A warning was all it took to erase investor confidence in this company…

From the desk of Miles Everson:

Investing has provided many individuals with the opportunity to gain financial security and independence for decades.

That’s why every Wednesday, I talk about this in the hopes of helping readers attain financial independence through this activity.

Today, we will talk about IBM, and the underlying reason behind the massive selloff that it recently dealt with.

Curious?

Keep reading below!

A few weeks ago,  International Business Machines (IBM), one of Big Tech’s legacy firms, delivered a modest, if not slightly pessimistic, earnings warning to investors.

It estimated its second-quarter revenue to sit at around USD 17.2 billion. That would be just 1% above the prior quarter and well below the 5% growth analysts expect.

Future expectations made investors especially nervous too.

Management warned that IBM's customers aren't spending money like they used to. They've rushed through AI-infrastructure purchases due to rising equipment costs.

In addition, IBM's routine software and consulting projects slipped down the priority list, particularly when  Anthropic's Claude Mythos came on the scene. This AI model could exploit the toughest cyber defenses, and forced companies like IBM to rethink their technology budgets.

The result?

Investors reacted to this news by handing the company its worst trading day ever.

However, there has to be more to that story than meets the eye.

A Hardware Giant in the Age of AI

IBM was still deeply tied to hardware back in 2020, a few years before the AI boom.

The company sold mainframes, power systems, and storage solutions for hybrid cloud environments.

According to  Professor Joel Litman, Chairman and CEO of  Valens Research  and Chief Investment Officer of  Altimetry Financial Research, IBM's Uniform return on assets (ROA) sat at around 16%. That was its lowest level since the early 2000s.

Management then spent the next five years pushing the company towards AI-strategy consulting. IBM wanted to be the go-to for large companies that needed to modernize complex tech systems.

That helped IBM grow revenue. Professor Litman says its Uniform ROA recovered to the low 20% range by 2021, held that level through 2023, and then surged above 30% in 2024.

Investors began treating IBM as a stronger, more efficient service platform. At one point, the stock more than tripled from its pandemic low.

Its combination of software and consulting seemed to generate more recurring revenue until its latest quarter…

Customers pivoted to expensive AI hardware and cybersecurity solutions. Unfortunately, the company failed to meet the demand.

IBM's latest quarterly results showed that AI infrastructure revenue fell 7% even as software revenue grew 5%. 

When IBM provided a preview of its second-quarter earnings, investors who sold off its stock panicked and thought that the good times had ended for IBM.

Professor Litman says this can be seen through Valens’ Embedded Expectations Analysis (EEA) framework, which starts by looking at a company's current stock price. From there, Professor Litman and his team can calculate what the market expects from the company's future cash flows. They then compare that with their own cash-flow projections.

In short, the EEA shows how well a company has to perform in the future to be worth what the market is paying for it today.

IBM's Uniform ROA climbed to around 33% in 2024 and hovered near 30% in 2025. Analysts expect its Uniform returns to stay around that level during the next two years.

Unfortunately, the rest of the market is more conservative. Investors expect IBM’s Uniform ROA to fall to nearly 24% by 2030.

Professor Litman says that across the company's history, that would be fairly ordinary profitability.

In short, IBM is a company that can still generate returns in line with its historical performance.

According to Professor Litman, IBM’s recent sell-offs mark the beginning of another chapter for the firm.

The company enjoyed strong profits as businesses moved their workloads to the cloud and invested in AI systems. That said, management admitted it was slow to adapt to AI, letting several large deals slip past it.

As a result, investors interpreted it as a sign that IBM might not be able to post record profits for much longer.

Hope you’ve found this week’s insights interesting and helpful.

Stay tuned for next Wednesday’s The Independent Investor!

Recent years have been marked by breathtaking innovation.

Learn more about  why the markets will never see another D.B. Cooper  in next week’s article!