As part of my investment process, I like to watch companies that used to feature in my portfolio but that I have sold for one reason or another.
There are a couple of reasons why I follow this approach. Rather than selling up and not looking back, I try to understand what went wrong to see if I can learn something from the error.
Looking back at past ideas also helps me identify the challenges a company may face if it is struggling or trying to turn itself around. I can then use this knowledge to better understand business situations in the future.
A troubled company
International Business Machines (NYSE:IBM) is an example of one such former holding of mine. I bought this business shortly after Warren Buffett (Trades, Portfolio) in 2011, using a cloning approach. While I did not know much about the company at the time, I figured if Buffett was buying, it would be a great business.
I learned a lot from this trade. The biggest lesson was that copying another investor, even a superinvestor like Buffett ,is a bad idea, but that’s a lesson for another time.
Ever since I sold the stock in 2016, I have been watching the business, trying to understand where it went wrong and how it has been dealing with the challenges it faces in the ever-changing technology sector.
Over the past year, shares in IBM have produced a total return of 0.4% per annum. That is compared to a return of around 12.5% for the broader tech sector.
One does not have to look far to understand why IBM’s stock has struggled to keep up with the rest of the market. Net income has slumped from $13.2 billion in 2015 to $5.6 billion for 2020. Sales have slumped as well. From $81.7 billion in 2015, sales totaled $73.6 billion in 2020 and are projected to fall further to $60.7 billion by 2022.
IBM’s growth (or lack of it) is clearly a problem. It seems one of the reasons why the business is struggling is a lack of investment. Indeed, as net profit has been cut in half over the past six years, IBM’s dividend per share has increased 30%. In 2020, $5.8 billion flowed out the door to investors. Capital spending for the period amounted to $3.2 billion.
These figures do not reflect all of IBM’s spending. As a tech company, much of its investment will be in people and intellectual property, which falls on the income statement under the cost of doing business rather than capital spending on the cash flow statement.
Still, it is notable that the company has returned nearly $50 billion in dividends to investors over the past 10 years as sales and profits have declined. The group has returned far more in share repurchases, but that’s yet more money that could have been used to prevent the business from shrinking instead. Despite all of these cash returns, the stock has returned only 0.5% per annum over the past decade.
Fixated with dividends
There is one main conclusion I can draw from these figures. IBM has become fixated with investor returns and is not looking after its own future. The firm is returning too much cash and investing too little.
This has been a giant waste of money, especially for newer shareholders. The firm has repurchased tens of billions of dollars of stock at higher prices than it would be able to pay today.
It has also returned $50 billion in dividends, of which investors will have had to pay tax on (up to 20%). Assuming every investor paid the higher rate, IBM has given an extra $10 billion to the IRS.
This issue was starting to emerge in 2016, and the company has persisted with the strategy that is destroying shareholder value. The main lesson I have learned by watching this business over the past five years is that a sensible capital allocation strategy is vital for success. Businesses that ignore this factor, and become fixated on shareholder returns, could be bad investments.
This article first appeared on GuruFocus.