Google and Buffett: Why he Never Brought and his Regrets
Warren Buffett admitted in 2019 that he made the wrong call in not buying Alphabet Inc (GOOG)
Legendary investor Warren Buffett admitted in 2019 admitted that he overlooked Google, now known as Alphabet Inc. His investment regrets offer insight on the business of Google and implications of value investing under the current market.
Google’s wide moat
Moat investing rates companies according to their projected future ability to earn above average returns on capital and retain sustainable competitive advantages in their sector.
Despite acquiring more than 80% of its revenue from advertising, Google is not an advertising company. Its true moat lies in its “free” search services. Google has been maintaining nearly 90% market share of the global search traffic — and it has been maintaining such dominance for over a decade.
The “network effect” whereby the value of certain products or services increases as more people use them, is key to Google’s success; the network has become more profitable as it has become bigger. It is a self-sustaining positive feedback loop: more users in this network will lead to more relevant and accurate search results will be, which will make the network lead to an even better and more valuable for the users, which will attract more new users to join and make it harder for existing users to leave, which again will lead back to more users and an even larger network.
Buffet has a particular distain for businesses that point to deprecitated properties and equipment. Google is the opposite — it only needs low levels of reinvestment to fuel further growth. Google is essentially debt-free and interest expenses are negligible compared to profits. The business generates so much cash that it has so much financial flexibility in terms of capital allocation. As seen, in recent years, GOOG only needs 18% of its operation cash (“OPC”) to cover the maintenance CAPEx. GOOG does not pay a dividend (even though it can easily afford it).
This leaves a whopping 72% of the OPC to be dispensable cash, and the company can choose what to do with it: reinvest to fuel further growth, retain it to the bank account, pay a dividend, pay down debt, buy back shares, etc. Moreover, 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. Such repurchases, besides reflecting the confidence of the management in their own business and the cash generation capability, again also signals the lack of good reinvestment opportunities that could move the needle.
If you subscribe to Buffett’s concepts of owner’s earning, perpetual growth rate, and equity bond, then the long-term return is simpler. It is “simply” the summation of the owner’s earning yield (“OEY”) and the perpetual growth rate (“PGR”), i.e.,
Longer-Term ROI = OEY + PGR
OEY is the owner’s earnings divided by the entry price. . At its current price levels, the OEY is ~3.2% for GOOG (~31.6x price to FCF — no cheap at all, but wait for the PGR part).
The next and more important item is the PGR. To understand and estimate it, we will need to first estimate the return on capital employed (“ROCE”). Note that ROCE is different from the return on equity (and more fundamental and important in my view). ROCE considers the return of capital ACTUALLY employed, and therefore provides insight into how much additional capital a business needs to invest in order to earn a given extra amount of income — a key to estimate the PGR. For businesses like GOOG, consider the following items capital actually employed:
1. Working capital, including payables, receivables, inventory. These are the capitals required for the daily operation of their businesses.
2. Gross Property, Plant, and Equipment. These are the capitals required to actually conduct business and manufacture their products.
3. Research and development expenses are also considered as a capital investment for such a business.
GOOG was able to maintain a remarkably high and stable ROCE over the long term: on average 55% for the past decade. Thanks to such ultra-high ROCE, it only requires a bit of reinvestment to fuel future growth.
So why didn’t Warren Buffett invest?
Google is a business that meets all Buffet’s criteria as an autonomous and perpetual compounder — wide moat, high switching cost, high ROCE, lots of cash generated and only a little cash required, and a toll bridge role in the business ecosystem — and he missed all of that.
One hypothesis is that he found a better idea — Apple Inc. around that time he regretted GOOG. He was able to purchase AAPL under the Buffett’s 10x Pretax Rule — the observation that many of his largest and best deals were purchase with a price below or near 10x pretax earning. Besides AAPL, the list also included Coca-Cola (NYSE:KO), American Express (NYSE:AXP), Wells Fargo (NYSE:WFC), Walmart (NYSE:WMT), Burlington Northern, and even his recent $25B repurchases of BRK.A as analyzed in my other article. He was able to purchase AAPL around 10x pretax earning around 2016~2107. And AAPL features an even higher ROCE than GOOG. As a result, it was no-brainer and he must feel more comfortable with the AAPL idea — judging from the fact more than 1/3 of BRK’s book value is in AAPL stocks currently.
Warren Buffett admitted in 2019 that he made the wrong call in not buying Google, now known as Alphabet Inc. (GOOG). He regrets not having “some insights into certain businesses” especially given Google was making “a lot of money” at the time of its IPO from Geico. This article analyzes the reasons for his regrets — the wide moat, the autonomous growth prospects, and the incredibly high and consistent ROCE that GOOG enjoys and he missed. And his investment regrets seem to offer more insights on the business of GOOG and value investing than some of his investment success. Lastly, this article also shares my thoughts on why he never bought GOOG after he had those insights, and my reflections on its implications of value investing under the current market.