Why Warren Buffett's Goldman Sachs Stake May Mirror IBM

NEW YORK (TheStreet) -- Goldman Sachs  (GS) and IBM (IBM) have a lot in common right now.

Both firms are suffering from weak top-line revenue growth, they have spent years repurchasing shares in what has been a slower than-expected economic recovery from the 2008 financial crisis, and they are now both members of the Dow Jones Industrial Average. After Warren Buffett-run Berkshire Hathaway (BRK.B) converted a crisis-time stock warrant for Goldman shares in early October, both firm's also count the "Oracle of Omaha" as a top shareholder.

Thinking about Goldman Sachs and IBM's disappointing earnings results within the context of Berkshire's investment may help investors weed through short-term factors impacting both firms' quarterly earnings and long-term trends that may eventually play to the benefit of patient shareholders.

IBM has missed revenue and profit expectations for two of the past three quarters, while investors have generally discounted Goldman's better-than-forecast profitability in 2013 because results have been driven by legacy private equity investments and not the firm's core investment banking, wealth management and trading businesses.

In early Thursday trading, investors were selling shares in both firms. Sell-side analysts were also trimming their expectations for coming earnings reports. After an over 7% tumble, IBM shares now sit at their lowest level since mid-2011, when Buffett was building an over $11 billion stake in the IT services giant. 

However, before Buffett-watchers begin to question the acumen of the billionaire investor, they should remember he isn't banking on "Big Blue's" near-term share price performance. In fact, Buffett said in Berkshire's 2011 letter to shareholders he wouldn't mind if IBM's shares stagnated for as long as five years -- comments that likely raised a few eyebrows in IBM's C-Suite.

"I won't keep you in suspense. We should wish for IBM's stock price to languish," Buffett wrote in the February 2012 investor letter. In particular, Buffett said that as IBM set out on a $50 billion, five-year, share buyback program, he wouldn't mind an under-performance in the firm's stock.

If IBM's shares were stagnant, the company's authorization to buy up to $50 billion in stock would boost Berkshire's economic interest in "Big Blue" and give it an even more attractive claim on future earnings streams, Buffett said.

"If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly [through your ownership of a company that is repurchasing shares], you are hurt when stocks rise. You benefit when stocks swoon," Buffett.

Thank God IBM's earnings are suffering? Thank God the firm's hardware unit has turned to losses and sales in China are reflecting a significant slowdown in corporate activity? Kudos to Salesforce.com (CRM) and Oracle (ORCL) for trying to win IBM's data center customers?

Not quite.

As IBM continues to conduct its stock buyback, the firm will eventually need to return to growth. In particular, IBM will need to execute on its "Smarter Planet" and "Smarter Cloud" initiatives to build tens of billions of dollars in revenue from new data analytics and cloud computing businesses. No amount of share buyback will compensate from poor execution on the firm's strategic goals, especially in the ultra competitive technology industry.

Buybacks, however, are a predictable way for a firm like IBM and its investors to smooth out a transition process. If management executes, patient shareholders like Buffett will be rewarded.

Goldman Sachs faces similar challenges.

The firm is trying to adapt its business to a new regulatory climate that is cutting at the profitability of key trading businesses and is making overall earnings far less exciting. Goldman also is struggling to report growth in a lukewarm macroeconomic environment that is constraining the merger, IPO and financing activities of its biggest corporate customers. 

Still, like IBM, Goldman Sachs is likely relying on a multi-year share buyback program to help the firm transition to a new regulatory era that promotes higher capital, less leverage and makes risk taking more burdensome.

Goldman Sachs quietly has been among the biggest net share repurchasers in the entire financial sector.

Since the third quarter of 2010, Goldman has plowed over $10 billion into share repurchases, cutting its overall share count by about 15%. The firm escaped the financial crisis with a diluted share count nearing 600 million shares. After $1.65 billion in third quarter share buybacks, that count has fallen to below 500 million shares for the first time since the crisis.

For now, Goldman's share repurchase activity is helping to boost the firm's earnings per share metrics in a flat economy. While revenue for the third quarter and for 2013 has fallen from 2012 levels, the firm's earnings continue to grow. There is reason to expect Goldman will earn over $15 in earnings per share this year, a new record for the firm.

Those earnings per share records may help to mask Goldman's falling revenue and a decidedly weak outlook for year-end, however, they also augur well for the firm in a better economy.

"Goldman Sachs is not drawing its capital down, but what it is doing is using the capital it generates to retire shares until such time that the world's economy has grown to the point where GS can earn a 15-20% return on equity on the ~66B of capital that it has," Chris Kotowski, an Oppenheimer analyst, wrote ahead of the firm's earnings results.

"We have no idea when that point will come, but when it does there will be fewer shares around to share the wealth," he concluded.

Like IBM, Buffett has committed to being a long-term holder of Goldman shares after he converted 43 million stock warrants to an over $2 billion stake in the firm. As with IBM, Buffett stands poised to benefit from Goldman's industry leading share buyback program if his confidence in the firm's management proves to be correct.

"In my early days I, too, rejoiced when the market rose. Then I read Chapter Eight of Ben Graham's The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock prices," wrote Buffett in the 2011 shareholder letter.

"Immediately the scales fell from my eyes, and low prices became my friend. Picking up that book was one of the luckiest moments in my life."

Goldman Sachs shares were falling over 3% to $157.29 in early Thursday trading.

-- Written by Antoine Gara in New York.

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