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Alphabet Inc.: Perpetual Growth And Our Barbell Retirement Model

Dec 14, 2021

Envision Research profile picture

Value, Deep Value, Growth At A Reasonable Price, Long Only

Contributor Since 2017

** Disclosure: I am associated with Sensor Unlimited.

** Master of Science, 2004, Stanford University, Stanford, CA 

Department of Management Science and Engineering, with concentration in quantitative investment 

** 15 years of investment management experiences. 

Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.

** Writing interest - Long term portfolio management, quantitative portfolio management, selection of value stocks, dividend stocks, personal finances, investment psychology

** And most importantly, write to share and exchange lessons I've learned since I started investing in 2006, and to learn new lessons from this wonderful community

Summary

  • Alphabet Inc. offers an optimal combination of a wide and stable moat, strong financial safety, and excellent perpetual growth.
  • It is, therefore, an ideal candidate for the growth end of a barbell investment strategy.
  • Even under its currently evaluated valuation, a double-digit total annual return can still be expected in the long term.
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Thesis and Background

You may feel a bit strange that we hold a stock like the Alphabet Inc. (GOOG) (GOOGL) for our retirement portfolio. It is not the typical retirement stock you would normally consider. It pays no dividends, and the tech sector is not the typical “safe” sector that retirees go for.

As detailed in an earlier article , a key lesson we’ve learned is that you ALWAYS, at any stage of life, need to clearly delineate short-term issues from long-term issues. So contrary to the popular advice of building “a” retirement portfolio or “the” perfect retirement portfolio, we suggest you always build 2 portfolios - one for the long term and one for the short term – the so-called barbell model. The long-term portfolio is to take care of ourselves when we live to 90 years old and to plan out estates for our kids and grandkids. And the short-term portfolio is to take care of our immediate needs (e.g., a visit to the ER next month). This is diversification at a grand level!

Under this background, hope it now feels less strange why we hold GOOG in our retirement portfolios. We hold it for its long-term prospects, not for its current income or short-term gain. We are only concerned about its long-term yields – in the general sense, not only dividend yields. And as you will see, it combines all the hallmarks of a perpetual compounder – excellent profitability, remarkable return on capital employed, and enviable capital allocation flexibility. And it very likely will lead to double-digit shareholder return in the long term.

Potential GOOG investors may have concerns about its growth rate and current elevated valuations – rightfully. However, this analysis will show you how one of the most powerful insights from Warren Buffett applies to GOOG (which he regretted not buying earlier himself). The insight is that you do not need a doubt-digit growth rate (which, admittedly, is unlikely for GOOG to sustain in the long run) or a dirt-cheap entry price to achieve a double-digit 10% long-term return.

Profitability and moat

GOOG is a poster boy for a wide-moat business. Thanks to its technological lead and scale, GOOG enjoys superior profitability both relative to other peers in the same sector and also to the overall market, as illustrated by the following chart. The profitability is simply superb on every metric – both in absolute terms and in relative terms when compared to its peers. The company derives its current revenues primarily through delivering targeted advertising, and at the same time, invests aggressively into future growth segments such as AI, cloud computing, and so on. The business is perfectly and globally diversified: 47% of the revenues in 2020 came from the United States, and 53% from the rest of the world.

Furthermore, it is unlikely that its moat and profitability would change in the future (barring any major regulation or antitrust legislation change) due to the so-called "network effects". The network effects refer to the fact that the value of certain products or services increases as more people use them (at least to a certain point), and many of GOOG’s businesses are textbook examples of such network effects.

GOOG profitability grade

Source: Seeking Alpha.

