There are three characteristics of a business that I find highly suggestive of an excellent investment: (1) dominant industry positions; (2) high earnings per share growth rate; and (3) very large cash reserves. These types of investments, while difficult to identify, amount to what can change one’s life when a block of the stock is purchased and held for very long periods of time.
On the short list of the biggest errors I have made in my life is the omission of recognizing Alphabet, Inc. a/k/a Google as the modern day incarnation of Standard Oil, except instead of relying upon petroleum, data is its lifeblood. The analogy even holds in the event that the European Commission or the Federal Trade Commission ever results in a breakup of the technology powerhouse. Just as ExxonMobil, Chevron, and even BP (through Amoco) would be the stockholdings today of an original Standard Oil investor, Alphabet would give rise to a search, video, and phone powerhouse.
Or, as appears to be more likely, Google will continue to dominate all of these areas, especially search and video, as its algorithms remain superior and its reputation as the go-to authority for search at www.google.com and video at www.youtube.com gives the company an extreme anchoring advantage–i.e. Even when Bing images were briefly superior to Google images, and Bing was providing rewards for users to engage with its platform, it could still not gain meaningful market share due to the strength of Google’s anchored brand.
I recently gave Google a refocused analysis after talking to an attorney who remarked that Google was serving as a proxy for legal advice to many people. He did a lot of dog bite cases in the 1990s, with prospective clients unaware of what the lay of the land was–is the state one that has duties for dog owners according to whether there dog has a “dangerous propensity” for biting? Does it apply the one-bite rule, which does not hold a dog owner liable for a bite until it has already bitten someone previously? Or is it a strict liability state that applies liability to any dog bite under any circumstances? Usually, an attorney would have to look it up on Thomson Reuters or LexisNexis to answer that question for a client. Now, a client can google “dog bite law in my state” and bring up the legal rule instantly. As long as people rely upon google as an access point to institutional knowledge, shareholders will get enriched.
Then, there are the soft factors. The brightest minds are flocking to work at Alphabet. The company is on the march, hiring and expanding among the world’s most intelligent. It is in a very different employment situation than, say, IBM, which is perpetually laying off, downsizing, and severancing its employee base and destroying morale.
Also, in contrast to IBM, Alphabet is sitting on $102 billion in cash against only $4 billion in debt. Its profits are rolling in at a rate of about $33 billion per year, which is an enormous amount of funds being retained. While many other mega-cap corporations have to pay off substantial debt obligations in servicing past operational initiatives, Alphabet can pay out dividends, repurchase shares, or go on an extreme buying binge. At a minimum, the $100+ billion cash build-up can greatly augment future earnings per share by purchasing other competitors or investing heavily into new growth initiatives.
Quietly, the stock has come down a bit from its July highs of $1252 to the present price of $1167. This year, Alphabet is expected to earn $45 per share, and next year, $52 per share. That is a current P/E ratio of 26 and a forward-looking P/E ratio of 22. For a company that is growing revenues in the 15-18% range and profits at a similar rate, that premium looks modest compared to the high likelihood of real double-digit growth that you are getting in return.
There may even be a dividend angle here as well. There are many professionals who have some assets in a taxable account that they want to be both tax-efficient and to shower them with cash down the road simultaneously. These businesses that do not currently pay a dividend, but will almost certainly be the Dividend Aristocrat of tomorrow, are worth a look. Just as someone may have wished that he could have purchased Apple over five years ago before it starting paying out a dividend so they could be collecting a four-fold increase in price and a 9% yield-on-cost today while paying minimal taxes in the interim, Alphabet may offer a similar opportunity. In the meantime, investors get their 17% earnings per share growth.
I think it is wise to take action on an investment when you combine your analysis of the likely earnings per share growth rate of the business, against the degree of certainty you have in that prediction, and then reduce it to the extent that P/E compression is likely.
If Alphabet grows profits at 14% for the next decade, which would be lower than its recent five-year average, the earnings per share would be $181. A P/E ratio of 20 would imply a stock price of $3620. That is 12% compounding on your money even with the P/E compression, sufficient to turn a $10,000 investment today into $33,000 a decade from now.
If a best case scenario of 17% earnings per share growth continues, the end value would be $54,000. In other words, at the present value, Alphabet represents a company with a reasonable chance of tripling your investment within a decade, and an outside but realistic chance of more than quintupling your investment over the same time frame.
I, personally, am intrigued. Alphabet has so, so, so much data on its users that it can predict what advertisement would be most effective for you, which enables it to command such an advantageous revenue share arrangement with its advertisers. Google knows your age, gender, politics, religion, hobbies, and what has been on your mind lately. People lament it, but abide by it. Therein is the reason why their shareholders are building very substantial wealth right before our very eyes.
I see a high probability of 12-15% returns in the offing, and in particular, I think Alphabet is going to have a very long runway for double-digit wealth creation, which intrigues me most. Right now, investors are having the conversation about whether the years of Alphabet’s robust returns are behind it–i.e. the age-old wondering about whether one has missed the boat. In 2028, those who contemplate an Alphabet investment will likely be asking themselves the same question after looking on with envy at Alphabet’s 2018-2028 performance.
N.B.: This is an article of ancient vintage and should be analyzed as such.
