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Grahamites
Grahamites
Articles (328) 

IBM: A Reality Check on Thinking and Investment Process - Part I

April 05, 2015 | About:

One thing I absolutely love about writing articles and posting them on GuruFocus is that doing so helps me keep track of what I thought in the past. As I evolve as an investor and hopefully get better over time, and as future events play out, I can go back and assess what I thought then compared to what I know now and what happened in reality. Then I can ask myself if I made a mistake in my thinking and analysis. Or was my analysis correct, but the most probable outcome failed to happen, or failed to happen on time?

This brings me back to a stock that I have written about twice in the past – IBM (NYSE:IBM). In my first article written in May last year, I laid out what I thought was the case for IBM based on my very limited knowledge about the business. Here is the link to the article. In it, I wrote the following reasons why IBM could be a good investment:

First of all, as we all know, IBM's business model has changed. IBM gradually transitioned into a software and enterprise-service company from a hardware-based business. What has not been widely recognized is the impact on profit margin.

Second, in the long run, return in common stocks will correlate to the return on equityIBM's ROE is admirable. If you look at the latest Value Line report, you will see IBM's return on shareholder equity during the past five years has been over 50%. This is mostly achieved by high net profit margin and a little bit equity leverage.

Third, IBM is a cannibal. Share counts have been shrinking every year in the past 15 years. Through years of share buybacks, IBM's common shares outstanding have decreased from 1.85 billion in 1998 to merely above 1 billion shares today.

I ended my article with the following conclusion:

I do see IBM will likely to continue to enjoy the secular trend toward distributed, open-standards computing. Furthermore, IBM's hardware, software and service business each is the leader in the area, the combination of these businesses provides IBM with economies of scale in product development and distribution of services. IBM's established franchise as the indisputable leader in computing gives it a significant competitive advantage in acquiring new services business. Considering all the above factors, I think there is a good chance that IBM in 10 years will generate much higher revenues. When growth kicks in, with a high margin and high ROE, IBM will likely to enjoy the double joy of profit expansion and multiple expansion. I don't know when this will happen but the odds are good.

Then in October last year, I wrote another article explaining why IBM went from a great business to a good business since Buffett bought it, and I raised the question of whether IBM may be too hard for most of us to understand. Here is what I wrote:

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. 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.

Fast forward to today. As I have evolved from the idiot investor that I was in 2014, and after reading IBM’s annual reports for the past 25 years, a few books on both the history and the business of IBM, as well as the recent investor presentations and earnings call transcripts of IBM, there are a few things that became clear to me related to what I wrote in the first article:

  1. Everybody knows that IBM has changed its business model to a software-oriented and service-oriented with higher margin and less capex need.
  2. Everybody knows that artificial intelligence, cloud, analytics, security, mobile are the future.
  3. Everybody knows that IBM’s ROE is higher than what it was 20 years ago.
  4. Everybody knows that IBM’s reported EPS is improving but sales are declining.
  5. Everybody knows that IBM is a cannibal.
  6. Everybody knows Warren Buffett (Trades, Portfolio) holds a significant amount of IBM’s shares.
  7. Everybody knows that IBM has survived each technological revolution in the past and think that it will do it again in the future.
  8. Everybody knows that “you can’t get fired from hiring IBM.
  9. By everybody, I mean even the average investor who hasn’t done any deep-dive research on IBM, which included me when I wrote the article a year ago.
  10. If everybody knows, the price of IBM back in May had most likely incorporated everything that I listed above. And the price of IBM today is also likely to have reflected them as well.

I have argued for the importance of second-level thinking, which is different and better thinking. In the case of IBM, I have yet to talk to an IBM investor who did not base their thesis on the things I have listed above. I’m not sure how many investors would have bought IBM if Berkshire Hathaway had not been a shareholder. From my observation, many investors, including myself, didn’t know enough about IBM but looked for confirming evidences of why Mr. Buffett bought it. I am not a shareholder of IBM but as you could tell from my previous articles, I have been the "one-legged man in the ass-kicking contest" as I was also subject to the lollapalooza confirmation bias, liking bias, authority bias, and consistent and commitment bias.

In the second part of this article series, I will share further thoughts on the complexity of IBM’s business and provide readers with some disconfirming evidence.

About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 4.8/5 (12 votes)

Voters:

Comments

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Thanks Grahamites. I look forward to part 2. I thought your comment that you weren't sure how many investors would have purchased IBM if BRK hadn't done so is quite astute. One of the dangers of piggybacking with gurus is stepping outside your circle of competence or investing criteria. They are a guide to learn from not a sure bet opportunity. Thanks again for the post. Best. - Tom

Praveen Chawla
Praveen Chawla premium member - 4 years ago

I too look forward to Part 2. I am long IBM. I also think that sometimes we can get outself into trouble by over-analyzing an issue. It is easy to tie freeze your self into inaction.

Hpeterscheck
Hpeterscheck premium member - 4 years ago

Great points.

One of my favorite areas where I think IBM in highly undervalued is in R&D. Another everyone know is:

"Everyone knows IBM is a slow dinosaur that is getting laped by the fast moving new companies."

I think this is where the general public is completely ignorant. There are lots of articles on cloud, social media, security and so on, but IBM is very far ahead when it comes to things that go beyond that. Anyone who spends a few hours here:

http://www.research.ibm.com/

will see what I mean. IBM research is taking on really big problems that are relevent for 20,30,50 and even 100 years from now and they are DEEPLY integrated into the governments, schools and private institutions that are doing that... and have been for a long time. People forget IBM basically invented silicon valley, basically invented computer science, and many such things that modern technology is built on.

Aside from companies like Siemens or BASF I can find almost no companies that have this level of innovation and integration. Amazon, Microsoft, Facebook, Twitter, Tesla... they aren't even CLOSE to IBM's breadth of innovation. Google is probably the only competitor that is close here but they are fairly narrow still. It's hard to find an area of human endevor where IBM isn't involved in some way.

Now the problem is, it's VERY hard to draw the line from that activity to next quarter's and next year's top line and bottom line growth. And without that, all this research will go away to be sure. But I still think that this deep integration gives IBM access early and often to future leaders who will then have relationships with IBM that can then be leveraged.

As for the business areas, I think IBM will figure this out. They have done so many times in the past. Of course, it's possible that this time they don't, but this is always true. If IBM significantly slashed this kind of R&D I'd be much more concerned. IBM is part of the future of humanity in very deep and broad ways and I think this is a very underestimated moat because people look at things like "Amazon has more cloud customers" and "Google is investing driverless cars" and compares it to their ignorance of what IBM is actually doing.

varunfriend
Varunfriend premium member - 4 years ago

Great article - look forward to reading #2.

A key variable is time .. how long is one willing to hold the investment. One way of looking at depressed price is that the market does not believe that the stock price will be higher in the next 1 - 12 months. Beyond that, the "smart money" in all likelihood does not care.

My investment thesis is that all of the points you make are known but the value maybe realized in the next 36 - 60 months and I am prepared to wait. Like you say, the ROE is high and they keep buying back stock and they have earnings growth so the math sort of seems inevitable to me. If any of those change, then it'll be time to reassess.

Disclaimer: Long IBM

hobot
Hobot - 4 years ago    Report SPAM

Everybody knows that IBM holds the most patents in the US.

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