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IBM Still Trades Where Buffett Bought It. Is It a Good Buy?

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Warren Buffett's second- and third-quarter purchases of IBM (NYSE: IBM) last year sent a shock wave through the investment community; for the first time ever, the Oracle of Omaha had invested in a technology company. Clearly he believes the company has a defensible moat and will continue generating strong earnings for decades to come.

Now, many months after Buffett first revealed his position in the company, the stock still trades in the same price range in which he bought it. This means that investors can still buy IBM at a price that Buffett deems fair. But should the individual investor really buy IBM at this price?

Great business

Besides price, the most important determination of success for a company is the strength of the underlying business. IBM is a great business as evidenced by its high return on capital. Its high return on capital allows it to earn higher incremental revenue on incremental assets added to the business. For illustration, IBM's tangible assets declined at an annual rate of 3.23% over the last decade while sales increased at an annual rate of 3.11%. IBM is earning more money on fewer assets. That's a great business, and it's the kind Warren likes to buy.

IBM faces competition from companies of all sizes in many different categories. Oracle (NYSE: ORCL) is one of its fiercest competitors. Like IBM, Oracle offers a wide range of services to its customers and acts as a one-stop shop for many large- and mid-sized companies's IT needs. In addition, its big data applications are experiencing rapid adoption and out-competing smaller firms like Splunk. Oracle also has a dominant position in database technology, including the rights to the popular MySQL database, which differentiates it from IBM.

Cisco Systems (NASDAQ: CSCO) is another fierce competitor. It has had an identity crisis lately as it decides how to shape its future, but management is determined to return money to shareholders. It is likely that the company will grow the dividend at an above-market pace for several years into the future. In addition, Cisco's stock looks cheap, especially when you take its large cash balance into consideration. Management's promise to return free cash flow to shareholders is promising, but it would be nice if some of the cash on the balance sheet were distributed as well.

IBM has ample opportunity to expand in emerging markets. As the BRICs develop more sophisticated financial markets, they will inevitably need IBM's mainframe computers to operate soundly. Neither Oracle nor Cisco offers as wide an array of services as IBM, which makes it the logical choice for these emerging economies.

Is IBM a good investment?

Over the last three years, IBM has averaged $15.6 billion in free cash flow, or $13.68 per share. If you divide $13.68 by the share price ($195.40), you get an initial yield of 7%. In other words, IBM's current free cash flow level offers a 7% annualized return for investors who buy shares today. Investors who want a higher return will have to hope that IBM will grow free cash flow faster than inflation. In other words, they must pay for growth.

The answer to whether or not IBM is a good investment depends on your circumstances. If you have billions of dollars sitting on your balance sheet, a stable industry leader selling for a fair price with the possibility of a market-beating return looks like a good bet. But most investors have the freedom to look at a wider range of investment possibilities. Individual investors have the ability to invest in small-cap stocks, which often offer higher returns than enormous -- and well-followed -- companies like IBM.

So, there is no shame in mirroring the greatest investor of all time. But don't count on earning 20% returns by mimicking Buffett's purchases today.

Have a question about investing? Ask me! investorquestions@gmail.com

titans8904 has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems. The Motley Fool owns shares of International Business Machines. and Oracle.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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