The Telegraph - Is this the next Tesco?
I have been reading Warren Buffett's annual chairman's letter to the shareholders of Berkshire Hathaway for more than 30 years. But he's been having a bumpy ride lately.
Probably most conspicuous was his admission of a "huge mistake" in buying shares in Tesco. He sold part of his stake in Berkshire's only significant investment in a British company at a loss after Tesco's string of disasters.
But it is another stake purchased by Mr Buffett that is also going badly which interests me currently. In 2011 Berkshire bought a large number of shares in IBM and is now the largest shareholder, owning 7pc of the company.
IBM recently abandoned its 2015 profit target of $20 per share, having made only $10.76 in the first three quarters of this year. Its share price fell as a result to a current $162, against a high for the year of nearly $200 and an average price for Berkshire's holding of $170 per share.
By coincidence, when Mr Buffett was buying Berkshire's stake in IBM, we were looking at it for the Fundsmith Equity fund and rejected it. Why?
The computer services giant had just delivered its "IBM 2015 Roadmap" in May 2010 via a PowerPoint presentation. My defensive instincts are immediately aroused when someone uses the term "roadmap" unless they are in a motor vehicle. "Plan" is a perfectly good and much less pretentious term.
This "roadmap" was intended to show how IBM would grow its 2010 profits of $11.52 per share to $20 by 2015.
Quite why any other investor should be impressed with this goal, even if IBM could achieve it, is beyond me.
But it is particularly curious that Mr Buffett might have been impressed given that he wrote in his 1979 chairman's letter: "The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc) and not the achievement of consistent gains in earnings per share." (Emphasis added.)
He seems to have overlooked his own advice in this case, as well as with Tesco.
Just to add to our sense of unease, the IBM "roadmap" described a number of "bridges" to growth in earnings per share. There was me thinking that a bridge was a structure that crosses a physical obstacle.
The "bridges" ("source" is a good word unless you are a civil engineer) for this "roadmapped" growth were roughly 40pc revenue growth, although this included acquisitions; 30pc "operating leverage" (cost cutting or productivity gains in English); and 30pc share "buy-backs", where a company uses its cash to buy its own shares, reducing the number in issue.
Acquisitions, cost cutting and share buy-backs are not a particularly high-quality source of growth. The cost cutting and share buy-backs are certainly finite – you can't cut costs and shrink your business to growth, other than growth in earnings per share, which Mr Buffett had already correctly rejected as a useful measure of value creation or performance.
And how can you know you will make acquisitions, and doesn't price come into it?
The share buy-back "bridge" was particularly worrying. The slides show it as $50bn of planned share repurchases. How could anyone be sure that they will repurchase shares over the coming years, let alone such a vast quantity? After all, what will the share price be? If the shares are trading above their intrinsic value, a share repurchase will destroy value, other than for those shareholders who exit by taking the opportunity to sell.
Yet when he disclosed Berkshire's stake in IBM, Mr Buffett said: "I don't know of any large company that really has been as specific on what they intend to do and how they intend to do it as IBM." So he was clearly impressed by the "roadmap".
Since IBM's abandonment of its "road map" target for earnings per share, much has been made in articles and blogs of Mr Buffett's sanguine view of IBM's share price performance over the years of this proposed buy-back programme.
In his 2011 chairman's letter he wrote: "We should wish for IBM's stock price to languish throughout the five years [of the proposed buy-back programme]. The logic is simple: if you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon."
This has led commentators to suggest that Mr Buffett must be cheering the drop in the IBM share price. However, there are probably a few useful words of qualification that he should have added to his views on IBM's share price and stock buy-backs. They are: "But of course it depends on the reason why the share price falls."
If the shares fall because the company's prospects have deteriorated and so has their intrinsic worth, pressing on with share buy-backs may just be a waste of money – money that belongs to Berkshire and other remaining shareholders.
Given that this is exactly what appears to have happened, I suspect that the sound which can be heard from Omaha is not the cheering that some commentators have suggested but something reminiscent of an Edvard Munch painting.
Click here to view the article on Telegraph.com.
Terry Smith
The Telegraph