Alphabet stock, the artist formerly known as Google, shot up $50 per share to close above the $700 mark to imply a market capitalization of $450 billion. The reason for apparent investor jubilation is that Alphabet reported 13% growth in revenue over the past twelve months when it disclosed quarterly earnings on October 22nd. That growth is very impressive for a company of Alphabet’s size–it generated revenues of $66 billion last year, and this year’s figure should be in the $74-$77 billion range.
The current profits of $15.8 billion are way, way ahead of the $1.51 billion that Alphabet reported in profits ten years ago. It deserves credit for being the most dominant tech company during this time alongside Apple. It’s hard to create a moat in the online world where the barriers of factories and physical real estate are not present, but Alphabet has succeeded in doing so.
But yet, from 2010 through 2012, investors had the opportunity to purchase shares of Alphabet for under 20x earnings. The growth stocks of the world are the most affected by investor euphoria, and the new P/E ratio of Alphabet of 35x earnings reflects this fact.
Recency bias is a frequent topic I cover, and that is why companies like BP, McDonald’s, and IBM make such appealing long-term value investments–the expectations get so low that even modest business performance will put you on pace for good returns. The opposite, of course, is also true–when you value a company at a P/E ratio of 35 and give it a market cap of $450 billion, you are doing so because you believe that things like revenue growth of 13% annually will keep continuing.
That is an assumption that, at some point, will cause Alphabet investors some trouble. During the 2008-2009 recession, the average rate that investors were willing to pay fell by over 20% per ad. Alphabet was in its fast growth stage both in the United States and abroad, so this decline was not manifested in earnings number–it saw profits climb from $5.2 billion to $6.5 billion during the 2008-2009 period.
But I do not believe that performance will be repeated during the next recession. Google increased its ad exposure by 47.5% between 2008 and 2009 as it was rolling out ads on new websites and picking up new advertisers to run ads on those sites. The exceptional performance during 2008-2009 was a creature of fast-growth circumstances: the addition of new advertisers was so great that it dwarfed the declining per unit ad rates.
My argument for waiting to purchase Alphabet, rather than doing so right now, is twofold: (1) First, even though Alphabet grew profits from $5.2 billion to $6.5 billion between 2008-2009, it still saw the stock price fall from $348 to $123. This took the P/E ratio of the stock from 34x earnings to 12x earnings. (2) If the stock fell that far during a recession in which the fundamentals were improving quite substantially, the next recession may offer an even better opportunity when earnings result won’t have the high advertiser growth to offset the decline in ad rates.
Alphabet is a business that both impresses and scares me. It is probably the one company that has come into existence during my lifetime that very well may prove to be worthy of a lifelong hold. Charlie Munger said if he was forced to buy a tech company, he would choose Alphabet (this was a question about the business rather than the stock which would take into account valuation.) I agree with Munger’s assessment.
But valuation is just as much a part of your destiny as getting the company right. If you bought Coca-Cola in 1994, you went on to generate 9.5% annual returns through the present. Waited until 1998? 2.5% annual returns. The same company. The same soda factories. The same water plants. The same international distribution network that is so strong even Dr. Pepper uses it through a licensing arrangement. Despite owning the exact same asset, the person who came four years later achieved mediocre total returns while the person in 1994 earned returns in line with market expectations. The only difference is that the 1998 investor purchased the stock with a much higher P/E ratio, and the returns suffered for it.
You do not want your starting point with a $450 billion company to be 35x earnings. Sometime soon, the valuation will work its way down to 20x earnings. We are almost at the point where the valuation will provide a 50% haircut that will take a chunk out of your total returns–it is almost certain that the next twenty years will provide lower total returns than the earnings per share growth at Alphabet would indicate.
The company is being priced as if rates per advertisement will keep going up. When a recession hits, companies trim back their advertising budgets to cut expenses in a way to prop up their own earnings results that are suffering from slower sales growth. It is a natural part of the economic cycle, and it happens over and over again. With Alphabet in particular, and many growth stocks in general, the time to buy is during a recession. This is because they experience greater irrationality in pricing than the stalwarts like Coca-Cola or Johnson & Johnson. But it also means that during good times, like we have now, there is greater irrationality on the upside. I recommend patience. If you are willing to wait a few years to get your price, you will almost always get it, and be satisfied that you did.