Bronte Capital – Alphabet: Could Not Find Anything We Liked More

Summary:

• Our biggest position is Alphabet, the holding company for Google. It is currently about 12 percent of funds under management.
• We have trimmed it many times – and it is now merely a large position.
• We continued to hold Google stock because we did not have enough ideas that were sufficiently better than Google to induce us to sell.

The following segment was excerpted from this fund letter.

Google/Alphabet (NASDAQ:GOOG,NASDAQ:GOOGL)

Our biggest position is Alphabet, the holding company for Google. It is currently about 12 percent of funds under management. This has been a large position for over ten years.

We bought a large position in Google in October 2010, and the stock immediately dropped 11 percent.

That was an astonishingly good purchase and if we had held it all from October 2010 until the end of this month the gain would have been about 1300 percent.

Alas we did not hold it all. We have trimmed it many times – and it is now merely a large position. (We have lived to regret every single trim…)

In April, they put out simply astonishing results. Google Search is a 280-billion-dollar business growing over 10 percent per annum, and seemingly accelerating. This is beyond our wildest fantasy about how good Google could get.

And we mean that. We had – from inception of the position in 2011 – a view about how big Google could get – a view that turned out to be precisely wrong. We quantified that view in our end of 2015 client letter. To quote:

1. Global GDP is roughly $77 trillion USD,
2. The highest advertising spend in the world as a proportion of GDP is the USA at about 1.3 percent. Most the rest of the world is below 1% and usually a fair bit below 1%.
3. Suppose that the whole world gets a reasonable developed country level of advertising spend – say 1 percent of GDP. Global spend is 1.0 percent of 77 trillion dollars is 770 billion dollars. This is enormously generous.
4. Suppose – and this is also enormously generous – that Facebook and Google get to be 30 percent of this or $231 billion in advertising spend. (This is over three times current revenue.)
5. Suppose – and this is more reasonable – that having achieved global domination their pre-tax margin is 40 percent. (Google is running about 25 percent these days…) Then the pre-tax earnings would be $92 billion.
6. Suppose (and this is a little harsh) that they pay 30 percent tax on this. Then the post-tax earnings would be about $65 billion.
7. Now suppose that you want to put that on 15 times absolutely terminal earnings assuming everything goes right. The valuation should be $970 billion dollars.

At the time the combined market cap of Google and Facebook was about $780 billion.

We thought at the time that Google and Facebook were “fully valued”. We did not sell Google because we did not have sufficient other places to invest the money that we thought was of similar quality and reasonably priced.

Anyway – the combined market cap of Alphabet and Meta (the old Google and Facebook) is now nearly $3.4 trillion – about 3.5 times what we thought a maximum terminal value for these stocks was.

It is worth stating how we were wrong.

1. Global GDP is closer to $110 trillion than $77 trillion. We should have included some growth in global GDP.
2. Advertising spend keeps going up and will wind up over 1 percent of global GDP – primarily driven by online and, of course, Google.
   1. Firstly, online advertising can be measured – and as people worked out advertising actually works they buy more of it, and
   2. Online creates new people that must advertise. Once for example there was a fishing shop at Hyams Beach, a tourist town south of Sydney. It has closed now – at least in part because people buy fishing tackle online. The online replacement must advertise. But more importantly the local fishing guides used to advertise by sticking a sign up in the local fishing shop. Now they buy words like “deep sea fishing Jervis Bay” on Google. Total advertising spend thus rises.
3. Facebook and Google are already over 30 percent of global advertising. Google’s advertising revenue alone is now about a quarter of a percent of global GDP and growing much faster than global GDP.
4. We underestimated the long-term margin. Meta margins are just on 40 percent now, Google is in the low 30s. But, in both cases, this is after expensing what will wind up being a whole lot of growth expenditure (such as on AI development).
5. The tax rates paid are going to wind up less than 30 percent, and
6. The end multiple will wind up being more than 15 times earnings – especially as these are somewhat inflation resistant businesses.

In other words, we were close to comprehensively wrong. Except in one thing. We continued to hold Google stock because it was growing, the business was in the upper few percentiles for quality, and we did not have enough ideas that were sufficiently better than Google to induce us to sell.

And so it is now. We hold the position subject to finding sufficiently good ideas to replace it.

The uncomfortable implication is that the main reason we have held Google is that we could not find anything we liked more. We did not hold it because we were smart and realized the revenue would go to seemingly well over a quarter of a percent of global GDP. We were utterly wrong about how good Google’s prospects were. Our estimates – with the benefit of hindsight – are simply comically low.

But, if we look at Google against current multiples and growth, it is just not that expensive. But it is also just not that explicable. And we do not see good reason for holding 12 percent of the portfolio at a valuation and business performance we see as inexplicable. Expect us to trim it irregularly – maybe sharply if we find a position we like more.