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Why it's usually OK when Warren Buffett violates his No. 1 rule of investing

Warren Buffett's No. 1 rule of investing is "never lose money," followed quickly by his second rule — "Repeat No. 1." But it's OK to bend this rule — ignore it during times when a stock is purchased at a price that may seem high and make a short-term decline more likely. Berkshire Hathaway does when it buys stocks of companies that pay hefty dividends and buy back their shares.

Berkshire owns 81 million shares of IBM and another 61 million shares of Apple, a stake that was increased considerably in the fourth quarter. Some consider Berkshire's interest in IBM and Apple a curiosity. Both of these technology giants are leaders in their sectors but many believe their best days are behind them. The world is moving to cloud computing, and people can only own so many personal computing devices. So what could motivate someone to make bullish bets on the futures of these two American companies?

Warren Buffett, chairman and chief executive officer of Berkshire Hathaway Inc.
Daniel Acker | Bloomberg | Getty Images
Warren Buffett, chairman and chief executive officer of Berkshire Hathaway Inc.

Both IBM and Apple have settled in as slower-growth companies that pay investors back in dividends and share buybacks, enough to compensate for short-term drops in their stock prices.

Buffett's view of stock ownership is that it is the same as company ownership. Buffett considers himself (or, more accurately, Berkshire shareholders) entitled to a certain percentage of IBM's earnings, even though he can't actually ask for the money.

Berkshire owns about 9 percent of IBM, so it should be entitled to 9 percent of IBM's earnings, which were $11.9 billion last year, putting Berkshire's cut at around $1.07 billion. Depending on how much money Berkshire spent to buy IBM shares – say it's close to $14 billion, which is a rough estimate of Buffett's cost basis since he began buying IBM in 2011 – that would be a return of 7.6 percent, the $1.07 billion divided by how much Berkshire spent on the stake.

In his 2011 letter to Berkshire's shareholders explaining why he began buying IBM, Buffett said the stock would deliver benefits in the form of billions of dollars in dividends and repurchases over time. IBM's share count has fallen from 1.1 billion outstanding to 900 million, an indication the company is buying back shares, which boosts a shareholder's portion of earnings. IBM also pays out about 44 percent of its earnings as dividends.

"The lesson is don't give up on a stock just because it's down. A well-researched investment should be worth holding onto. The intrinsic value of an investment materializes over time."

If you were a private investor and you were entitled to 9 percent of a company's earnings, this is the way you would look at it, assuming the earnings were distributed. You would look at how much you invested and then how much earnings are being kicked off each year and that is your return. Even though earnings are not getting distributed in IBM's case, it's very relevant to how Buffett looks at these investments.

But if you just look at IBM's share price over time, you could get the wrong impression of how Berkshire's stake is doing. When Berkshire began building its stake, IBM was trading around $174. Four years later, in September 2015, IBM shares were at $137. Buffett got a lot of attention for this at the time, because at least on paper, it meant he was in danger of violating his first rule. But of course Buffett isn't a short-term investor, and temporary dips in a stock he owns aren't going to hold much influence over him.

Last year on CNBC he seemed sanguine about it. "We've owned stocks that we've lost money in. If I'm wrong, you sell them out and take a big loss. We've done that on a few occasions with stocks and bonds over the years."

Tesco is a good example of this. In his letter to shareholders reviewing Berkshire's 2014, Buffett said he was "embarrassed" about his decision not to sell the stake in the British grocer sooner. At the end of 2012, Berkshire held 415 million shares of the company at a cost of about $2.3 billion but his view dimmed on the investment soon after (the company faced an accounting investigation at the time, in addition to weakening earnings). He began shedding the stake but not quickly enough — he admitted to "thumb-sucking." Berkshire was out of it by the end of 2014 but took an after-tax loss of $444 million.

Berkshire hasn't lost faith in IBM, continuing to build its stake even as the company's shares declined. Last year Buffett told investors he had no intention of disposing of Berkshire's IBM stake and expected the shares to rebound. The shares are now at around $180. The IBM stake is currently valued at approximately $14.7 billion.

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"Never lose money" is a good rule of thumb when reviewing stocks but short-term trading swings shouldn't sway investors who are thinking long-term. Buffett demonstrates he does not try to market-time in Berkshire's buying of Apple shares. Berkshire took on 15 million shares at the beginning of last year, roughly $1 billion, when the stock was trading under $100. But Berkshire must have liked what it saw, because it added another 42 million shares to its holdings in the fourth quarter, when Apple was trading around $112. It is now trading at $136.

If IBM is a services company, its mission to help clients solve technology problems hasn't changed despite the world's a necessary shift away from computer hardware to analytics and security. Most of IBM's customers rely on more than one IBM product – Apple, too. And both brands command the hearts and wallets of their clients.

The lesson is don't give up on a stock just because it's down. A well-researched investment should be worth holding onto. The intrinsic value of an investment materializes over time, and only to those investors wise enough to stick with it.

—By John Reese, co-founder at Validea Capital Management, which manages the Validea Market Legends ETF (VALX). The ETF uses computer models based on legendary investor strategies for stock selection, including a Warren Buffett model.