Warren Buffett’s love for IBM is lost on me

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Some participating in the avalanche of analysis this week quickly cited another Berkshire Hathaway holding, International Business Machines Corp. – and not favourably. Mr. Buffett, who long proclaimed an aversion to and ignorance of tech, bought big into IBM in 2011, just as the company began to stumble in its attempt to adapt to the future of computing. Even as numerous Buffett followers cite it as one of the investing guru's greatest mistakes, Berkshire Hathaway continued to add to its IBM position in the first quarter of 2016, bringing it to more than 81 million shares, worth over $12-billion (U.S.).

And yet, Mr. Buffett is not alone among legendary value investors in his IBM love. Fairfax Financial Holdings, the vehicle for Canada's Prem Watsa, bulked up on IBM in 2014 and now holds 1.36 million shares worth more than $200-million. While small in comparison to Berkshire's position, it's Fairfax's biggest U.S.-based, U.S.-traded stock holding, according to documents filed with that country's regulators.

It certainly raises the question: What do Mr. Buffett and Mr. Watsa see in IBM that so many others do not?

I am among the long-time doubters, having written pessimistically about IBM in August, 2013, and again in October, 2014. My concern, as is the concern of many, is that IBM's legacy businesses are in decline as its customers look to new, cloud-based computing solutions. While IBM, along with every other systems provider, tries to pivot to that future, it has buttressed its earnings per share not so much by increasing profit organically, but by constant cost-cutting and through aggressive stock buybacks.

IBM shares, despite gains this year, are below the levels at which Mr. Buffett and Mr. Watsa have done the bulk of their buying.

Mr. Buffett hasn't offered a spirited defence of IBM (except to buy more, one supposes), instead lumping it in with his other major holdings of American Express Co., Wells Fargo & Co. and Coca-Cola Co., comparing them in his recent shareholders' letters to having a stake in the Hope Diamond.

It is in the 2011 annual letter where he discussed the IBM purchase, however, that Mr. Buffett outlined a vision for the stock that suggests things aren't completely off course. While he wrote "in the end, the success of our IBM investment will be determined primarily by its future earnings," he also emphasized the "financial management" – some might call it "financial engineering" – at the company.

"When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well."

Mr. Buffett's argument was that IBM would spend billions of dollars repurchasing shares over the subsequent five years; the lower the price of the stock, the more shares would be repurchased, and Berkshire Hathaway's stake in the company would grow without it having to add to its position.

"The logic is simple: If you are going to be a net buyer of stocks in the future … you are hurt when stocks rise," he wrote. "You benefit when stocks swoon."

The problem with Mr. Buffett's thesis, however, was the part about IBM's earnings "increasing at a good clip." In his explanation of the buyback principle, he suggested that IBM, having posted $15.9-billion in 2011 profit, might "earn, say, $20-billion" in the fifth year of Berkshire ownership, which would be now.

In the past 12 months, however, IBM has recorded $12.9-billion in profit, and the company has had to retire more than 200 million shares just to keep earnings per share flat at $13.25. Total revenue has fallen by 25 per cent. (Figures from S&P Global Market Intelligence.)

Of course, Mr. Buffett and Mr. Watsa have a famously long-term view, and this they see, perhaps, as just a bump in the road. And there are a handful of analysts who agree, offering "buy" ratings on the shares because they are cheap, the dividend yield of 3.7 per cent is appealing, and, importantly, the company says that 40 per cent of its revenue now comes from its "strategic imperatives" of data, cloud computing and social-media-driven engagement. Writes Morgan Stanley's Katy Huberty, "We believe IBM has better prospects than most hardware companies with limited strategies to transform."

It is indeed a transformation, and a slow one at that. Mr. Buffett, and one also suspects Mr. Watsa, see IBM as able to make the necessary changes to survive in the long run. For the near term, however, they are the owners of a growing piece of a shrinking pie.

Disclosure: The author owns Berkshire Hathaway and Apple shares.