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Robert Abbott
Robert Abbott
Articles (799)  | Author's Website |

Book of Value: Buffett, IBM and the Refutation Process

Applying Anurag Sharma’s refutation process to a real-world investment case

As a capstone to his ideas on core portfolios, Anurag Sharma discussed Warren Buffett (Trades, Portfolio) and Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) in chapter 25 of “Book of Value: The Fine Art of Investing Wisely.”

The selection of Buffett should come as no surprise. Both Sharma and the guru come from the same school of investing thought, the one initiated by Benjamin Graham and David Dodd in their 1934 book, “Security Analysis.”

Sharma’s observations come from filings in November 2011, when Berkshire had a core portfolio of 27 stocks. The top 10 companies represented 95.6% of the full portfolio and the top five companies represented just under 76%.

It remains a conviction portfolio in early 2020. At the end of 2019, Apple (NASDAQ:AAPL) was the largest single holding, comprising nearly 30% of Berkshire’s holdings. The top three stocks represented more than 50% and the top 10 made up almost 80% of the total holdings.

In November 2011, the company disclosed that it had purchased 57.4 million shares of IBM (NYSE:IBM) for just over $10.5 billion. It was another of Buffett’s blockbuster moves; the new position represented about 17% of the company’s $59 billion portfolio.

As Sharma observed, that meant the company’s performance was tied to just a few stocks and any mistakes in picking them could be costly. He added, “The key to building such a concentrated portfolio is to avoid unforced errors by sparing no effort in due diligence.”

In addition to having relatively few stocks, Buffett also kept those stocks for a long time. At the time of the IBM acquisition, the average tenure for the top 10 stocks was more than a decade. He had held Coca-Cola (NYSE:KO) for 27 years, Wells Fargo (NYSE:WFC) for 25 years, Proctor & Gamble (NYSE:PG) for 24 years and American Express (NYSE:AXP) for 21 years.

Following up on these characteristics, note that Sharma was describing a portfolio that might have been put together by any of the gurus who in one way or another follows Graham. Because value investors invest in businesses, not stocks, they do deep research, meaning they can put together a portfolio with fewer stocks and hold those stocks for longer periods.

And while the author conceded he did not know what Buffett was thinking when he bought that large position in IBM, he could find no reason of his own to disconfirm it as a good investment at the time. According to Sharma, Berkshire managed to accomplish “controlled diversification” by intuition and ignored standard deviations and variance-covariance matrices (which is what practitioners of academic finance and modern portfolio theory might have done).

Turning to the specifics of the IBM purchase, Sharma pointed out that Buffett paid roughly $170 per share for almost 64 million shares, at a cost of $10.6 billion. At $170 per share, the market was expecting that future revenue growth would be weaker than it had been between 2001 and 2010. Earnings per share remained strong, but revenue growth was weak. Over the preceding 10 years, the compounded annual growth of earnings was just 1.69% per year.

When Sharma looked into the details, he found that the company had been undergoing a major transformation, one that had begun in 1993. It involved shifting the company away from the hardware business, with its low margins, and toward software and services, which delivered higher margins.

During the first decade of the new millennium, it also bought back $66 billion of its own common stock, which reduced outstanding shares by nearly 29%. It had paid $18 billion in dividends over the same period. In addition, Sharma noted that the three-year earnings yield was 6.07%, well above yield available on 10-year Treasury or corporate bonds. He wrote, “At $170 per share, therefore, we could not at that time refute the investment thesis for IBM based on implied growth rate or yield tests.”

He came to a similar conclusion after reviewing qualitative factors. IBM was a good company with a leading brand name and a reputation for being shareholder-friendly. At the same time, though, the business climate was changing quickly; aggressive competitors (including Amazon.com (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT)) were challenging its lead and its international operations were vulnerable to geopolitical turmoil and exchange rate losses.

In June 2015, Sharma reviewed his previous analysis from 2011. He found IBM had continued to transform itself into a software and business services company. That, along with currency exchange problems, continued to drag down the company’s bottom line. From the perspective of 2020, we can see revenue continued to decline—and pull down the stock price:

GuruFocus chart IBM revenue and price

Eventually, Buffett lost confidence in IBM. In a 2018 GuruFocus article titled, “How Much Did Warren Buffett Lose on IBM?” Rupert Hargreaves reported that Buffett had “substantially” exited from the stock. And he did so at prices below those he had paid, though Hargreaves thought he may have made a small profit after dividends were considered.

So we might ask, did Sharma’s disconfirmation or refutation process fail? On the face of it, we might argue it did, at least as far as capital gains go; IBM’s share price has now dropped to about $110 and if current trends continue, it might even fall further.

However, in substance, the process did not fail. Remember that no one can foresee the future and so every investment decision ultimately rests on a combination of good luck and good judgment. Good luck because future events may hurt or harm an investment case; over 10 years or more, there may be both kinds of events.

Good judgment is not about getting the future right. It is about performing due diligence on a company, considering both quantitative and qualitative information. Sharma’s disconfirmation process was disciplined and thorough. He knew that revenue was a problem and could continue.

Sometimes investment cases simply don’t work out, so like Buffett, we must cut our losses and move on to the next stock.

Conclusion

To further illustrate the idea of core portfolios, Sharma examined Buffett’s Berkshire Hathaway in the first decade and a half of the 21st century. In particular, he looked at Buffett’s purchase of a large stake in IBM in 2011, a decision that now looks like one of the guru’s rare mistakes.

It also was an opportunity for Sharma to show how his refutation/disconfirmation process might work with a real-world case. While his analysis did not disconfirm the IBM case, it did show how the process might be applied to our own investment decisions.

And, importantly, the case showed how risk in a stock might be lessened by going through a process that challenges all the important fundamental and qualitative arguments in favor of buying.

Disclaimer: This review is based on “Book of Value: The Fine Art of Investing Wisely” by Anurag Sharma, which was published in 2016 by Columbia Business School Publishing. Unless otherwise noted, all ideas and opinions in this review are those of the author.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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