How To Get A Better Deal On This Stock Than Buffett
By Jody Chudley | November 13, 2014 |

Everyone who invests money is aware of Warren Buffett -- the richest and most successful equity investor the world has ever known. Unlike many billionaires who made their fortune with one really good idea, Buffett made his by repeatedly picking outperforming investments.

Arguably, there is no better stock picker from whom to borrow ideas.

What might surprise many is just how concentrated Buffett’s massive portfolio still is. As of his most recent annual report Buffett’s company Berkshire Hathaway, Inc. (NYSE: BRK-A) had a $117 billion equity portfolio and a whopping $64 billion, or 54.7%, of that was invested in just four companies.

Buffett has always run with a very concentrated portfolio. The reason: he is laser-focused on not making mistakes. Buffett’s first rule of investing is don’t lose money.  His second rule is don’t forget rule #1.

If an investment isn’t an absolute slam dunk, then Buffett doesn’t invest a penny. Three years ago, when Buffett invested the largest single sum of money in his career in one company, people paid attention.

Buffett quietly accumulated a massive $11 billion position in International Business Machines Corp. (NYSE: IBM) starting in 2011. I say quietly because he received a special exemption from the Securities & Exchange Commission allowing him to accumulate shares without disclosing his actions. This was by far the biggest initial stake Buffett had ever taken in a publicly traded company.

Now three years later, IBM shares have taken a hit and we have an opportunity to invest alongside Buffett at prices that are better than what he paid for much of his position.

According to the 2013 Berkshire annual report, the company owned 68.1 million shares and paid $11.68 billion for them. That means Buffett paid $171.76 on average for those shares. Shares currently trade around $163.

The IBM investment was a bit of a departure for Buffett, who has always contended that he avoided buying stocks of technology firms because it was hard for him to understand their business plans and forecast their prospects.

At the core of Buffett’s concentrated investing style is buying businesses that have giant moats around them -- meaning a typical Buffett company is almost immune to competition. Buffett believes that a superior business with a moat protecting it will, over time, be able to compound its earnings at acceptable rates of return. The larger the moat, the less chance Buffett’s investment won’t work out over a long time horizon.

A lack of a moat is why Buffett has typically avoided the technology sector where change happens quickly and a moat is difficult to create.

IBM is a little different than most technology companies, and apparently it took Buffett a long time to figure that out.

IBM provides information technology support services to companies on a global scale.  The really attractive thing about IBM is that more than half of its revenues are recurring, with nearly two-thirds of revenue generated from international operations.

The company's moat is the idea that once IBM is ingrained in a business (the customer), it is very tough (and prohibitively expensive) for that company to move away from IBM. That creates the company's recurring revenue stream and predictable cash flow, which Buffett loves.

IBM's cash flow is attractive, but what it does with it is even more appealing.

The first part of IBM’s return of capital is in the form of a dividend. At current share prices, the stock yields 2.7%, which, in a world of zero interest rates, is quite attractive.

The second part of IBM’s return of capital is in the form of share buybacks. Over the past four years, IBM repurchased (as per the most recent SEC filings) large amounts of stock:

YearStock Repurchased ($ billions)
2014 (Through September)13.5

IBM just announced the addition of another $5 billion to its share repurchase plan.

The key to making share repurchases effective is doing them when the share price is undervalued. Buffett believes that is the case.

Over the past four years, IBM’s cash flow from operations looks like this:

YearCash Flow From Operations ($ billions)

With 991 million shares outstanding and a share price of $163, IBM has a market capitalization of $162 billion. Add in the $32 billion of long-term debt outstanding and you have an enterprise value of $194 billion.

Based on the average operating cash flow of the past three full years (2011 to 2013), IBM trades at an operating cash flow yield of 9.7% (= $18.9 billion / $194 billion). Its price-to-earnings ratio is similarly just more than 10 times.

For a blue-chip company like IBM, these kinds of metrics are very cheap. A world-class company should trade for at least an average market multiple of 16 times earnings or higher.

Even if the IBM’s share price remains stagnant, the return of capital in the form of dividends and stock buybacks will, over time, turn this into an accretive investment. With every share that IBM repurchases, the earnings per share for remaining shareholders grow. So while earnings and revenue aren’t growing (of late) in absolute terms, earnings per share continue to increase.

That is the beauty of owning a big cash flow machine like IBM and undoubtedly a big part of what Buffett sees in the company.

Risks To Consider: Nobody is perfect, not even Buffett (although he has been pretty close), take a position size in accordance with your risk tolerance.

Action To Take --> Take advantage of recent share price weakness and follow Warren Buffett by buying shares of IBM -- at lower prices than he did.

With its solid dividend yield and share repurchases, IBM would make a solid addition to the Total Yield portfolio. Total Yield is a measure of shareholder friendliness, which equates to outstanding stock performance. Since 1982, this group of stocks has returned an average 15% a year and has outperformed the broader market during the dot-com bubble and the 2008 financial crisis. For more information about Total Yield investing, click here.

This article originally appeared on How To Get A Better Deal On This Stock Than Buffett