All too often, value investors can fall into the trap of buying stocks simply because they are cheap. However, if the companies behind cheap stocks aren't growing, their profits could fall, dragging share prices even lower.
With that in mind, let's take a look at International Business Machines Corp (IBM, Financial), which was one of Warren Buffett (Trades, Portfolio)'s biggest mistakes of the past few decades. This represents a time when even the Oracle of Omaha himself made the mistake of buying cheap stocks of a declining business.
A big mistake
The Oracle of Omaha did not set out to lose money on IBM. Like any other investor would have done, he entered the position hoping the company would return to growth and defy its doubters. Buffett may have been hoping that he was buying an overlooked champion at a discount price.
It certainly looked that way. IBM has a long and colorful history of driving change in its industries. The management also has a track record of rewarding shareholders with dividends and buybacks when the time is right.
Unfortunately, IBM did not live up to expectations. After holding a position for several years, Buffett dumped his holding.
IBM initially appeared to be a value investment. However, as the company's income deteriorated, the stock grew into a lower valuation. Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) revealed in 2011 that it bought $10.7 billion worth of common stock in IBM at an average price of $170 per share. That year, the company reported basic earnings per share of $13.25, putting the stock on a price-earnings ratio of 12.8.
In 2017, when Buffett had finished selling, the stock averaged a price-earnings ratio of 12.9 at a price of around $155. The stock's valuation had remained the same, but the price had fallen as earnings had declined. To put it another way, the stock had grown into a lower valuation.
The hard part
This is an elementary example, but I have used it to illustrate the point that without growth, stocks that appear to look cheap can only become cheaper. Meanwhile, stocks that look expensive can become cheap as they grow.
The hard part is finding these growth investments in the first place. I wish I could say I have a simple formula or solution to help anyone discover the best opportunities. Unfortunately, I do not. It's mpossible to know straight away which companies will succeed in the future and which will fail.
For investors, the key to finding the winners in the long run is capital allocation. One of Buffett's best qualities is his ability to cut losers and run winners. That's precisely what he did with IBM. He realized the company wasn't going in the right direction and decided to sell the holding. In comparison, Coca-Cola (KO, Financial) has lived up to his expectations, and rather than taking profits, he held on, watching the stock and company grow year after year.
Investors sometimes use simple ratios like the price-earnings ratio to try and develop a shortcut to the complex process of investing. While these can be useful at times, they should never be considered in isolation. There's no shortcut available to become a successful investor. It requires time, effort and continuing education.
It's important to distinguish between those companies that are succeeding and those that are struggling. That way, it's possible to run winners and cut losses with struggling enterprises.
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