM’s share repurchases.

At this price, I think the likelihood of permanent loss of capital in IBM is very small, considering the market is giving IBM a 10 times PE and the fact that IBM has a dividend yield of 2.7%. However, whether the upside is unlocked depends on when IBM can rebuild itself from a good business to the best business. That is a question that may be too hard for most of us to answer.