Five Reasons Warren Buffett Should Take His Losses On IBM

Warren Buffett is a living investment legend. But he’s not always right.

He made a mistake when he invested in IBM — the 412,775-employee, $92.7 billion (2014 revenues) IT company — that has been shrinking every year since 2011.

And there are five good reasons for him to cut his losses at $2 billion and invest the proceeds — perhaps in Microsoft.

Before getting into those reasons, let’s examine Buffett’s philosophy of investing. As I wrote in September 2014, while thinking about whether Buffett would have invested in Alibaba’s IPO; I discovered that Buffett’s partner, Charlie Munger, had done a nice job of summarizing how Buffett thinks about investments.

Munger created a character named Mr. Glotz — modeled after Buffett. According to a 1996 speech by Munger, Mr. Glotz is a hypothetical investor who is looking for opportunities to turn $2 million into $2 trillion over the next 150 years — at a compound annual growth rate of 10%. Munger’s talk revealed that he believed Coke was such a company.

Munger suggested that Mr. Glotz would pick such companies by listening for 15 minutes to the CEO’s pitch. And he’d decide based on how well he thought it had built an indomitable global moat thanks to a strong trademark and a ”universal appeal” from harnessing “powerful elemental forces” that compel consumers to buy almost addictively.

Another important Buffett test for an investment back in 1998 was whether he could understand the business.

In May 1998, Bloomberg asked Buffett whether he would invest in tech stocks. He said, “The answer is no, and it’s probably unfortunate. I don’t know what that world will look like in 10 years, and I don’t want to play in a game where the other guy has an advantage over me.”

On November 14, 2011, Buffett decided to violate his rule against investing in technology companies. That was when he announced that he had acquired 5.7% of IBM — betting $10.7 billion on Big Blue (his stake in IBM is now 8.2%).

When Buffett bought IBM, he justified the decision based on a specific financial target – to hit EPS of $20 a share by 2015. As Buffett said, “They have laid out a road map and I should have paid more attention to it five years ago where they were going to go in five years ending in 2010. Now they’ve laid out another road map for 2015.”

I estimated that he bought IBM shares at $185 apiece in 2011 — they’ve since lost 25% of their value. And in the ensuing years, he’s acquired more shares at lower prices. So his cost basis is below $185. Forbes estimated that IBM shares trade 15% below Berkshire Hathaway’s cost basis in them.

Buffett is sticking with Big Blue. According to Berkshire’s quarterly filing, “IBM continues to be profitable and generate significant cash flows. We currently have no intention of disposing of our investment in IBM common stock. We expect that the fair value of our investment in IBM common stock will recover and ultimately exceed our cost.”

IBM believes that Buffett’s confidence in its future is justified. According to Ian Colley, Vice President IBM Communications, “In the Cloud market, IBM already has $9.4 billion in revenue for the last 12 months. This is higher than any other company.”

Unlike Amazon — whose AWS revenues track cloud infrastructure service, IBM includes hardware in its definition of cloud. Synergy Research Group argues that IBM’s $7.7 billion first quarter 2015 cloud revenue included $2.9 billion worth of hardware and $3.8 billion in service.

“Overall, IBM’s strategic imperative areas (Cloud, Analytics, Mobile, Social and Security) represented $25 billion in IBM revenue in 2014, and have been growing at 30% so far in 2015,” notes Colley.

Here are five reasons Buffett should take his losses on IBM.

1. IBM lacks a roadmap

In October 2014, IBM abandoned its roadmap to earn EPS of $20 a share by 2015 (employees had long dubbed it Roadkill 2015).

It looks like IBM will be lucky to pull in the $14.88 a share 11 analysts expect it to make by the end of 2015.

Moreover, CEO Ginni Rometty has presided over 14 straight quarters of declining results since taking over at the beginning of 2012.

2. IBM’s products lack universal appeal

I will concede that organizations do buy computer hardware, software, and consulting services and IBM is in all those markets.

But the IBM brand does not have the power that Coke has created and maintained for all these years.

3. Customers lack an addictive need to buy IBM’s products

IBM was a leader in the IT industry. But is it still? If customers had an addictive need to buy IBM’s products, I would expect it to be a market leader in all its product lines.

Colley says IBM’s $17 billion in analytics revenues makes it “a global leader in analytics and big data.”

Sadly, it is not the leader in

4. IBM has no moat

IBM used to have the best business sales force in the computer industry. It used to be said that nobody got fired for buying from IBM.

But IBM faces serious competition in every market in which it participates — except perhaps for mainframe computers.

It wants to make a splash in the cloud — but how will it take market share from Amazon and Microsoft?

IBM prides itself on its high patent count (7,534 in 2014) – but does IBM turn those patents into a moat that would impress Mr. Glotz?

Is there any IT industry segment in which IBM enjoys a lead that rivals can’t erode?

5. Buffett lacks computer industry insight

Buffett long ago admitted that he had no edge in investing in the computer industry.

He is friends with someone who does though — Bill Gates. And Buffett is planning to give all his money to Gates’s foundation.

Microsoft is getting close to an all-time high after languishing under Steve Ballmer’s leadership for many of the last 15 years. But Satya Nadella has brought its shares back to life — since he took over as CEO in February 2014, Microsoft stock is up 50%.

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