Sunday, November 15, 2015

No “All Time” Growth Stocks Exist
IBM: Yesterday’s Apple


My blog post of November 1, 2015, was entitled “Rising Earnings Do Not Make a Growth Stock.”  In keeping within the topic of looking for sustainable growth, being a confirmed contrarian is useful at times like this when I search for a contrary value. Sometimes this approach produces good results. At the moment many people are giving up on growth investing in general but chiefly in healthcare, tech (particularly Apple*), China and other emerging markets and many consumer goods/services companies.

*Held personally and/or by the private fund I manage

Many of today’s portfolio managers and most individual investors don’t know during my investment lifetime there was one very prominent growth stock that was the Apple of its day, International Business Machines or IBM. In last week’s blog post I suggested that critical investment and business management courses could be focused on Berkshire Hathaway; I believe every investor who is going to devote a significant portion of his/her portfolio should also have a course on IBM. (This thought was triggered by a lengthy article in a Sunday New York newspaper on the company’s attempting to a bring a style focus to its products. As usual with this paper it was an incomplete piece which neglected to track the major shifts in how IBM’s shareholders have viewed its stock over time. The change of their attitudes mirrored many of the changes in the operations of the company.)

A Personal Note 

My Grandfather who led his own brokerage firm for the first twenty or so years of the 20th century told his grandchildren about being one of the few outsiders other than company executives to attend a dinner with the then CEO Tom Watson and many of his family who were placed at each table. My Grandfather was not a security analyst, (at that time called statistical people), or a technologist of any type. He was impressed with the reported growth of the company and was impressed with Mr. Watson. On the basis of this appreciation and friendship IBM played a prominent role in many investment accounts for my family. When my brother and I became professional investors, we urged with some trepidation that the oversized positions be reduced as the market had placed a higher value on IBM’s growth than we did.  At the present time I don’t directly own any IBM and it is not a prominent position in our much larger investments in mutual funds. Perhaps, as the company evolves to more of a service company we should own the stock, but I hope more of our growth oriented mutual funds take positions in IBM.

I have had three other interactions with IBM that colored my evolving views on the company. The first was that while in the US Marines (as often the case in training as one of the smallest Marines) I was assigned to carry and fire a Browning Automatic Rifle (BAR). It was the only automatic weapon the infantry squads carried. It was considerably heavier than our usual rifles particularly with its ammunition. During World War II IBM converted its factories to war production including BARs.

The second interaction was when I was setting up my performance analysis service, I wanted to have our own in-house computer rather than continuing to rent time on a trucking company’s mainframe. Not surprising  my computer associates talked me into going on the waiting list for the IBM 360 computer. Perhaps as part of the sales effort I was invited to spend close to a week at a school for IBM clients which was very interesting in terms of theory and a tour of its manufacturing line. (I must admit that the most long-term benefit of the school was for me to get to know the soon to be president of a client who was executing a major turnaround of a slowing great old name in the mutual fund business. He succeeded.) After returning from the school I was as usual impatient to move ahead and not wait six months for delivery. So I cancelled the order and had a Wang (which was good for us) operating within a few weeks.

The third interaction was that IBM was using our mutual fund data within their domestic pension operation. The domestic side did not control the retirement activities for the foreign affiliates. The domestic people asked whether we could help with providing statistical guidance for the separate foreign plans. At that time we had too little that we could do to help them, but the request reinforced the need  for non-US fund data in my mind. This in turn led to opening of offices in London and Hong Kong and the eventual sale of the data operations to Reuters Group. All of these interactions demonstrate to me that IBM is a multifaceted jewel that has been evolving for 104 years and like the blind men feeling the elephant, each interaction is informative, but incomplete.

