Merlin Weekly Macro: IBM tells a tale of our times

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This week’s profit warning from the long-established US technology company IBM serves as a timely reminder that markets can be unforgiving when companies disappoint. It is also indicative that in what is described as this new paradigm of “ecosystems” and the rapidly changing landscape in new frontier technologies both in how they are developed and applied, everyone is feeling their way and nobody has hard and fast answers.

Vinegar today

At the turn of the year, IBM group CEO Arvind Krishna forecast “We enter 2026 with momentum and in a position of strength, giving us confidence in our full-year expectations of more than 5 percent constant currency revenue growth and an increase of about $1 billion in year-over-year free cash flow.”

Six months later, his optimism had all but evaporated. With the second quarter management accounts complete but not yet publicly released, far from the 5% revenue growth anticipated, at the half-way stage the company became acutely aware that the full-year outturn was looking more like 1% revenue growth. With neither certainty nor conviction of making up the difference in the remaining six months, the company had no choice: the regulatory requirement was to admit the shortfall to the market. The reaction was an immediate and brutal 25% beating administered to the share price.

The company has experienced significant share price volatility this year: between 1 January and mid-May, the price had given up 26.5% (losing approximately $70 billion of market capitalisation); over the following two weeks to 2 June, it rocketed by 54% (gaining $110 billion, on its own a move equivalent to the entire market capitalisation of Glaxo SmithKline PLC). Today, it is a third off its 2026 peak. So what on earth is going on? And is there a read-across that is applicable to the rest of the sector and the market? There is a lot to unpack.

Remember, IBM is a very big company: it hovers on the edge of the top decile by market capitalisation in the US S&P500 index; if it were listed in the UK, it would currently rank as the fourth largest company, immediately behind Shell.

The term “Technology” carries the connotations of newness and lack of history associated with this very in-vogue, cutting edge sector. However, as a tech company IBM has an unbroken pedigree spanning more than a century. Interrogating the internet using Google search, an appropriately AI-generated summary tells me that it was founded in 1911 as the Computing-Tabulating-Recording Company and was renamed International Business Machines in 1924. It was the pioneer of the mainframe central processing unit in the 1960s which allowed networking to be developed, including the introduction of the first ever personal computer (what became the ubiquitous PC) in 1981.

Its financial filing reported $67.5 billion of annual revenues for 2025, up 7.6% year-on-year; it booked $39.3 billion of gross profits (+10.7%), $10.3 billion of pre-tax profits (+77.6%) and $11.36 of earnings per share (+74.0%). It has a long dividend history and in 2025 it rewarded shareholders with $6.72 per share in cash dividends (+0.6%). With a balance sheet valued on December 31, 2025, at £151.9 billion, generating cash and paying dividends it is a substantial, mature, “proper” company. It has a market capitalisation today of $206 billion, implying a valuation of 3.1x historic revenues and 19.4x 2025 earnings per share; the shares have a dividend yield of 3.1%.

Jam tomorrow

The Investor page on its website proudly says that “Today’s IBM has defined a clear strategy to lead the era of hybrid cloud and AI”. Moving with the times in an exceedingly competitive and very rapidly developing technological environment, at least to keep up with or ideally to get ahead of the Jones’s, early in June IBM announced a major new strategic initiative: “to invest more than $10 billion in quantum computing over the next five years. The investment will span research and development, capital expenditure, manufacturing scaling, ecosystem partnerships, and M&A (mergers & acquisitions). Together, these areas are designed to accelerate IBM's quantum roadmap beyond delivering the world's first large-scale, fault-tolerant quantum computer in 2029, and advance quantum leadership anchored in the United States.” At the cutting edge, the plans include $1 billion being invested in “Anderon”, the world’s first “pure-play quantum wafer foundry”.

What to make of it all?

The weakness in the share price in the first five months reflected broader market concerns about the vulnerability of software and services to being eroded or replaced by artificial intelligence (the precipitous share price falls in the subsector being dubbed in the market, the “SaaSpocalypse”). The May and June spikes were positive company specific reactions both to seemingly decent first quarter results and that major $10 billion capex announcement. The July collapse was the rapid reaction to the revenue warning.

There are four observations:

1) The first is tactical: companies which issue profit warnings because they have missed their own revenue guidance are either not fully in control of their business or do not understand their customers. Where the business environment is changing rapidly, financial and management reporting and systems need to be on point, producing timely information that warns the business leadership of significant deviations from budget. In IBM’s case that variation meant a shortfall of almost $3 billion of revenues against expectations of $70.9 billion implied for 2026; either business orders suffered a significant setback in the second quarter, or weakness was there already but the warning signs were not picked up.

