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Why Do Hedge Funds Like International Business Machines Corp (IBM)?

International Business Machines Corp. (NYSE:IBM) is the granddaddy on our list of the ten most popular tech stocks among hedge funds– not in the sense that it is the most frequently owned or the largest in market cap (Apple takes the crown in both of those) but in the sense that the company itself has been in the technology business for over 100 years (originally under the name Computing-Tabulating-Recording Co). This makes it 88 years older than fellow tech pick Google, and 66 years older than Apple. After the PR the company received from the development of the “Watson” program that defeated top human players in a Jeopardy! game last year, IBM has faded out of the spotlight as seemingly every large technology company offers smartphones and tablets to the consumer world. International Business Machines Corp. (NYSE:IBM) offers technology services and software to businesses, and so does not get as much of a following in the technology media.

Warren Buffett

Yet IBM crept onto our list of top tech picks among hedge funds as it quietly builds up a following among investors. According to our database of 13F filings, 45 hedge funds and other major investors owned shares of IBM at the end of June. They are led of course by Warren Buffett, whose Berkshire Hathaway reported a position of 67 million shares of stock in the company. Berkshire had initiated a position in IBM in summer 2011 and then added shares in the second half of the year. Find more of Warren Buffett’s favorite stocks. Billionaire D.E. Shaw’s hedge fund increased its stake by 22% during the second quarter of 2012 and finished June with 2.1 million shares in its portfolio (see more stock picks from D.E. Shaw).

Revenue at IBM decreased 3% in the second quarter of 2012 compared to the same period in 2011, but the company also cut costs (notably in SGA expenses) to pull its earnings up 6%. With a decrease in share count, EPS for the quarter came in at $3.38 against $3.04 for the second quarter of 2011. The first half of the year told a similar story: a small decline in revenue, but increased margins and a smaller number of shares outstanding powered IBM to a 12% in EPS compared to the same period in the previous year. Even the decline in revenue, which was driven by poorer business in EMEA, was entirely an artifact of the rising dollar, with sales being flat when adjusted for currency changes. Overall we would say that IBM is doing well in a challenging macro environment.

The market is trading IBM at a moderately low valuation, with a trailing P/E of 15. The forward P/E based on analyst estimates is 12, and given the company’s historical increases in EPS we think this might be a bit low compared to fundamental value. IBM also may look attractive to defensive-minded investors thanks to its beta of 0.6 and 1.7% dividend yield.

We think that Accenture Plc (NYSE:ACN), Hewlett-Packard Company (NYSE:HPQ), Microsoft Corporation (NASDAQ:MSFT), and EMC Corporation (NYSE:EMC) make for a good set of peers. With the exception of Hewlett-Packard (whose business is suffering as smartphones and tablets squeeze the PC market), these comparable companies trade at trailing P/E ratios at least as high as IBM’s: 17 for Accenture, 15 for Microsoft, and 22 for EMC. Accenture and EMC also have higher forward P/E ratios, with Microsoft expecting a bump in EPS next year as the new versions of Windows and Office are released. However, Accenture and EMC grew their earnings at a faster clip than IBM did in its most recent quarter. Microsoft, Hewlett-Packard, and EMC all joined IBM on our list of the ten most popular tech stocks among hedge funds for the second quarter. We can see Accenture or EMC justifying their higher multiples on the basis of their growth potential, though International Business Machines Corp. (NYSE:IBM) seems safer in terms of its valuation and its market exposure. Investors should decide which of those factors is more important to them.

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