A Brief Financial History

The original people of IBM came out of National Cash Register and formed a punch card reader and related products producer. The company that they formed had more debt than equity when it was publicly traded. Thus IBM started its financial history as what was then called a “watered” stock. We would call it junk. (The term ‘watered stock’ came from the stock yards where cattle were bulked up through large consumptions of water.) One of the functions of the punch card reader that was the company’s initial main product was reading punch cards of employee hours. Thus at one point it is possible that IBM was the largest clock producer in the US. During the Depression era the financial conditions were so stretched that the company paid its clock repair people partly in company stock. Years later some of these workers had multi million dollar portfolios for repairing time clocks. During WW II as much as possible the company’s manufacturing base was converted to war work. During the war some of IBM’s research was on the beginnings of the computer. Initially Tom Watson was not a believer in its commercial development. He is quoted in 1943 as saying, “I think there is a world market for maybe five computers.”

As shown in last week’s post on Berkshire Hathaway, analysts need to pay attention to legal, accounting and tax elements. IBM conducted its foreign activities in IBM World Trade which for a number of years was not consolidated fully into the company’s financial reports. Many of us analysts performed this task, including calculating the overall tax rate. One of the mistakes many early analysts made is that they thought of IBM as a manufacturer. In truth most of its revenues after the War until relatively recently were from leasing computers directly to ultimate users or third-party leases. Due to length of the leases one could project with a high level of certainty what future revenues would be. The leasing activities were helped greatly soon after the War ended.  Prudential loaned IBM at that time a very large $100 million for at least one hundred years. Thus IBM which was in effect a finance company, but was viewed as a leading institutional growth stock with a high multiple.

By the time I came to Wall Street in 1960, IBM was probably the single largest holding in most trust-quality portfolios. (Hence my family’s over commitment to the stock.) The company had competitors including Sperry Rand which had major support from General MacArthur for use in re-building Japan. None of the other competitors had IBM’s installed base of leasing revenues so they competed on both price and technology. Often the competition came down to IBM’s image, financing, and a good sales force against lower prices and faster machines. In addition, IBM’s sales force included sales engineers, think of Ross Perot. In response to the competitive pressure, the firm bet its future on a new computer system the 370 which eventually succeeded, but with lots of additional expense which hurt the relative stock price. Over time the fall in the stock price was halted by the dividend yield.

Thus over its history the IBM stock was viewed as an extremely leveraged speculation, an essential business manufacturer, a high quality growth stock, an income stock, and a turnaround candidate.

What Makes a Growth Stock

In essence a growth stock is a stock that many market participants will trade higher into the future. This is usually expressed as earnings per share growing faster than the market.  I take a different point of view as follows:

1.  All growth is cyclical and for some future periods each item will under-perform.
2.  I am not interested primarily in statistical measures. I am primarily interested in growth...of my capital.
3.  Combining the first two points I want to own value stocks that become growth stocks and growth stocks that become value stocks.
4.  To accomplish these goals I have two valuation metrics. The first is the long-term prospect of dividend growth. (The only reason for buy backs is to benefit management with their short-term employment contracts and remove some of the takeover target value.) The second metric is the strategic value of the company to a knowledgeable buyer.

Why is Growth Important Now?

In these posts we have introduced the Timespan L Portfolios®. We will need to populate at least half of the Endowment Portfolio with Growth investments, and even more in the Legacy Portfolio. As of the twelfth of November the only major mutual investment objectives both US and non-US showing positive performance are growth funds of varying market capitalizations; Large-Cap Growth +4.9%, International Small/Mid-Cap Growth 4.34%.

Globally the current job imbalance is reinforcing the focus on the lack of qualified workers to fill existing jobs. This indicates that there is a growing replacement of labor with capital, in part evidenced by machines. According to a recent advertisement by Fidelity, 80% of global GDP comes from non-US countries and only 26% of the world’s publicly traded companies are based in the US. Further a Bank of England economist suggests that up to 50% of the existing jobs in the UK could be replaced by smart robots in the future.

As a global society we need to support growth as a way to solve our growing employment problems. I wonder if the murderers involved in the dastardly attacks in Paris would have chosen a different approach to life and death if they were employed in a growth sector. 

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