That narrowness has been propelled by the Magnificent Seven technology shares in the US – Microsoft, Apple, Alphabet, Nvidia, Amazon, Meta, and Tesla. For the most part, we haven’t owned them during this period of rapid growth. But in the middle of the Global Equity Strategy’s top 10 holdings, one of the seven does stick out: Alphabet.
At the right price, we would fill the portfolio with the rest. The Orbis Global Equity Strategy first owned Alphabet (then just called Google) in late 2008, and the strategy has held it cumulatively for over a decade on and off since then. We have also held Microsoft, Apple, Amazon, and Meta before. But while several of the seven are now regarded as unassailably successful, sentiment has been less rosy for Alphabet. For us, that is part of the appeal.
The sceptical view of Alphabet goes something like this. Microsoft and its partner Open AI have eaten Google’s lunch on artificial intelligence (AI), which will become the key capability for all technology businesses, including internet search. Employees worry that shareholders dominate the company’s culture, while shareholders worry it has been dominated by overly political employees and a thick layer of middle managers.
It is easy to understand the scepticism on Google’s AI efforts. In November 2022, Open AI launched ChatGPT, and the next February, Microsoft announced it would incorporate ChatGPT into its Bing search engine. Microsoft CEO Satya Nadella took explicit aim at Google, noting that Bing could win market share and profits even while driving down the profit margins of all internet search players. The next day, Google previewed its own AI bot, called Bard, which spectacularly flopped.
That paints a scary picture for Google’s prospects, particularly Nadella’s search salvo, which calls to mind Jeff Bezos’ quip that “your profit margin is my opportunity”. However, it is easy to overstate Google’s challenges.
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Most importantly, chat apps do not produce better results for all searches. We see this in the numbers, where both ChatGPT and Bing have lower weekly retention rates than Google Search. While ChatGPT’s app and website have raced ahead of other AI competitors, they have added just 20 million daily users over the past year, bringing the total to 50 million.
That sounds big, but Google has 800 million daily users on its mobile app and 1.6 billion on its Chrome web browser. Comparing search against search, you have to squint to see Bing’s inroads. On mobile, Bing has less than one daily user for every thousand Google users, and on desktop, Bing’s share of daily searches is just 4% – up a grand total of 0.4 percentage points from the pre-ChatGPT days. Neither challenger has stopped Google from growing, and its search volumes and ad revenues are both up about 10% over the past year.
In its April earnings release, Google laid some of these demons to rest, materially increasing our conviction in its fundamentals. After embedding AI into its own “search generative experience”, Google’s search engagement is up (because users are getting better answers), its search profit margins are up (because advertisers are following users), and its cost to serve AI queries is down (by 80% since their initial introduction). We took this as encouraging evidence that Google is not just surviving in an AI world, but thriving. The market agreed, and the shares are now higher than before that earnings report.
And Google’s core business remains attractive for other reasons. Even today, digital advertising accounts for less than 60% of total US ad spending, and less than half in other developed markets. Digital ads should continue to take share from traditional television advertising, boosted by the far better relevance and returns on investment for marketers. That, in turn, should allow Google’s core advertising revenues to keep growing for years to come.
‘Google cannot coast’
That does not mean Google can coast. In a few areas, it clearly needs to improve, including in its AI products. The company has already fixed the most glaring problems with Gemini (the new Bard), explaining that the model was improperly calibrated. That may be true, but it is hard to dismiss the idea that Gemini’s output has been skewed by the political priorities of Google’s outspoken staff.
Still, we believe Google will continue to improve. Proficiency in AI boils down to engineering talent, access to cutting-edge computer chips, and large data sets on which to train the AI models. Google has all three.
While the company was slower to launch consumer AI apps than OpenAI and Microsoft, that is not for a lack of ability. The company has been developing AI for years, and experts across the tech world regard Google’s AI engineering prowess as first class, backed up by the company’s 58% share of citations for academic papers on AI.
