Value Investing 101 - Google vs. Berkshire Hathaway
Value Investing Involves Looking at Risks and Probabilities
As a value investor, sometimes I'm asked what I mean when I talk about paying attention to the underlying characteristics of a company or industry. Today, I was having a discussion with a close friend about the fact that very few people view individual stocks for what they are - proportional ownership in a business that must be evaluated on an enterprise-level to determine their relative attractiveness - and thought that allowing my readers to be a "fly on the wall" would provide some insight into the methodology Ben Graham made so famous.
What follows is meant solely as an illustrative example of how a value investor might think; we make no claims or recommendation to buy or sell any stock or security nor is the information you read necessarily still accurate by the time you see this article. Also, let me state that I have enormous respect for Google's founders, Sergey Brin, and Larry Page. They have certainly improved the world and created an enterprise that allows countless businesses to generate revenue from the web, growing our nation's GDP and perhaps even increasing standards of living. This commentary does not regard them, but rather the faceless mass of Wall Street speculators that focus on momentum rather than fundamentals.
Berkshire Hathaway vs. Google: The Numbers
Larry Page and Sergei Brin, founders of Google, are big fans of Berkshire Hathaway. As a simple exercise, compare the two firms. With virtually identical market capitalization (the price it would take to buy all shares of a company's outstanding common stock at the current market value), what exactly is an investor in each respective firm getting for his or her money?
With Berkshire Hathaway, you are buying a business that has little or no debt (in the traditional sense; the insurance reserves are very real liabilities but a fair amount of the reported debt figures are those of the subsidiaries that are not guaranteed by the corporate parent company, meaning that under no situation could they be held liable for those amounts but due to the limitations of GAAP they must report them), $47 billion in investments in businesses such as Wells Fargo, Coca-Cola, Wal-Mart, and the Washington Post, $45 billion in cash, and $8.5 billion in net income.
Perhaps, most importantly, the income is generated from over 96 diverse operations that are generally not correlated. This means if the insurance group experiences a catastrophic loss due to a 9.0 earthquake in California or a severe hurricane in New York, the candy companies and furniture businesses are still going to be trucking along, generating cash.
With Google, on the other hand, you are paying nearly the same price for the entire business yet you are only getting a company that generated $1.5 billion in net income, has little or no debt, and $9 billion in cash on the balance sheet. Most concerning, virtually all of its income comes from a single source - paid search listings.
Why has the market placed such a high valuation on the Internet firm and priced Berkshire more rationally? Google's growth has been nothing short of explosive. However, at nearly 63 times current earnings - a whopping p/e ratio, to be sure - even if the firm were to grow its profit to the level of Berkshire - $8.5 billion - it would still lack the liquid assets and marketable securities the house that Warren Buffett built has, and it would not have a diversified income stream, making it far more vulnerable to changes in the competitive landscape; a major concern when you contemplate that Google operates in an industry where dramatic shifts consumer behavior can happen overnight.
At the point the growth began to slow, the multiple would contract, meaning that even if its earnings do grow 600% in the next few years, if it becomes subject to the law of big numbers - that ever increasing amounts eventually forge their own anchor - the result would be a market capitalization substantially similar to today, leading to no increase in the stock price over a long period of time.
Looks Can Be Deceiving
In other words, Berkshire Hathaway at $98,500 per share appears to be substantially cheaper and safer than Google at $420 per share. What people hope for is short term price momentum - for there is nothing stopping an overpriced stock from getting even more overpriced, to paraphrase Benjamin Graham. The key difference is that an investor in Berkshire Hathaway could feel like he was becoming a part owner in a stable business that was sure to compound at a respectable rate over the coming decades whereas the owner of Google is facing the very real possibility of catastrophic financial loss or capital impairment should the firm disappoint by turning in a lower growth rate than is otherwise expected.
Personally, I've never understood people who got into this business for the excitement - get your kicks from theme parks or sports; the goal of investing should be to make guaranteed rates of return substantially in excess of your personal hurdle rate.
An Update on Google vs. Berkshire Hathaway, Nine Years Later
Berkshire Hathaway with a few minor accounting adjustments to account for some derivatives activity is generating north of $20 billion in after-tax profit per year. On top of this, it generates billions of dollars in additional "look-through earnings" that don't show up, as previously mentioned, due to the nature of GAAP. It has a net worth of almost $250 billion. It's widely diversified across almost every conceivable industry, is largely immune to the sorts of technological changes that could still wipe Google off the map due to fact profits come from selling stuff like ketchup, jewelry, insurance, furniture, railroad freight services, and more (though management is smart enough to realize this so the technology giant has been making investments in everything from medical to energy companies). Investors are valuing Berkshire Hathaway at $341 billion.
Google, or Alphabet as it is now named due to changing its corporate structure to model Berkshire Hathaway with its expansion into other industries to reduce its reliance on the core search engine, which could be overthrown by a kid in a garage under the wrong set of circumstances, generates after-tax earnings of $14.4 billion and has a net worth of almost $112 billion. Investors are valuing it at $505 billion.
The overvaluation of the p/e ratio corrected itself in the 2008-2009 crash when Google's stock price lost so much value it obliterated most of the gains made since the IPO. However, optimism returned and investors have once again bid it up to a p/e ratio that is not particularly intelligent, especially contrasted with Apple. Apple earns more than $39.5 billion after taxes and has a net worth of almost $112 billion. Investors are valuing it at $680 billion, or much cheaper per every dollar of earnings than Google.
So far, both investments have turned out satisfactorily. Berkshire Hathaway, which remains undervalued, has compounded by 210.09%. Google, which remains overvalued, has compounded by 349.12%. I'd sleep better at night owning Berkshire Hathaway but Google's recent diversification moves make it far less terrifying to me. It very well could become a successful, stable blue chip in its own right.