Why Warren Buffett Is Wrong About IBM

By Jeremy BowmanFool.com

No one has been a bigger cheerleader for IBM over past five years than Warren Buffett, but the venerable tech giant seems to have lost that trusty road map.

IBM shares got crushed again two weeks ago, falling more than 5% after the company reported its 14th straight quarter of declining sales, with revenue falling 14% and adjusted EPS down 9%.

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The explanation for IBM's woes is a familiar one. Big Blue's transition from a hardware/software company to a cloud-based services provider is taking longer than expected, and sales and profits continue to fall as IBM sheds its older units. Management has maintained its claim that its strategy is the right one, but the market continues to disagree.

The stock is now trading at a five-year low, and has fallen more than a third from its 2013 peak. Buffett once asked for a stock swoon, saying in 2012, "We should wish for IBM's stock price tolanguishthroughout the five years."Needless to say, he's gotten his wish.

The stock has languished, allowing IBM to buy back even more stock than it otherwise could have, a strategy it hasn't hesitated to implement.

But after three-and-a-half years of sliding sales and broken promises about reaching $20 in EPS, it's clear that IBM's management has failed to achieve the goals it set for itself, and Buffett's bet has thus far been a poor one. Looking back at his quotes defending his purchase of IBM, we can now see that his logic was flawed. Here are a few reasons why:

Lauding past CEOsWhen he first dumped over $10 billion into Big Blue, Buffett argued that IBM had an excellent record of setting goals for itself and knocking them down, and praised former CEOs Lou Gerstner and Sam Palmisamo for rescuing the company from near-bankruptcy and driving growth ever since.

But current CEO Ginni Rommety was named to the leadership chair in 2011, and brought a new strategy. In the tech world, the direction of a single leader can mean the difference between blockbuster success and utter failure, and the accomplishments of Gerstner and Palmisamo mean little as the company transitions into the cloud era. There is no benefit derived from portraits hanging in the board room.

Incorrectly assessing IBM's economic moatPerhaps the most important quality of a Buffett stock is that it has an economic moat, or a sustainable competitive advantage. The Oracle of Omaha loves stocks like TheCoca-ColaCo,for example, which has an unrivaled brand name and distribution pipeline that provide it with a global reach and fat operating margins.

"I would imagine if you're in some country around the world and you're developing your IT department, you're probably going to feel more comfortable with IBM than with many companies,"Buffett once said.The statement indicates he believes IBM's competitive advantage is in its relationships with IT departments, along with its reputation and history as a provider of IT services and products. But as IBM transitions into a different kind of company than it's been previously, that advantage loses value.

The fast-changing computing landscape explains why other legacy tech giants likeOracle,Hewlett-Packard, andMicrosoft have struggled in recent years, compared to younger web-based companies. If Buffett's thesis were true, we'd expect IBM to be leading the cloud revolution. Instead, that title belongs to Amazon.com, which saw the opportunity early and invested heavily in it. According to tech research firm Gartner, Amazon has more than 10 times the computing capacity of the next 14 largest cloud providers.

Investing outside of your wheelhouseBuffett long eschewed investments in tech companies, claiming he didn't understand the industry and couldn't project future cash flows. But he made an exception for IBM for the reasons above, claiming he had studied the company closely over his career, having read its annual reports for 50 years. However, in technology especially, oldest is by no means equivalent to best, and the biggest tech stocks today are much younger than IBM. As the chart below shows, IBM has significantly lagged the biggest names in tech since Buffett first bought shares in 2011.

IBM data by YCharts

Facebook, not included in that chart, is up more than 150% since its 2012 IPO. A bet on any four of those stocks would have delivered more than $10 billion in gains back to Buffett'sBerkshire Hathaway . Instead, his conglomerate is in the red on its IBM bet

Buffett's wish for the share price to languish has been granted, but cheap buybacks without growing earnings are meaningless. After all, the best companies on the market don't thrive because of share repurchases. They invest in research and new opportunities, and develop new businesses that drive profitable growth. IBM, with its sluggish transition into cloud computing and excessive on returning capital to shareholders, seems to have forgotten how to do that.

The article Why Warren Buffett Is Wrong About IBM originally appeared on Fool.com.

Jeremy Bowman has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Facebook. The Motley Fool owns shares of Microsoft and Oracle and has the following options: long January 2016 $37 calls on Coca-Cola, short January 2016 $43 calls on Coca-Cola, and short January 2016 $37 puts on Coca-Cola. The Motley Fool recommends Coca-Cola. 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.

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