The Hinterland recently had the ultimate test of value investor conviction when buying IBM; buying a stock and then seeing it immediately drop in value on the back of another quarterly decline in revenues. Just to galvanise the test, an acquaintance then publicly goaded me on Facebook for not buying Google or Apple, which both had enjoyed significant ‘pops’ on the back of quarterly results.
I’m happy to say that the Hinterland didn’t suffer from even a momentary pang of doubt. Quarterly results are of little concern to a value investor, and watching the vagaries of the stock market when they are published only reinforces the mantra that in the short term the market is voting machine whilst in the long term it is a weighing machine.
So why is IBM the preferred option over Google and Apple? The market’s obsession with revenues is a superficial measure when one looks at IBM as an asset and the yield from that asset. IBM has moved away from the declining and highly competitive hardware market (in which companies such as Hewlett Packard are suffering) in to the higher margin and less capital intensive ‘solutions’ space, enabling clients to benefit from technologies such as ‘Cloud’ and ‘Big Data’. Being an early mover in to this solid strategy has enabled IBM to post steady earnings growth over the previous decade.
A solid strategy has been reinforced by excellent financials and capital allocation. Gross margin is consistently hovering a little under 50% and net margin is consistently c.15%. Debt is not particularly low, but passes the screens of long-term debt being payable with less than 3 years of operating earnings and a debt to equity ratio of less than 0.8. The ratio of capex to net earnings is excellent, being consistently just c.30%. The Hinterland calculates owner earnings to be $16.5bn and it bought in at a market cap of $200bn, resulting in an ‘equity bond’ yield of 8.5%. This is a terrific return on such a stable, well-run company with a top-ten market cap globally. IBM also consistently ‘eats itself’ with stock repurchases at this sensible valuation, with c.$33bn of buybacks over the previous three years.
So why is Apple not such an attractive investment? At first glance it may appear to be with current owner earnings of $41.75bn producing an ‘equity bond’ return of 8.75%. However, when valuing a bond one is looking to be assured of a return over the long term and unfortunately consumer electronics does not offer this. Apple is a superb brand, attracting consumers with its ease of use and aesthetics and invoking almost fanatical loyalty among some. However, the consumer electronics market has no barriers to entry and the technological landscape moves as quickly as tidal sands. Look at the mobile phone market in the early noughties and where Nokia ended up. The same may easily happen to Apple’s iPhone. Look at the tablet market, in which Apple had a 60% market share, which eroded to just 30% in a single year. There is just too much uncertainty and no ‘economic moat’. The Hinterland can’t see where this company will be in ten years.
A similar rationale appears to Google. Google’s growth from its genesis as University research project in 1996 is little short of miraculous and one can only pour praise upon those who have founded and grown the company. The fact that 65% of the voting stock is still held by three individuals (Larry Page, Sergey Brin and Eric Schmidt) means the company has the advantage of retaining its entrepreneurial drive and control. The odds are that Google, with a brand name so strong it has actually become a verb, will do very well in the future, but it does face some significant threats in the constantly evolving internet market. Google’s dominance (which has seen off competitors such as Microsoft’s Bing) was built in the desktop browser arena. Consumer interaction with the internet is quickly moving towards alternative devices such as tablets, mobile phones, games consoles and televisions. This gives Google multiple new spaces that require conquering. The risks are that either manufactures do not elect to use Google, or that the varying portals and apps bypass a choice of search engine, or that Google’s full service offering does not integrate with these platforms. Another serious risk is that someone will develop a piece of software which filters out advertisements from internet browsing and this becomes widely used. Essentially what discourages The Hinterland is that there may be a guy sat in either a garage or University lab as we speak tapping away on something that will revolutionise the industry as Google did in the late nineties. Microsoft has survived for so long because essentially every business in the world uses Windows and moving away would be too much of a wrench. Google is still essentially a consumer brand. It could be dropped by consumers as internet technology moves on with hardly a second thought. If anyone tells you they know what the Internet market will be like in 10 years, they are deluded. I graduated with a Bachelors degree in Multimedia Technology in 2004. At that time I had used a tablet and developed a mobile application in ‘WAP’, but I couldn’t have foreseen the industry as it is now, and more importantly, who would have the competitive advantage within it.
The author is long IBM and holds no positions in either Apple or Google.