Current Market Conditions And Valuing Big Tech

Hey, The Investor’s Podcast Network Community!

I wanted to follow up on the newsletter I sent out June 9th. Back then, I pitched Micron Technologies and Alibaba which are two companies I’m currently invested in. I’ve also talked about them on the show. Since then, I’ve received a lot of feedback on both picks and was encouraged multiple times to provide an update for the TIP Community.

On June 9th, Micron Technologies closed at $33.99. Now, it’s trading at $43.06. In stock investing, we never know for sure what causes stock price fluctuations. In this case, my best guess is that the market had initially overreacted to the news about the trade war, and the stock market has gradually started to realize that.

The same can be said about Alibaba. It was trading at $154.23 then. Now, it’s trading at $174.19. Depending on when you read this, please be aware that Alibaba decided to split the stock into 8 yesterday. Therefore, the price you look up might be one-eighth of the actual price when the position was taken. I still plan to hold both stocks for the foreseeable future, and I still think that they are both trading below their respective intrinsic values.

The key lesson for this month’s newsletter is understanding how to read between the lines of the big tech companies like Alibaba and Alphabet Inc. (parent company of Google).

Not too long ago, we interviewed Bill Miller, and he talked about why P/E ratios were no longer as good at predicting valuations as they used to be. I also had a call with Bill Nygren from Oakmark Funds recently and he said the same thing. Like Bill Miller, Bill Nygren might appear to be an old school value investor. He currently manages more than $24B through three different value funds. He is heavily invested in big tech, especially Alphabet Inc., and when I asked him why, he generously shared his very insightful thoughts about valuation in the 21st century.

Let’s take Alphabet Inc. as an example. The Google segments in the fiscal year of 2018 accounted for as much as 99.6% of all revenue (primarily from advertising), whereas “Other Bets” accounted for only 0.4%. Where Google made $36.5B in operating income, the meager revenue of “Other Bets” was only $595M. “Other Bets” in total even reported an operating loss of $3.4B(!). As if that is not bad enough, Alphabet Inc. also had $109B in cash on their balance sheet that makes close to no income at all.

For us, as stock investors, it’s actually pretty good news. What? Yes, an operating loss for a business unit is actually very good in some cases, just as excess cash does not have to mean that the company is inefficient. Okay, let’s discuss them one at a time.

If you look at Alphabet Inc. from a pure P/E perspective, it does not look too appealing with a multiple of 26. However, keep in mind that you’re also including business units that are not making a profit in that calculation. So what are the “Other Bets” of Alphabet Inc.? One example is Waymo, the self-driving technology development company. One way is to simply take out the deficit from the “Other Bets” in your P/E calculation. Another more meaningful approach is to add the value of the assets that are currently producing a loss.

This seems complicated, but you don’t have to be accurate about your valuation of a business unit like Waymo. Right now, I would estimate that the value of Waymo is north of $100B. Nonetheless, the key takeaway is that regardless of the exact valuation, the valuation of a company’s assets is not always directly reflected on the bottom line from the most recent fiscal year.

Let’s talk about the excessive amount of cash on the balance sheet. Should we, as investors, be impatient about the $109B that is put to no use? You could surely argue that, but consider this: Alphabet Inc. is reporting $26.3B in operating income. Take note that this includes the $3.4B loss from the “Other Bets” mentioned before, other highly valuable assets, and a $6.8B fine from the European Commission. In other words, $26.3B is already understating the true operating income, and the impressive result is still without using the $109B in cash that Alphabet Inc. could plow into profitable business units. As you can see, the P/E of 26 for Alphabet Inc. gives you a distorted image.

This is similar for Alibaba. In the latest quarter, their reported earning does not reflect the true quality of their business as only “Commerce” is currently making a profit for the company. Their other business units are losing $0.25(!) every time Commerce is making $1. So, let’s again look closer and consider why Alibaba is losing money on almost all their business units.

One unprofitable example is their cloud computing division, which grew 76% Y/Y and by far is the largest cloud service company in China. Globally, it only trails behind Amazon, Google, and Microsoft. Currently, it’s hard to determine what Alibaba Cloud is worth, but anything less than a valuation of $50-80B would seem highly ungenerous to me. I wouldn’t be surprised if its true value in the future will be much higher. Just like Alphabet Inc., if we look at the current earnings alone, we won’t be getting the true valuation of the company.

I hope my newsletter helped clarify a few things about how to approach the intrinsic value assessment of big tech stocks. Please make sure to check out the two stock picks that Preston and I found trading at attractive valuations since our last newsletter in June. I’ve attached our intrinsic value assessments of both stocks in this email. Also, here is the link to all of our stock analyses.

Your Friend,

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P.S. I’m hosting TIP networking events in Aarhus, Denmark on August 10th and August 11th, and another in Manila, Philippines on August 30th. During these events, you can meet other listeners of The Investor’s Podcast Network and it’s completely free (you just have to pay for your own food and drinks).

We don’t have a fixed agenda for the events, and we haven’t arranged for any speakers. We just meet up at a restaurant — perhaps move on to a bar afterwards — and have casual conversations with everyone in attendance. Sometimes, mastermind groups have been formed after a TIP event and very often, business relationships have started that way. But most importantly, we’re not there to sell or promote anything. We’re there to have fun together and help each other.

If you would like to attend any of the free networking events, please respond to this email and I’ll send you more information.