Long-term return and perpetual growth rate

If you, like this author, are a long-term investor who subscribes to the concepts of owner’s earning and perpetual growth rate, then the long-term return is simple. As detailed in my earlier article , the long-term return is “simply” the summation of the owner’s earning yield (“OEY”) and the perpetual growth rate (“PGR”), i.e.,

Long-Term ROI = OEY + PGR

Because in the long term, all fluctuations in valuation are averaged out (all luck at the end even out). And it doesn’t really matter how the business uses the earning (payout as dividends, retained in the bank account, or repurchase stocks). As long as used sensibly (as GOOG has done in the past), it will be reflected as a return to the business owner. That is why we do not mind the lack of current dividends from GOOG.

With the background, we will examine these two pieces for GOOG one by one next.

GOOG’s owner earning yield

OEY is the owner’s earnings divided by the entry price. All the complications are in the estimation of the owner’s earning - the real economic earning of the business, not the nominal accounting earning. Here as a crude and conservative estimate, I will just use the free cash flow (“FCF”) as the owner’s earning. It is conservative in the sense that rigorously speaking, the owner’s earning should be free cash flow plus the portion of CAPEx that is used to fuel the growth (i.e., the growth CAPEx). At its current price levels, the OEY is ~3.4% for GOOG (~29.4x price to FCF).

GOOG’s capital allocation flexibility

The next and more important item is the PGR. The growth rate of our business in the long term is governed by two factors - reinvestment rate and return on capital employed (“ROCE”). More specifically, it will be a product of these two factors, i.e.:

PGR = Reinvestment Rate * ROCE

The reason is straightforward and intuitive. If a business earns more profit on every $1 of capital employed, then it only needs to plow back a smaller fraction of its earnings to further grow its future earnings, and vice versa.

So we will first examine GOOG’s capital allocation and reinvestment rate. How much to reinvest probably is the most important capital allocation decision management has to make. And fortunate to GOOG, its management enjoys enviable capital allocation flexibility. The capital allocation picture is really simple here: GOOG earns a load of cash organically from its operations but does not need to spend much. Just take a look at its finances in recent years as shown below. It generates more than $65B of operating income on average (3-year average).

As seen, GOOG has been using on average only ~18% of the OPC as maintenance CAPEx. So this is it – this is the only mandatory expense for GOOG. All the remainder cash, more than 72% of a whopping $65B, can be deployed freely. It can use it for a variety of things: reinvest to fuel further growth, retain it to strengthen the balance sheet, start paying dividends, buy back shares, et al. It obviously makes total sense to reinvest all of it to fuel further growth given its high profitability. But the problem is that for businesses at this scale, there are just not that many opportunities to reinvest the earnings. As a result, GOOG has been allocating a large part of the remaining earning, on average 37% in recent years, to buy back shares. With all the above considerations, the business has been reinvesting at about 10% in recent years and retaining the remaining 34% of OPC.

Alphabet use of cash

Source: author based on Seeking Alpha data.

I have analyzed GOOG’s ROCE in an earlier article and here I will just directly quote the results below. As seen, GOOG was able to maintain a remarkably high and stable ROCE over the long term (on average 55% for the past decade). The ROCE has been on average 47.5% in recent years. There is no need to be alarmed by this small decrease in recent years. A ROCE on the level of 47.5% is still very respectable and competitive even among overachievers like the FAANG group. In this analysis, I considered the following items as capital actually employed 1) Working capital, including payables, receivables, inventory, 2) Gross Property, Plant, and Equipment, and 3) research and development expenses as also capitalized.

So now with a 10% reinvestment rate and 47.5% ROCE, it could maintain a 4.75% PGR (again PGR = ROCE * fraction of earning reinvested = 47.5% * 10% = 4.75%).

Alphabet ROCE in recent years

Source: author and Seeking Alpha.

Perpetual growth rate and long-term return

Now we have all pieces of the puzzle in place to estimate the long-term return, as summarized in the chart below. Again, at its current price levels, the OEY is estimated to be ~3.4% for GOOG. And the PGR is about 4.75% as mentioned above. So the total return in the long term at the current valuation is almost about 9%, a pretty decent long-term return considering the safety of the investment. And as you can see from the following chart, the return does not change that much even when the ROCE fluctuates by quite a bit as shown in the green box. This echoes the comment that I made above that there is no need to be alarmed by a relatively small decrease of ROCE in recent years compared to the 10-year average.

