John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
Three years ago, the normally tech-wary Warren Buffett and Berkshire Hathaway began snatching up shares of tech sector titan International Business Machines (IBM). Since then, Mr. Buffett's firm has increased its stake in the New York State-based company to 7 per cent, or more than 70 million shares.
But while IBM has a number of Buffett-esque qualities – a decade of increasing annual earnings per share, reasonable debt, a high return on equity – could another tech sector powerhouse now be even more Buffett-esque?
Yes, according to my Buffett-inspired Guru Strategy. This quantitative model, which is based on the book Buffettology (written by Mr. Buffett's former daughter-in-law and colleague Mary Buffett), is looking west to Cupertino, Calif. – the home of none other than Apple Inc. Following Apple's fiscal fourth-quarter earnings announcement in mid-October, my Buffett-based model upgraded the stock to a very strong 93-per-cent score, eclipsing IBM's still-solid 75-per-cent score.
While Mr. Buffett certainly looks at non-quantitative factors when assessing a stock, in the end his approach comes down to the numbers on a company's balance sheet and in its fundamentals. And on that basis Apple comes out ahead of IBM. For example, Mr. Buffett likes conservatively financed companies, and my Buffett model calls for companies to have enough annual earnings that they could, if need be, use those earnings to pay off their debt within five years (and preferably two). With about $33-billion (U.S.) in debt and $16-billion in annual earnings, IBM makes the grade. But with $29-billion in debt and $38-billion in annual earnings, Apple looks even better.
Mr. Buffett also likes to see strong management in a company, and one way he has measured that is by looking at how management uses the company's retained earnings – that is, the earnings a company keeps rather than paying out in dividends. My Buffett-based model requires a firm to have generated a return of 12 per cent or more on its retained earnings over the past decade. At 14.1 per cent, IBM passes the test, but Apple's 25.8-per-cent return is truly exceptional.
On several other Buffett-based tests, Apple and IBM's scores are close. Both have lengthy track records of increasing annual earnings per share, with Apple having just one EPS dip over the past decade and IBM having none. And both have stellar 10-year average returns on equity, a sign of the "durable competitive advantage" Mr. Buffett looks for in his investments. Both also have strong free cash flows – $6.33 a share for Apple and $8.42 a share for IBM – satisfying another Buffett model requirement.
There is one potential issue I'd point out with IBM, however. Over the past six years, IBM's returns on equity have soared, dwarfing Apple's. In three of those years, in fact, the company's ROE has been more than 75 per cent. But don't be fooled. Mary Buffett notes that "the problem with looking at high rates of return on shareholders' equity is that some businesses have purposely shrunk their equity base with large dividend payments or share repurchase programs. They do this because increasing the return on shareholders' equity makes the company's stock more enticing to investors." To account for that, she says, Mr. Buffett also looks at return on total capital. On that basis, the apparent big advantage IBM has over Apple based on its high ROE disappears – both firms' returns on total capital have averaged about 30 per cent over the past six years. (Because of issues like this, my Buffett-based model likes to see ROEs that are high, but also consistent – and not so high that they are unsustainable.)
While a return on total capital of 30 per cent or so is excellent, this gap in IBM's ROE and ROTC echoes what a number of analysts have been saying in the wake of the firm's recent earnings miss. The New York Times' Andrew Ross Sorkin wrote, for example, that "shareholder friendly" manoeuvres such as share buybacks and dividend payouts "have been masking an ugly truth: IBM's success in recent years has been tied more to financial engineering than actual performance." Indeed, while Apple's growth has slowed, it has still increased sales in each of its past two fiscal years (which end each September), by a total of about 17 per cent. IBM's sales, meanwhile, are on track to fall in 2014 for the third straight year.
In the end, the Buffett model still sees a lot to like about IBM. But in Apple's lower debt load, higher return on retained earnings, and more consistent, sustainable return on equity, it sees several reasons why investors might want to be a Mac instead of PC right now.
Disclosure: The author is long AAPL.