November 19, 2015
Should You Follow Buffett Into
This Beaten-Down Blue Chip?
By Joseph Hogue
When Warren Buffett's Berkshire Hathaway (NYSE: BRK-B) released its quarterly 13F statement this week, two things were clear.
For starters, the filing showed the Oracle of Omaha still has what it takes to make huge profits for his investors. For instance, his backing of the merger between Kraft and Hathaway-controlled Heinz in July generated more than $4.4 billion in profits.
It also reminded me of one of Buffett's greatest strengths: patience. One long-time Buffett pick has declined more than 20% over the past two years. Yet, he has been scooping up shares in recent months.
While short-term losses and long hold times aren't a problem for the third richest man in the world, average investors need to be able to realize a profit in a much shorter time frame.
Today's trade allows us to benefit from Buffett's ongoing bullishness on International Business Machines (NYSE: IBM) while potentially locking in a double-digit return in a matter of months.
Big Blue Will Rise Again
Buffett has continuously upped his position in Big Blue over the past two years as the stock has sold off. Earlier this month, he said he had no intention of exiting his stake, and the recent SEC filing shows Berkshire Hathaway bought an additional 1.47 million shares in the third quarter. It now owns 81 million shares worth about $11.7 billion, making it IBM's largest shareholder with an 8.3% stake.
A shift from high-end enterprise hardware to commoditized servers and cloud solutions has led to shrinking revenues.
But Buffett is thinking long term. And while revenue has been declining since 2011, Big Blue has shed non-performing divisions and improved profitability by 2.1% since then. System hardware now accounts for just over 7% of total sales while outsourcing and systems services make up about 62% of revenue.
Meanwhile, revenue from strategic imperatives like cloud, analytics and engagement grew 20% in the first three quarters of the year. Last year, strategic initiatives brought in $25 billion and accounted for 27% of sales. Management's goal is for the faster growing segment to bring in $40 billion a year and generate 40% of sales by 2018.
As for the balance sheet, it's difficult to find one stronger than IBM's. The company reported $118 billion in services backlog at the end of last quarter and has topped the annual list of U.S. patent recipients for 22 consecutive years. It's also sitting on $9.6 billion in cash, more than 7% of the company's market cap.
Management has proven its commitment to returning cash to shareholders. They repurchased $1.5 billion worth of shares in the third quarter as part of a $5 billion share buyback program approved a year ago. And the board of directors approved an additional $4 billion for that program late last month, bringing the total remaining authorization to $6.4 billion.
In addition to buybacks, management increased the quarterly dividend payment by 18% earlier this year. It now stands at $1.30 per share for a current annual yield of 3.8%.
Get Paid for Your Patience
While Buffett has said his favorite holding period for stocks is "forever," we can't afford to be that patient. So rather than simply buy the shares, I plan to exploit an "income loophole" that allows me to bring in cash every few months-- in addition to the already generous dividend -- while I wait for shares to rebound.
The strategy is known as a covered call. If you're not familiar with how it works or need a refresher, watch this short training video now.
With IBM trading at $135.82 per share at the time of this writing, we can buy 100 shares and simultaneously sell one IBM April 145 Call, which is trading around $3.12 ($312 per contract) for a net cost of $132.70 per share. This is 2.3% below the current price, offering us some downside protection.
If IBM closes above the $145 strike price at expiration on April 15, our shares will be sold for that price. In this case, we will make $9.18 in capital gains and the February dividend payment of $1.30 per share. When you combine this with the option premium of $3.12 we received for selling the calls, we get a total return of $13.60 per share, a profit of 10.2% over our cost basis of $132.70. Since we'd earn that in 149 days, it works out to an annualized gain of 25%.
If IBM does not close above the strike price on expiration, I'll keep the shares and write another call option against the position. Buffett has faith in IBM long term, and this "income loophole" provides a way to earn a steady cash stream while we wait for the company to prove him right.
And if you'd like to learn how to pocket an additional $795 in the next 48 hours using this "income loophole," follow this link.
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