Buffett’s Startling Lack of Diversification (Part Four): Why a 30% Gain in IBM Saddens the Old Boy

Since the beginning of 2011 Warren Buffett has built a 67 million-share stake in International Business Machines (IBM), worth close to $13 billion. That accounts for more than 18% of Berkshire Hathaway’s (BRK.B) common-stock investment portfolio, ranking just behind Buffett’s mega stakes in Coca-Cola (KO) and Wells Fargo (WFC), and followed by the fourth huge position, American Express (AXP). The four combined account for a staggering 70% of Buffett’s $75 billion portfolio.

So far, Buffett’s IBM stake has been a bit of a disappointment.

IBM Chart

IBM data by YCharts

The fact that IBM’s stock price has been on a tear is the exact opposite of what the long-term minded Buffett was hoping for. He told shareholders in last year’s annual report what would be best going forward: “ We should wish for IBM’s stock price to languish throughout the five years.”

With the stock doing just the opposite, IBM will be inclined to repurchase fewer shares. That in turn will reduce Berkshire’s prospective gain from higher per-share earnings that would occur if it repurchased a bunch of shares. “In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity.”

A quick buyback tutorial straight from Buffett (via last year’s annual report):

“Let’s do the math. If IBM’s stock price averages, say, $200 during the period [five years], the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%. If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $11⁄2 billion more than if the “high-price” repurchase scenario had taken place. The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon.”

And so far, IBM’s rising stock price has slowed down Buffett’s desired buyback activity.

IBM Stock Buybacks TTM Chart

IBM Stock Buybacks TTM data by YCharts

Now to be sure, Buffett’s not exactly regretting the IBM stake. As he noted, it’s the earnings trajectory that matters most.

IBM EBITDA TTM Chart

IBM EBITDA TTM data by YCharts

Still, Buffett has notoriously avoided the tech sector, so the fact that IBM vaulted into his Big Four might seem be a bit odd. But in fact, IBM is anything but a classic hardware or commodity-like tech manufacturer. More than half its revenue comes from the service contracts it has with enterprise customers looking to outsource all sorts of systems maintenance and development. That’s much stickier than flat out hardware sales that are tied to economic and product-cycle ebbs and flows.

IBM also fits the same global brand mode as Buffett’s Coca-Cola stake: nearly two thirds of IBM revenue comes from the 170 countries it sells into.

IBM and Wells Fargo are the only Big Four holdings that Buffett has added to in 2012. While the stock price run-up dampens the value proposition, IBM’s 13.9 PE ratio is still no higher than it was prior to the financial crisis, despite the fact that free cash flow has nearly doubled since 2008.

Carla Fried, a contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine.

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