Also as aforementioned, this chart also illustrates the beauty of a Buffett-style long-term value investor. You do not need a doubt-digit growth rate or a dirt-cheap entry price to achieve a double-digit long-term return. Assuming a double-digit growth rate is a dangerous premise to start with anyway. When a good quality stock with a reasonable perpetual growth rate is bought at a reasonable price, we would receive a solid return in the long term.

Finally, a word about the census estimates. As shown below, the consensus is quite bullish about the stock too. Based on 7 Wall Street analysts offering 12-month price targets, the average price target is $3287 with a high forecast of $3500. The average price target represents a 10.5% change from the current price and the high forecast is a 17% change. The main difference between my analysis and the consensus is the time frame. Again, in the short term, it is totally possible that a higher return can be achieved primarily because of a valuation change. However, in the long term, all fluctuations in valuation are averaged out and what matters are perpetual growth rate and the owners’ earning yield.

GOOG long-term ROI

Source: author and Seeking Alpha.

GOOG stock ratings

Source: TipRank.

Risks

There are risks involved with GOOG as detailed below:

  • There is a remote possibility of an anti-trust regulatory risk. But even if it comes to that, I am not entirely certain if it will be bad for GOOG investors for sure. If it really comes to that and the company has to be broken up, the market would be forced to value each of its business segments separately (search engine, targeted advertisement, YouTube, et al). And such a complete and transparent valuation may or may not result in a lower valuation.
  • Post-COVID economy recovery. The biggest macroeconomic risk as I can see is the pace and degree of the post-COVID economy recovery. Although the vaccination is progressing extensively and the economy is reopening at a steady pace, the pandemic is far from over yet and uncertainties like the Delta variant and the recent discovery of the Omicron variant still exist. Experts are concerned that the new Omicron variant could possibly be even more contagious than the Delta variant and more resistant to vaccinations, and can prolong the economic recovery.
  • Lastly, there can be significant short-term volatility risks too. Regardless of GOOG’s scale and business model, the valuation is at a high level and the overall market itself is also near a historical record valuation. Such a combination of volatility and high valuation certainly could cause some short-term risks.

Conclusion and final thoughts

In our barbell retirement model, GOOG is an attractive stock for the growth end of the barbell. It features an optimal combination of excellent financial safety, strong secular support, and excellent prospects for perpetual growth. Specifically,

  • It offers favorable odds for double-digit total annual return in the long term. At its current price levels, the owner’s earning yield is conservatively estimated to be ~3.4%. And a perpetual growth rate of about 4.75% can be sustained organically considering its ROCE and capital allocation flexibility. So the total return in the long term at the current valuation is almost about 9% under these conservative estimates.
  • GOOG is a textbook example to illustrate one of the most powerful insights from Warren Buffett. You do not need a doubt-digit growth rate or a dirt-cheap entry price to achieve a double-digit annual return in the long term. Assuming a double-digit annual growth rate for the long run is a dangerous premise to start with anyway.

This article was written by

Envision Research profile picture

** Disclosure: I am associated with Sensor Unlimited.** Master of Science, 2004, Stanford University, Stanf...

Value, Deep Value, Growth At A Reasonable Price, Long Only

Contributor Since 2017

** Disclosure: I am associated with Sensor Unlimited.

** Master of Science, 2004, Stanford University, Stanford, CA 

Department of Management Science and Engineering, with concentration in quantitative investment 

** 15 years of investment management experiences. 

Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.

** Writing interest - Long term portfolio management, quantitative portfolio management, selection of value stocks, dividend stocks, personal finances, investment psychology

** And most importantly, write to share and exchange lessons I've learned since I started investing in 2006, and to learn new lessons from this wonderful community

Disclosure: I/we have a beneficial long position in the shares of GOOG either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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