Alphabet Stock: High Chance Of Outperforming S&P 500

From a psychological point of view, I find that growth at a reasonable price investing is far more satisfying than deep value investing.

If you overpay for a strong company, you know that the passage of time is your friend. With each earnings report that propels the earnings per share rate ever higher, you get to see the intrinsic value of your ownership position increase in value. It’s fun owning things where the question is: “How much did the profits grow this year?” When the underlying profits are growing quickly, it is easy to dismiss moments when the stock price lags the growth in earnings. If earnings grow by 15% in 2016, and the stock price only advances 5%, there’s no real cause for concern unless you dramatically overpaid at the outset.

Deep value investing doesn’t usually come attached with that feel good cheer. Often, there is no guarantee that the earnings will grow in the coming year, and there are almost always many ongoing problems that explain why you’re able to get a discount in the first place. Your basis for investment is something like “I think this stock is worth x but is only trading at 0.7x.” There, you do need to focus on the price of the stock as you are trying to build wealth during the path from 0.7x to x. The faster the stock price aligns with fair value, the better your result, as you can quickly move on to the next value investment.

If you got a second, read that last sentence again. That’s the tricky part with value investing–as soon as the dark clouds clear away and the results from the business are actually satisfactory, it is probably your cue to sell. Once it reaches intrinsic value, your moment for superior gains is gone, and you just own a league-average stock at best. It is lucrative, but it requires you to be mechanical and exercise perfect stoicism (not reacting to the bad news along the way, and then selling when the days of good earnings arrive).

Contrast that to the experience of owning Alphabet, the stock formerly known as Google. The stock grew at 40% annually in the five years after its 2006 IPO, and has been growing at a rate of 15% annually since then. Earnings of $14.88 in 2011 grew to $16.23 in 2012, to $18.03 in 2013, $20.82 in 2014, $22.84 in 2015, and somewhere between $28 and $30 per share this year. That is a fun stock to own!

It’s reached that social status alongside Kleenex where the brand name is synonymous with the thing itself. Just as people hand you a Kleenex when you’re clogged up instead of a tissue, you say you’re going to google something rather than use a search engine for it. Google is so far ahead of its competition when it comes to placing ads with web pages that there is no clear close second. It’s something I see on my own site here, as over 90% of the traffic comes from Google.  Heck, even Google Canada brings in more traffic than Yahoo, and Google India brings in more traffic than Bing, and Google China brings in more traffic than Baidu.

It also has a bunch of side projects, ranging from the well-integrated Youtube to Android to Nest to Fiber to Verily to the prospect of self-driving cars. It is the closest thing I have ever studied that is analogous to the 1960s dominance of IBM, although it holds more promise if it occupies a central position in the creation of a self-driving car market.

And lest you think the IBM comparison was an insult in light of IBM’s issues today, don’t forget that IBM has created shareholder wealth at a rate of 12.6% over the past fifty years. A $10,000 IBM investment back in 1966 would be worth $5.2 million today (and $10,000 back then was analogous to $75,000 today).

After hitting a high of $789 earlier this year, the price of the stock has come down almost a hundred bucks to $695. If earnings hit $30 this year, we are looking at a P/E ratio of 23. I find that price fair. I stick Alphabet alongside Visa, Nike, Brown Forman, Becton Dickinson, and maybe even Disney, Colgate-Palmolive, and Hershey where it makes sense to pay a slightly higher than you’d otherwise find comfortable to own a business that has a very high earnings per share rate.

Analysts expect Alphabet to earn $50 per share five years from now. That suggests a stock price of at least $1,000 per share, or a compounding rate of 7.5% annually. I find that estimate conservative because it measures core earnings growth. Those estimates ignore Alphabet’s enormous cash hoard.

People, including me, talk about Warren Buffett sitting on $60 billion over in Omaha that he can deploy at a moment’s notice on behalf of Berkshire’s shareholders. Well, Alphabet is sitting on $75 billion in cash compared to $5 billion in debt for a net surplus of $70 billion. And, like Berkshire, Alphabet has almost $2 billion in new cash showing up at Mountain View headquarters each month. That is a lot of stagnant cash that can lead to a sharply higher earnings per share figure at a moment’s notice, whether it be due to bolt-on acquisitions or large share buybacks.

Sometimes, I get comments from readers: “Why do you cover stocks that don’t pay any income to shareholders? Aren’t you failing to live up to your site’s name?” Well, the way I see it, a stock with a strong dividend growth streak ought to act as a presumption. Maybe it reads something like “I’ll take my surplus income and put it into new shares of Coca-Cola, Johnson & Johnson, or Colgate-Palmolive unless I can find something that is clearly and convincingly more compelling.” One way of meeting that hurdle is by purchasing companies at a fair price that have a high probability of 12% to 15% annually over the coming decade. Alphabet is one such stock that fits the bill.

Also, my audience consists of people with a wide range of goals. Somehow, California readers have become my largest audience source. Well, they have to deal with state tax rate of 13.3%. A California reader buying a couple hundred shares of AT&T in a taxable account is going to end up with drastically different results than someone purchasing the same exact block of stock through a Roth 401(k).

Also, for those of you that don’t desire income know but want to be generating passive income five, ten, fifteen years from now, Alphabet is a good stock for consideration. It is a question of when, rather than if, Alphabet starts paying out dividends. While core earnings grow at a double-digit rate, it is justifiable to continue retaining all earnings as in the best interest of shareholders. Though the ballooning cash hoard may suggest that Alphabet ought to get on with it and start paying out a dividend sooner rather than later. If you anchor a position in Alphabet today, you might be collecting $25 per share in dividends eight years from now and reap large capital gains as a reward for your patience. Going to where the puck will be rather than where it is, and all that.

I would be quite surprised if Alphabet failed to outperform the S&P 500 from here. Both the S&P and Alphabet trade in the 23x earnings range. The S&P 500 pays out a dividend (while Alphabet does not), and has a projected earnings per share growth rate of 6%. As long as Alphabet grows earnings per share at a rate of at least 8% per year, it ought to perform the S&P 500 over the medium term. Musicians sue Youtube because they feel powerless to create fair contract terms. The European Union is always slapping down (or threatening to slap down) Google on antitrust grounds. Auto manufacturers are getting nervous about the rise of self-driving cars, and are eager to form partnerships with Alphabet. The old guard telecom industry fears the disruptive effects of Google Fiber. And yet, very few people connect the obvious dots and conclude, “I need to make a large investment in Alphabet today and watch it grow over the years.”