This morning on CNBC Warren Buffett, the largest holder in IBM (with nearly 9% of the shares outstanding), said he is not sure if he’s made a mistake owning the stock, but he has not sold a share. Watch the interview here:
Buffett started out by saying that sometimes when they buy a stock and it goes down they just sell it, other times they buy more and it works out. This coming from a guy who’s preferred investment time horizon is “forever”. There is recent precedent where Buffett bought a large stake in a U.S. mega cap stock, was wrong and closed. Exxon Mobile (XOM) early last year (read here). But in general, he has the luxury of being patient with investments that are not working. You and I don’t.
Since buying his initial $11 billion IBM stake in 2011, and registering mark to market gains, IBM has declined nearly 40% from its all time highs in 2013, while the S&P 500 (SPX), is down less than 10% from its highs and still up close to 70% from its 2011 lows. Sadly, Mr. Buffett could have thrown a dart at his Bloomberg Terminal and had a better return:
Since Buffett bought his initial stake in IBM, the company’s annual sales have dropped 23% from $107 billion in 2011 to $82 billion last year, while consensus is calling for a 5% decline in 2016 and its second consecutive 10% eps decline and eps estimate that is expected to match 2011’s $13.45 a share. The problem is that since 2011 the company has shrunk their float by over 200 million shares, massively aiding that eps number, with most of their operating cash flow going to capital return. Last fall legendary hedge fund investor Stanley Druckenmiller explained to Bloomberg’s Stephanie Ruhle why he thought it was a “high probability” short. To him IBM is old technology that will be replaced by the cloud. And he thinks there is a bunch of financial engineering and they are not investing in their future. He does not seem too bothered by Buffett’s investment. Watch here:
IBM’s nearly 4% dividend yield and commitment to share buybacks means the stock screens as cheap. But it seems clear that Druckenmiller thinks it is a value trap because they are losing at the innovation battle with companies like Amazon (AMZN) who are not managing earnings and are investing in their businesses to dethrone the likes of IBM.
That’s all fine and good, but the stock’s recent test of the long term uptrend at 5 and half years lows earlier this month could offer fundamental bulls a little hope that the stock might have capitulated:
Taking a look at the chart since its lows in 2009, it might have just bounced off of its prior post financial crisis breakout level:
IBM has been in a volatile stock despite its old tech status, which has been reflected in prices of its options prices, with 30 day at the money implied volatility at about the mid point of the one year range, options prices look fair to cheap:
So what’s the trade?? Well, you have a couple investing legends who view the stock in a very different way. If you asked little ol’ me, I’d say the stock likely sees lower lows as revenue growth may be very elusive without an expensive acquisition that would likely mean a slowing of their financial engineering and a higher leverage ratio.
But cause we are the risk reversal guys and we recognize that some of you might like to ride the coattails of some investing whales, we’ll lay out a long stock alternative with defined risk, and a way to short a company that is “short innovation” as Druckenmiller has referred to IBM.
We think it makes sense to look at to October expiration and give a long biased trade time as any stabilization and turnaround from here will take quarters. October expiration will catch Q1 results in April, Q2 results in July and likely even Q3 results in October. If I were inclined to play IBM from the long side, I might consider financing the purchase of longer dated calls.
IBM ($131.50) Buy April / October 140 call calendar for $4.35
- Sell to open 1 April 140 call at 1.05
- Buy to open 1 Oct 140 call for 5.40
Break-Even on April Exp:
The ideal situation is that the stock grinds higher to 140, the April calls expire worthless, offsetting the time decay of the October calls that you own. At that point you consider selling a higher strike call in Oct creating a vertical call spread, or possibly turn again into a calendar. The max risk to the trade is the $4.35 in premium paid.
Rationale: Targeting April expiration as Q1 earnings are already confirmed for April 18th, after April expiration:
If you agree with Druckenmiller, you might want to also use a put calendar, but play for a miss near term and possibly play for capitulation after Q1 results scheduled for April 18th.
IBM ($131.50) Buy April 120 / May 125 put vertical for $2.90
- Sell to open 1 April 120 put at 1
- Buy to open 1 May 125 put for 3.80
Break-even on April Expiration:
If the stock is above $120 on April expiration then the April put you are short expires worthless and you own the higher strike May 125 put (of a different strike) for $1 less. The ideal scenario is that the stock works lower in April expiration and then you have the opportunity to sell a lower strike put in May, creating a vertical put spread in front of earnings.