Thoughts on Business and Technology

How to Sell a Stock

declineofIBMWarren Buffett sold off a third of his 81 million shares of IBM stock in the first two-quarters of 2017. This was one of the headlines in the past couple of days. Investors and reporters were eager to know Buffet’s opinion on IBM and his prognosis of its future.

Most of us are used to thinking in an all-or-nothing way about stocks. We either like a stock and own it or we sell out of our position when we are doubtful about its prospect or when we hear negative news about the company.

The human brain is inherently bad at dealing with probabilities. This is largely evident in the field of investing where investors try to handicap companies as potential investments, especially in the face of uncertainty.

Successful investors think in terms of probabilities, as Charles Munger noted in his 1994 lecture to the University of Southern California

“Buffett…automatically thinks in terms of decision trees and the elementary math of permutations and combinations…”

The reasons to sell IBM stock and the process Buffet followed as described in the interview with CNBC’s Beckie Quick are instructive for value investors. We can see Buffet’s probabilistic thinking and his disciplined approach in action.

Let’s first recap Buffet’s reasons (i.e. initial thesis) for buying IBM in his own words from his interviews in 2011/12

 #1 IBM had a clear roadmap and proven execution record under Sam Palmisano’s  leadership in the past years. 

I don’t think there’s any company that’s—that I can think of, big company, that’s done a better job of laying out where they’re going to go and then having gone there. They have laid out a road map and I should have paid more attention to it five years ago where they were going to go in five years ending in 2010. Now they’ve laid out another road map for 2015. They’ve done an incredible job. First, Lou Gerstner, when he came in, he saved the company from bankruptcy. I read his book a second time, actually, after I read the annual report. You know, “Who Said Elephants Can’t Dance?” I read it when it first came out and then I went back and reread it. And then we went around to all of our companies to see how their IT departments functioned and why they made the decisions they made. And I just came away with a different view of the position that IBM holds within IT departments and why they hold it and the stickiness and a whole bunch of things. And also, I read very carefully what SamPalmisamo has said about where they’re going to be and he’s delivered big time on his—on his—on his first venture along those lines.

#2 IBM is a shareholder-friendly company and has been buying back shares consistently

The other thing I would say about IBM, too, is that a few years back, they had 240 million options outstanding. Now they probably are down to about 30 million. They treat their stock with a reverence which I find is unusual among big companies. Or they really—they are thinking about the shareholder.

#3 IBM customers have significant costs and that protects IBM from competition in the short term while they work on their transformation

And if you think about it, I don’t want to push the analogy too far because it could be pushed too far. But, you know, we work with a given auditor, we work with a given law firm. That doesn’t mean we’re happy every minute of every day about everything they do but it is a big deal for a big company to change auditors, change law firms. The IT departments, I—you know, we’ve got dozens and dozens of IT departments at Berkshire. I don’t know how they run. I mean, but we went around and asked them and you find out that there’s—they very much get working hand in glove with suppliers. And that doesn’t—that doesn’t mean things won’t change but it does mean that there’s a lot of continuity to it. And then I think as you go around the world, IBM, in the most recent quarter, reported double-digit gains in 40 countries. Now, I would imagine if you’re in some country around the world and you’re developing your IT department, you’re probably going to feel more comfortable with IBM than with many companies.

#4 Cloud is not a winner take all business and there will be room for a player like IBM, especially in hybrid cloud 

The cloud space, which IBM is making a big push into, is not a “winner take all” business, and if you ask some of America’s biggest companies if they’re doing a lot of business with IBM, the answer is and will likely continue to be “yes.”

Since 2011 IBM’s revenue and profits continued to decline and the first quarter of 2017 marked a 20th consecutive quarterly decline as growth in new businesses like cloud services and artificial intelligence failed to make up for slumping legacy hardware and software sales.

For years, Chief Executive Officer Ginni Rometty has been investing in higher-growth areas and moving the technology company away from older products like computers and operating system software. Even as she has shed units to cut costs and made acquisitions to bolster technology and sales, the legacy products are still a drag. During this time, investors have been waiting for the inflection point when the newer areas make up for the declines in the older ones.

In May 2017 Warren Buffett disclosed the sale of a third of his 81 million shares of IBM stock in the first two-quarters of 2017. Buffett outlined his thought process and reasons for selling IBM and why he sold a third of his stake in his interview with CNBC. Here are some key learnings from this interview.

When do you sell a stock?

   Once you make the decision to buy a stock (i.e. a piece of ownership in a business)

  1. Monitor the health and progress of the business periodically and verify if it confirms or disproves your thesis
  2. If your initial thesis is completely proven wrong, you should sell out of the stock, regardless of the price. Unless you have a new thesis based on the changing conditions in the industry and you till believe in the management and the prospects of the business.
  3. If part of your thesis is not playing out as you had expected due to changing industry conditions, however, you still believe in most of your initial thesis and the should reevaluate your valuation or the intrinsic value of the business

Why Buffett sold nearly a third of his position in IBM ?

One of the critical factors for IBM’s success is their transformation in the era of cloud. However, the industry conditions are changing fast and are not favorable for IBM with tough competition from string players like Amazon , Google and Microsoft.

Buffett waited patiently for six years and allowed IBM’s management to execute on their plan without any pressure, however, after six years he recognized he had sufficient data to make an informed assessment of IBM’s business and valuation.

He concluded that some of his initial thesis was not playing out as expected due to change in business conditions, however, it does not mean the end of IBM’s business. Based on his reevaluation and opportunity costs, he made the decision to sell one-third of his position in IBM.

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