Google can back up that engineering ability with computing power, as one of the handful of companies that can afford to deploy Nvidia’s leading AI chips at scale. Rarer still, Google has even developed an in-house AI chip with competitive performance to Nvidia’s.
Nor will data be a problem. Google’s decades-long dominance of search gives it access to a trove no competitor could hope to amass today. As the company refines Gemini, we believe it should be seen as more competitive with ChatGPT, helping to stave off any threats to the search business.
If AI isn’t likely to threaten Google’s profitability, its expenses still could. There, the company has lagged peers like Meta in managing its sprawling workforce. Though Alphabet did conduct layoffs in 2023, it still has 15% more full-time employees today than it did in 2021, while Meta’s full-time headcount is smaller.
‘Meta is now focused and disciplined’
Meta’s experience is instructive. In 2022, the company was perceived as unfocused, bloated, burning money on unprofitable initiatives, and sloppy at executing – all criticisms that have been levelled at Google today. After reducing its workforce, Meta is now seen as focused and disciplined, and it seems to be executing better as a result. If Meta’s example is any indication, any improvement from Google could be well-rewarded by stock markets.
Alphabet, to its credit, is not ignoring shareholders. Last year, the company bought back $61.5bn of its own stock, reducing its share count by 3.3% even after awards to employees. We expect the company to buy back around $70bn this year, suggesting an ongoing “shareholder yield” of about 3%. That is remarkable for a company of Alphabet’s quality.
We look at the maths the following way. Alphabet earned $74bn last year, but that is weighed down by severance expenses and losses in the “other bets” segment focused on nascent opportunities. Excluding those losses, we see the company trading at 20 times trailing core earnings, to say nothing of the $70bn of net cash on its balance sheet.
That valuation represents a discount to both the S&P 500 and the MSCI World Index, and in relative terms, it is unusually low for Alphabet. In our view, Alphabet deserves more of the premium it usually has.
This is a business with returns on equity and net profit margins of over 20%, both well above the market average, with above-average growth prospects to boot. If the valuation stays where it is and the company can grow at even 10% per annum, growth and free cash flow alone should drive a near-15% p.a. long-term return.
That growth potential is supported by Alphabet’s commanding positions in several big businesses. Its core search business is unique, and its YouTube unit is unique in the West. Alongside OpenAI, Alphabet is one of two leaders in AI services; alongside Nvidia, it is one of two in AI accelerator chips; alongside Apple, Android is one of two mobile operating systems; and behind Amazon and Microsoft, Google is one of three hyperscale cloud services operators. Each of these businesses is valuable and has extraordinary potential – but that is often lost as investors focus excessively on threats to the search business.
The company does have its risks, however. AI could prove more disruptive than we expect. Advertising spending is cyclical, so if the US economy slows or crashes, Alphabet won’t be immune. But weighing up the risks against the price and the quality of the business, Alphabet looks reasonable to us, and it also brings diversification to the portfolio, as its share price behaves differently to many of our other holdings.
Alphabet’s more magnificently valued brethren would also bring that diversification, but while we appreciate the fundamental quality of the others, we see less to like in their share prices.
Microsoft, for example, has similar growth potential and returns on equity to US payments and fuel card business Corpay (formerly Fleetcor), yet trades at double the valuation. To sustain the 15% p.a. growth rate markets expect on its $86bn profit base, Microsoft must add roughly another Coca-Cola in profits every year. On its $100bn profit base, Apple must add a Wells Fargo in profits this year to sustain its growth, and the climb gets harder from there.
Perhaps Microsoft and Apple can achieve those feats. They are great companies. But we would prefer to invest where expectations are lower: in shares like Corpay, US managed care organisations, quality industrial companies, banks in Korea and Europe – or even Alphabet.
Ben Preston is the director of client capital in the Orbis Global Equity Strategy
Orbis is a global, privately owned investment firm founded in 1990 with offices across four continents and over 400 professionals.
