Why Buffett Broke His Rule And Bought A Tech Stock

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One of the most interesting holdings in the Berkshire Hathaway (NYSE: BRK-A ) portfolio is VeriSign (NASDAQ: VRSN ) , which specializes in domain names and internet security.

What makes the company interesting is that VeriSign is a tech company and Warren Buffett famously said that he doesn't invest in technology.

His stock picking prowess has made him arguably the greatest investor of all-time, and when Berkshire buys something, other investors want to get in on the action. So when Buffett contradicts himself, it is worth taking note.

He prefers to stick to financials, railroads and companies he can easily understand. Technology is not his thing.

What many investors might not know is that Buffett, at 83 years old, is grooming two men to take over when the time is right. And the purchase of VeriSign is indicative of the changes Ted Weschler or Todd Combs are making behind the scenes at Berkshire.

So let's take a look at the two Berkshire-teers' unorthodox purchase.

VeriSign has worked hard to build a strong moat against competitors by accruing exclusive contracts with ICANN, a nonprofit that administers policy for the internet name and address system. However, shares of VeriSign are down about 8% so far this year amid uncertainty related to the U.S. Department of Commerce's plan to relinquish control of ICANN.

This hasn't stopped Berkshire Hathaway from increasing its stake in the company. Last month, Berkshire bought an additional 1.29 million shares, bringing its total stake in the firm to almost 13 million shares. Berkshire now owns just over 10% of the company.

After VeriSign's earnings report last month, it's easy to see why Berkshire upped its stake. VeriSign earned $0.68 per share in the second quarter, beating estimates by 6.3%. VeriSign added 420,000 domain names in Q2, which brings the total to 128.9 million domain names, an increase of 3.7% from last year.

For the current quarter, VeriSign expects to add between 600,000 and 1.1 million net domain names. This is good news because more domain names equates to higher revenues.

VeriSign has a very profitable business that generates a tremendous amount of cash. Free cash flow -- the amount of money a company has left after making capital expenditures -- is a great way to analyze a business.

Over the trailing twelve months, VeriSign generated $437 million in free cash flow. That puts its free cash flow yield (free cash flow per share divided by share price) just above 6%, which is right in-line with the cash flow generating giant Apple .

Free cash flow is used to buy back shares or pay dividends. In the second quarter, VeriSign spent $300 million on share buybacks and has to ability to repurchase a total of $1 billion worth of shares, which would reduce its outstanding shares by 14%. Aside from free cash flow, VeriSign has an additional $1.5 billion in cash on its balance sheet to fund buybacks.

Shares of VeriSign look cheap for a tech company. Its PE (price-to-earnings) ratio is only 14, while the tech industry average is closer to 45. VeriSign also has one of the highest operating margins in the business at 55%. The industry average is only 22%.

Despite this, shares are down 12% from their 52-week high back in January and are down nearly 80% from its all-time high in the early 2000s.

Risks to Consider: VeriSign faces a lot of competition in the domain registry business. The company competes with the likes of GoDaddy and other operators. All of which want to capture VeriSign's business and reduce its leading market share.

Action to take --> Verisign is uniquely positioned in the web space. It has contracts with regulatory bodies that give it a competitive advantage and it should benefit from the increasing need for companies to have a web presence. Investors should purchase shares of VeriSign and take a buy-and-hold approach that Warren Buffett preaches. This is the path either Ted Weschler or Todd Combs will likely take with Berkshire Hathaway's stake in VeriSign.

If the Berkshire buy-and-hold approach appeals to you, then you might want to learn about "Forever" stocks . These are world-dominating companies that pay investors a fat dividend, dig a deep moat around their business to fend off competitors and buy back massive amounts of stock, which boosts the value of remaining shares. They're solid enough stocks to buy, forget about and hold "Forever." To learn more, click here .



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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