Leave it to Warren Buffett to flummox investors.
The latest portfolio disclosure for Berkshire Hathaway (NYSE: BRK-A) reveals the Oracle of Omaha now holds a $10.7 billion stake in International Business Machines (NYSE: IBM).
That ranks as his portfolio’s second largest, based on market value. But it’s not the size of the bet that’s significant. It’s the sector.
IBM marks Buffett’s first major foray into technology stocks. For years, he shunned them. Yet now he appears to be embracing tech stocks with open arms. You see, Buffett also disclosed a roughly $220 million stake in chip giant, Intel (Nasdaq: INTC).[ad#Google Adsense 336×280-IA]But let’s forget trying to get inside Buffett’s head to discern this shift in strategy. There’s no direct profit potential in such a pursuit. Instead, let’s determine which one of Buffett’s newest portfolio additions holds the most upside potential for us.
And I know of no better way to arrive at such a conclusion than a good old-fashioned stock war…
Rules of Engagement
Just as we did with Visa and MasterCard, and Nokia and Research in Motion, the way a stock war works is simple. We conduct a blow-by-blow fundamental comparison of each company. And then determine a winner, in regards to current investment merit.
In this case, we’re going to focus on six fundamentals that Buffett covets most. So let’s get to it…
~ Economic Moat: Buffett coined this term to define the competitive advantages a company possesses that act as barriers to entry for competitors. And we’d be hard-pressed to find two companies with wider moats.
Intel ranks as the world’s largest semiconductor company, controlling roughly an 80% marketshare. Its unmatched research and development spending (equal to about 15% of sales in 2010) – and roughly $5 billion in capital expenditures each year – all but guarantee it’s going to continue to out-innovate and out-price (via lower manufacturing costs) any competitors.
IBM ranks as one of the world’s largest technology companies, selling hardware, software and services. Although it competes with different companies in each area, no competitors can match IBM’s breadth of offerings. Such status as a one-stop shop – and a focus on non-commoditized technology products – translates into a wide economic moat for the firm.
~ Profitability and Growth Opportunities: One of the most important profitability metrics to Buffett is return-on-equity (ROE). He insists on a minimum of 15%.
Based on that threshold, Intel passes muster with a ROE of 27.2%. But IBM passes with flying colors, boasting an ROE of 69.8%.
As for growth opportunities, although the personal computer market is maturing, analysts still expect both companies to increase profits, thanks to the exploding use of mobile devices. It’s a statistical dead heat, though.
Over the next five years, analysts expect Intel to increase earnings by an average of 11.1% each year. The forecast for IBM’s earnings is growth is 11.2% per year.
Advantage: IBM, given its much higher ROE.
~ Financial Strength: Buffett prefers companies with conservative balance sheets and more than enough cash flow to cover interest expenses, pay dividends, develop new products and/or buy back shares.
By those standards, both companies would be considered financially strong in their own right. When pitted against each other, however, Intel holds the advantage.
Despite being nearly half the size of IBM, based on market cap, Intel sports $15.2 billion in cash and only $7.3 billion in debt. IBM, on the other hand, is sitting on only $11.3 billion in cash and $30.2 billion in debt.
Moving on to operating cash flow, both companies generated just under $20 billion over the last 12 months. Again, given Intel’s smaller market capitalization, it’s impressive that the company spins off the same amount of cash as IBM.
~ Management: “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact,” says Buffett.
However, Intel and IBM have reputations for strong fundamental economics. So the quality of management is important. And in this case, both companies are in good hands.
“Lifers” with a strong track record of success sit atop both companies. Paul Otellini has been with Intel since 1974 and Virginia M. Rometty’s tenure with IBM goes back to 1981.
~ Valuation: First and foremost, Buffett is a value investor. So it’s no surprise that he scooped these stocks. Both are undeniably cheap. But one’s clearly cheaper than the other.
Intel trades for just 10.4 times historical earnings and 9.4 times forward earnings. Meanwhile, IBM trades for 14.5 times historical earnings and 12.4 forward earnings.
~ Yield: Being a value investor requires patience. That’s why Buffett prefers to get paid while he waits. And both Intel and IBM pay extremely safe and reliable quarterly dividends, based on their dividend payout ratios (32% for Intel and just 22% for IBM). However, Intel’s current yield is more than double IBM’s – 3.5% versus 1.6%.
And the Winner Is… Intel!
In the end, both companies represent compelling value investments. But Intel wins because it ranks as a cheaper, more financially secure and higher-yielding investment.
And in about six months, we’ll check up on the performance of each stock to declare the ultimate winner of this stock war.
Ahead of the tape,
— Louis Basenese[ad#jack p.s.]
Source: Wall Street Daily