Warren Buffett Buys More IBM: Should You Do the Same?

By Markets Fool.com

Warren Buffett's Berkshire Hathaway first bought shares of IBM in 2011, a drastic departure from Buffett's typical avoidance of tech stocks. Buffett has added to that stake over the past few years, including spending $400 million on shares of Big Blue in the first quarter of this year. Berkshire Hathaway's position in IBM now accounts for 11.9% of the company's stock portfolio.

Continue Reading Below

While blindly following well-known investors into stocks is rarely a good idea, there are a few good reasons for investors to consider loading up on IBM.

A wonderful company
During Berkshire Hathaway's annual meeting this year, Charlie Munger called IBM "a wonderful company" -- and for good reason. IBM's competitive advantage comes not from any individual business, but from the combination of its hardware, software, and services businesses. In other words, the company is worth more than the sum of its parts.

Providing integrated solutions for its clients has allowed IBM to thrive over the past decade, tripling earnings per share during that time. While the nature of these integrated solutions ultimately might change, given the rise of cloud computing, IBM's competitive advantage remains intact.

The cloud itself isn't a solution, it's a tool. Furthermore, the rapid growth of the infrastructure-as-a-service market, in which computing resources are rented, isn't as big of a threat to IBM's business model as many seem to think. The cloud is unlikely to ever replace IBM's mainframes, which are designed to run for decades and provide the reliability and security required by its customers, such as financial institutions.

IBM's own cloud platform, Bluemix, provides much of the company's software delivered as a service. Developers can use IBM's analytics, security, Big Data, and mobile services to power the back end of their applications, including IBM's cognitive computing system, Watson.

Continue Reading Below

IBM isn't focusing on simply renting out computing resources, a la IaaS leader Amazon.com, because there's no competitive advantage besides scale to be gained there. In the age of the cloud, IBM is still providing integrated solutions to its clients, whether through on-premises hardware such as mainframes or Power servers, hybrid cloud configurations, or the company's public cloud platform. This excerpt from IBM's 2014 annual report sums up how deeply embedded Big Blue is in the enterprise:

IBM lives at the intersection of technology and business. This enables us to change the way the world works, and in so doing, to be essential to our clients and to society. We work with 90 percent of the world's top banks, 9 of the top 10 oil and gas companies, 40 of the top 50 retailers and 92 of the top 100 health care organizations. IBM systems manage banking, reservations, transportation, retail, trading and health care systems. Our mainframes alone process 75 percent of the world's business data.

A bargain price
In 2014, IBM reported net income of $15.8 billion. With a current market capitalization of about $170 billion, this puts IBM's trailing P/E ratio at 10.75.

Now, the P/E ratio is only half the story -- the faster a company is growing earnings, the higher the P/E ratio it deserves. IBM grew EPS by 2% in 2014, but this was due to extensive share buybacks. Net income actually declined by 7% year over year.

Revenue has also been declining. In 2014, IBM recorded revenue of $92.8 billion, well below the $106.9 billion the company reported in 2011. At first glance, this looks like a disaster for the company. But IBM's revenue has been mostly stagnant for the past decade, fluctuating around $100 billion. Meanwhile, earnings per share has increased dramatically.

IBM is not a company that attempts to grow revenue at the expense of profit. The company routinely sells off businesses in which it no longer has a competitive advantage, causing revenue to decline but margins to rise. In 2014, IBM disposed of its x86 server and microprocessor manufacturing businesses, neither of which contributed much to the company's profit. In fact, the microprocessor manufacturing business was losing billions, and IBM had to pay GlobalFoundries to take it off its hands.

This transition -- getting rid of low-margin businesses and shifting resources to opportunities including analytics and the cloud -- has added some volatility to the company's quarterly results. In the long run, however, IBM expects to grow EPS by a high single-digit percentage annually, driven by single-digit revenue growth, margin expansion, and share buybacks.

It doesn't take much growth at all to justify IBM's rock-bottom valuation, and if the company even comes close to these long-term targets, investors should be handsomely rewarded.

A solid dividend
Along with sporting a bargain valuation, IBM has transformed into one of the most attractive tech dividend stocks. Historically, while IBM has consistently raised its dividend, share buybacks have taken precedence. Over the past five years, IBM has reduced its share count by 6% annually; while it has also raised its dividend by a double-digit percentage each year, the yield has lagged behind those of other large tech companies.

The story has changed. IBM plans to reduce its share buyback activity going forward, repurchasing only 2%-3% of its outstanding shares each year. This creates more room for dividend increases, and with the dividend payment in 2014 at only about 34% of IBM's free cash flow, double-digit increases are likely for years to come.

Earlier this year. IBM bumped up the quarterly dividend payment by 18.2%, bringing the yield based on this new payment to about 3%. This is IBM's highest dividend yield in a decade, and it makes this one of the best tech dividend stocks available.

The article Warren Buffett Buys More IBM: Should You Do the Same? originally appeared on Fool.com.

Timothy Green owns shares of International Business Machines. The Motley Fool recommends Amazon.com, Apple, and Berkshire Hathaway. The Motley Fool owns shares of Amazon.com, Apple, Berkshire Hathaway, and International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.