2) Strategically, investors in IBM were taking a great deal on trust that everything would go well with the five year investment plan. The rapid 54% share price appreciation (in market cap terms, worth ten times the amount the company plans to invest) implicitly discounted instant gratification despite many of the financial rewards anticipated being unlikely until the next decade and with no promise that all would yield a commercial return. (With supreme mis-timing, on 1^st June, a major investment bank initiated research coverage on IBM with an “Overweight” recommendation with a 1-year price target of $350 per share,
17% upside from when the recommendation was made; six weeks later at $219 the shares are 25% below the price at which they were recommended by that bank as a “buy”).

3)  In a recent Merlin Macro column, we talked about the significant effect on share prices caused by indexation and the acceleration towards investing in passive index tracker funds. As one of the biggest companies by market capitalisation not only in the US but the world, IBM’s share price is subject to those momentum forces. As investors have found out, it cuts both ways: while sentiment (e.g. concerns, real or perceived, over the vulnerability of the SaaS companies to the threats posed by AI) or events (e.g. in IBM’s case its capital expenditure announcement, a bank’s stock recommendation, the company’s own revenue warning etc) will cause the shares to react, there can be no doubt that the huge volatility in the share price in each case was exacerbated by the automatic reaction of passive funds either to buy or sell shares purely to maintain the requisite index weighting.

In his latest Fundsmith investor letter, veteran manager Terry Smith makes the point: market analysis says that at the turn of the Millennium (i.e. the Dotcom bubble), passive or tracker funds accounted for around 10% of the equity market; today that figure is more than 60% and thanks to the mechanics required constantly to juggle equity weightings to match the index, approximately 90% of all equity trades are now generated by passive funds. The effect only grows as more investors are attracted to index trackers.

4) Valuation: linked to the indexation factor, particularly when share prices are appreciating, valuation becomes ever more important. Equity investors are natural optimists: they want to own shares that will rise and to avoid those likely to fall. The principle of “buy low, sell high” is fundamental to compounding long-term wealth. Momentum investing accentuates both the highs and the lows by chasing rising prices and precipitating falling ones. There are many tools available to evaluate a company and its prospects to determine whether at today’s price, the shares are fair value or not. It is not a hard science so much as a matter of opinion as to what represents “good value”. The differences of opinion are what make a market: more buyers than sellers, the shares go up; more sellers than buyers, and down they go.

Feet on the ground; back to basics

But the essential thing any investor must ask themselves remains the fundamental sense check: taking everything into account, by pushing up the valuation, at what point does my investment become ever more reliant on hope than reality? Because when the two diverge and eventually part company, the further the shares are likely to fall.

And it is important to understand what your chosen valuation metric means in practice. For example, take the popular price/earnings ratio: a multiple of, say, 10 times (e.g. the share price is 100p while the EPS are 10p), means that for that nominal level of earnings per share (i.e. the company’s after tax profits attributable to shareholders), it will take 10 years to be recovered in today’s share price. In the absence of profits or positive cash flows, the temptation is to go further up the profit & loss account in search of justification as to why the shares are good value.

There is no better way of explaining it than to quote Scott McNealy, the former CEO of Sun Micro Systems. Back in 2002, he explained with great clarity to stock analysts what was being expected of his company implied in an aggressive valuation based on the group’s sales relative to its market capitalisation. It’s a masterpiece:

“Two years ago (i.e. at the height of the Dotcom bubble) we were selling at 10 times revenues when we were at $64 a share. At 10 times revenues, to give you a 10 year payback, I have to give you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses which is really hard for a company with 39,000 employees. That assumes I pay zero taxes, which is very hard. And that assumes you pay no taxes on your dividends which is kind of illegal. And that assumes with zero R&D for the next 10 years I can maintain the current revenue run rate. Now, having done that, would you still like to buy my stock at $64? Do you realise how ridiculous those assumptions are? You don’t need transparency. You don’t need any footnotes. What were you thinking?”. Wise words.

The Jupiter Merlin funds are created with portfolios of funds; we do not invest directly in companies. However, of the managers whose equity funds we own and who are investing in companies, we ourselves are constantly asking them about their approach to valuation and the justification for their arguments. The principles are the same, even if one step removed.

No stock recommendation, either positive or negative, is implicit in this commentary.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each.  With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.