IBM And Apple: The Truth About Buffett's Technology Buys

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So far this year, the Nasdaq composite has been the best performer out of the three major indices. Investors seem to be warming up to tech, particularly some of the larger players in the technology space, and while it might seem like a disconnect to talk about technology and Warren Buffett, the Oracle of Omaha has broken his longstanding "no tech" rule with major investments in both Apple (AAPL) and IBM (IBM)

He has held IBM for a couple of years, so that is not new, but Buffett did make recent headlines with a major increased stake in Apple. Berkshire Hathaway's stake, as of Dec. 31, 2016, rose to 57.36 million shares of Apple, almost four times the amount he held on Sept. 30 of last year.

To understand why Buffett might be starting to look at tech, you first have to look at some the rules that govern his investment philosophy.

Warren Buffett's number one rule is "never lose money," followed quickly by his second rule, "repeat No. 1," but his Berkshire Hathaway violates both tenets all the time.

Just look at its stake of International Business Machines, which makes up 9.1% of Berkshire's holdings and is considered one of its "big four" positions. Berkshire began building this stake in the spring of 2011, and at the end of June that year IBM was trading around $174.

Four years later, in September 2015, IBM shares were at $137, a clear violation of his first rule.

Last year on CNBC he seemed sanguine about it. "We've owned stocks that we've lost money in. If I'm wrong, you sell them out and take a big loss. We've done that on a few occasions with stocks and bonds over the years."

IBM was a curious pick for Buffett, who has famously avoided technology stocks over many decades of investing, Berkshire took on 63 million shares of IBM that year at a cost of about $11 billion. It continued to add to that position even as IBM shares fell and revenue declined quarter after quarter. Last year Buffett told investors he had no intention of disposing of it and expected the shares to rebound.

The mystery into his thinking--more likely that of his two investing lieutenants--deepened last year when Berkshire took on a stake in Apple. Back then, Apple traded at $93 a share. Berkshire has continued to amass shares, with Apple representing 4.5% of its holdings as of the end of last year. (as a side note, Validea's Buffett-based model has long rewarded Apple, ranking up as one of the top-rated stocks for some time and well ahead of Berkshire's own purchase of the stock).

Both of these technology giants are leaders in their sectors but many believe their best days are behind them. The world is moving to cloud computing, and people can only own so many personal computing devices. So what could motivate someone to make bullish bets on the futures of these two American companies?

Both have settled in as slower growth companies that pay investors back in dividends and share buybacks, enough to compensate for short-term drops in their stock prices.

Buffett's view of stock ownership is that it is the same as company ownership. Berkshire owns about 9% of IBM, so it should be entitled to 9% of IBM's earnings, which were $11.9 billion last year, putting Berkshire's cut at around $1.07 billion. Depending on how much money Berkshire spent to buy IBM shares--say it's $14 billion--that would be a return of 7.6%.

Of course this isn't going to show up on Berkshire's books all at once, but it's enough to suggest future earnings. In his 2011 letter to Berkshire's shareholders, Buffett said IBM would deliver benefits in the form of billions of dollars in dividends and repurchases. IBM's share count has fallen from 1.1 billion outstanding to 900 million, an indication the company is buying back shares, which boosts a shareholder's portion of earnings. IBM also pays out about 44% of its earnings as dividends.

Likewise, Apple's share count has declined over five years and it pays out more than one quarter of its earnings to shareholders. Apple's fiscal 2016 earnings of $9 billion means Berkshire's 4.5% stake works out to under $450 million.

If IBM is a services company, its mission to help clients solve technology problems hasn't changed despite the world's a necessary shift away from computer hardware to analytics and security. Most of IBM's customers rely on more than one IBM product--Apple, too. And both brands command the hearts and wallets of their clients.

IBM shares now trade around $180. And Apple trades at $135.

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