Is Alphabet the best buy in the US right now?

At last week’s webinar on US investing, I ran through the investment credentials of two of the most exciting stocks in the market at the moment.

The first, Nvidia - the semiconductor giant which has a sizeable stake in the AI market and has been one of the top performers in the US in the year to date (at the time of writing shares are up 240%). I compared the company to Taiwan Semiconductor Manufacturing, which also makes semiconductors but has had a far less profitable run on the stock market in recent months. Unlike Nvidia, it doesn’t have its own IP and hasn’t been working on manufacturing chips for data centres - the gateway to the fast-growing artificial intelligence market.

And then there is Garmin - best known these days for its wearable fitness devices which contributed $1.1bn of revenue in 2022, just under a quarter of overall sales. Garmin fitness revenue has risen rapidly in 2023 as the company rolls out more advanced products, but it is the diversity of its end markets which makes me excited about the stock. The company has a strong customer base in the aviation and automobile markets and is well placed to benefit from the evolution of autonomous vehicles.

If you missed the full analysis on the webinar, you can rewatch it here.

How to analyse US stocks

Of course there wasn’t time during the webinar to analyse all of the exciting stocks in the US, but after the session I noticed a question which I had missed: “If you were forced to buy only one US stock, would it be Alphabet?”

It’s an interesting question, Alphabet shares have recovered strongly in the last year, but the company is still facing threats to its position in the digital marketing and search markets - especially given Microsoft’s recent AI developments.

In addition to specific stock-related questions, we also received a few queries about the process for analysis US stocks: what changes do we need to make to our screens, what tools should we use for news and updates, are there any metrics that any differences?

And so in order to answer all the questions, I thought it would be worth walking you through my process for analysing US stocks using Alphabet as a case study.

I should start with a bit of background, I am already pretty familiar with the Alphabet investment case. I own the shares personally - although have managed to time my various share purchases very poorly over recent years. I run my portfolio for growth over the long term, hunting for high quality stocks which have a dominant market position. Alphabet certainly ticked those boxes when I first bought the shares, but it was (as it long has been) expensive based on traditional valuation metrics. And since then, wider market forces have disrupted the steady upward growth march, requiring me to attempt to shake my confirmation bias (looking for the positives in stocks I already own) and re-assess the shares as rationally as possible.

So, here is my process…

Step One: What is the data saying?

First up I will take a look at Alphabet’s StockRank. For anyone unfamiliar with Stockpedia’s proprietary algorithm, these are colour coded and can be used to as a quick guide to the fundamental investment case. Alphabet has a StockRank of 83 - not bad at all. It scores especially highly on the Quality and Momentum ranks.

Next I am going to have a look at my screens. Normally I would advocate using the screen to whittle down the investment universe and identify companies on which to do further research. But even if you start with the company in mind, your screens can still be useful.

I use a handful of different screens to identify investment ideas and scrolling through them I can see that Alphabet qualifies for two of the three screens I use to look for high quality stocks in the US: my Warren Buffett screen and my US quality share screen. On the third screen (which seeks Compounding Quality candidates) it only fails on one metric and on my Quality at a Reasonable Price Screen (which includes value metrics) it only fails on earnings yield.

So far so good. Based on the data alone, Alphabet looks like a candidate to add to my portfolio or watchlist.

Step 2: Review recent news flow and updates

Unlike the UK, where companies are required to publish financial results every six months, US update the market with detailed financial results every quarter. Alphabet most recently provided investors with an update at the end of July. In the second quarter of the 2023 financial year, revenues rose 9% to $74.6bn thanks to a strong performance from all three of the company’s key revenue generating divisions (Google advertising, Google services and Google cloud). More significant was the widening of operating margins and strong rise in both operating and net ‘income’ (or profits to us Brits).

The company remains heavily reliant on advertising revenue from Google (and to a lesser extent YouTube) and it is this part of the business which generates the vast majority of operating profits. The cloud business reported its first quarterly profits in the first three months of 2023 and has continued to be profitable in the second quarter of the year.

Step 3: Any fundamental change in the investment case?

Alphabet’s investment case has long hinged on the company’s ability to generate extraordinarily high volumes of cash from its search engine business, which can then be re-invested into further growth opportunities in its Cloud and Other Bets divisions.

That investment case is still (mostly) intact. In the first half of the financial year, the company generated over $52bn of cash from operations at a conversion rate of 130% and continued to invest heavily in research and development ($22bn of R&D investment in the first half of the year, equivalent to 15% of revenues). It is worth noting a drop in capital expenditure - a continuation of the trend in the first quarter of the financial year- and this is potentially significant because of the way that US companies account for development expenditure. Under US accounting principles all development costs must be expensed (and therefore reported on the income statement as R&D costs) until they have a proven long-term benefit to the company’s operations. A lower level of capitalised expenses (which appear on the cash flow statement) could perhaps suggest that Alphabet’s investment in new opportunities is taking a long time to become commercially viable - a suspicion which is reflected in the fact that revenue acceleration from the cloud and other bets businesses is taking a long time to kick into action.

Step 4: Assess updates from the wider market

Google has long dominated the search engine market, which is why Alphabet is able to squeeze such high cash profits from digital marketing - after all, all advertisers want a high position on the Google ranks. But what happens if Google becomes a less popular search engine? And what could cause that?

The answer lies in Microsoft, AI and Bing. Microsoft currently competes with Alphabet in the operating systems and cloud industries, but its search engine (Bing) is a long way behind Google. But Microsoft has taken bigger strides in the artificial intelligence (AI) market thanks to its large investment in OpenAI (the company behind ChatGPT) and has recently announced a big update to both its Windows operating system and search engine supported by AI. Google needs to keep innovating to prevent getting left behind.

Step 5: Review the valuation

A forecast price to earnings ratio of 20 times is not especially prohibitive for a company like Alphabet, which has historically traded around 25 times forecast earnings (and sometimes strays towards the 30 mark).

Investors assessing US shares should give a little more wiggle room in PE ratios for three key reasons.

The first is earnings growth rate. Over the last five years, Alphabet’s earnings have grown at a compound annual rate of 21%. A spectacularly profitable (Covid-boosted) 2021 skewed the numbers a little and made it hard to compare results last year, but 2023 numbers show a return to growth and earnings are forecast to climb at a double digit rate for each of the next two years.

The second is operating leverage. Alphabet (like many companies in the tech sector) has a very high level of operating leverage which means revenue growth leads to even fast profit growth.

And finally, the balance sheet. Alphabet (like many companies in the US tech sector) is sitting on mountains of cash and short term investments (otherwise known as marketable securities). At the last count, the company had $118bn of cash and short-term investments - enough to buy almost any company in the UK.

Cash shouldn’t be included in the company’s valuation metric because if you were to buy the whole company it’s an asset you’d be receiving for free (you don’t need to buy cash with cash). On a cash adjusted basis, the company is trading on a forecast price to earnings ratio of 17 times.

Does the Alphabet investment case stack up?

So, in summary: “If you were forced to buy only one US stock, would it be Alphabet?”

• The investment case, including the valuation is certainly very attractive at the moment
• The threat of competition from companies which are more advanced in their artificial intelligence is worth being aware of
• The AI market offers potentially more exciting investment opportunities right now
• Don’t be afraid to look beyond big tech - there is a lot of quality in the US