Clay Finck (03:52):
One key important point here that should be mentioned is not to fall prey to confuse the fast growing company with a company that has a strong moat. Just because a company is growing fast does not mean it has a strong moat. This is something I personally fell prey to with a couple smaller positions I added in 2021 with the high flying growth stocks that seemed like they could just grow to the sky. To find a strong moat, you’ll want to look out for a number of things. High switching costs are definitely a good sign. Having a first mover advantage is another good sign, and one I particularly like to look for is network effects. Network effects is probably the most powerful because as some companies networks grow bigger, they get better and even harder for competitors to disrupt. So really good network effects setup helps ensure a really strong moat for the company.
Clay Finck (04:44):
So many of the large technology companies have network effects, but I’ll quickly outline one for those who might not be familiar. Let’s use Airbnb as an example. So they create their site and they manage to get some homes listed on there in a particular city, which customers can then stay at. Let’s just say it’s in Los Angeles. Some consumers find out how much cheaper it is to stay in LA at an Airbnb site than in hotels, and they end up having a great experience so they go out and tell all their friends. This then drives up the demand for people to want to list their property on Airbnb. So with more properties listed, this brings more competition between the listings which pushes prices down. With lower costs this drives even more customers to their site, as it’s even more attractive. So more customers drive more listings and more listings drive more customers in the network effect continues and continues and strengthens and strengthens the moat for the company.
Clay Finck (05:40):
Another great thing about network effects is in today’s digital era is the speed at which they can take hold. Think of a company like TikTok. It was practically nothing and then suddenly within a couple of years, it seemed like every single teenager had it on their phone and they were spending hours per day on it. Amazon has similar network effects and greatly benefits from the digital era, but they are more limited in how fast they can grow that network as they have to build out these fulfillment centers with all these physical buildings that many other digital companies don’t have to deal with. Amazon has that physical component to their business, which can make their moat potentially even stronger. But again, it just takes them more time to build out that network effect relative to some of these other platforms. Moving on to the management side, the managers need to think and act like owners because they are making the decisions for how capital is allocated and where the company will be moving toward in the future.
Clay Finck (06:38):
The managers also need to understand what drives business value for the company. You’ll want to get a good idea of the level of integrity of the management and their level of honesty. Read the shareholder letters, put a heavy emphasis on the return on invested capital of the company. The way Bezos ran this company and communicated his strategy in his shareholder letters could almost be used as a template and a guidepost of what to look for in an executive team. Shifting gears to valuation, the most important driver is economic earnings. How much money does the company earn? And this isn’t driven by the gap earnings shown in the financial statements because this metric is often understated for tech companies in particular. I don’t want to get too deep to discuss why that is, but essentially tech companies are oftentimes spending considerable amounts on R&D to increase future earnings, which is then deducted from their earnings today.
Clay Finck (07:34):
If Amazon was a more mature business and they spent less on R&D, than they probably wouldn’t be nearly as expensive as they look or appear so on the surface level. When a company like Amazon spends money on R&D, it is a hundred percent expensed and deducted from their earnings. But when an old school business builds a new factory, that can be deducted and expensed over many years or amortized over many years. So comparing the earnings between the two businesses like Amazon and an old school business is not really an apples to apples comparison, due to the distortions that are created in gap earnings. So essentially we will need to work through each business on a case by case basis to determine economic earnings and not just take the gap earnings at face value because they aren’t super helpful when using that alone.
Clay Finck (08:22):
Now I’d like to walk through a case study that Adam does in his book with Google, AKA Alphabet. In his book and how he applies that framework to alphabet. Munger and Buffett admit that they made a huge mistake by dismissing Alphabet. The parent company of Google.
Clay Finck (08:40):
I quote from Munger. “If you ask me in retrospect what our worst mistake was in the tech field, I think we were smart enough to figure out Google. So I would say we failed there. We were smart enough to do it, and we didn’t do it. Buffett agreed, recalling how Google had first appeared on his radar screen a decade earlier when Geico began to buy Google search ads on a per click basis. And remember that Berkshire owned Geico at the time. Buffett mentioned how they were paying 10 or $11 per click to advertise on Google. And anytime you’re paying 10 or $11 every time someone just punches a little button where you’ve got no incremental cost, that is a great business. Each additional Google search on their site is just pure profit for them after they’ve just built out that big infrastructure that can’t be disrupted and has all this competition. It’s just this digital real estate that is just so valuable to Google, and it’s just so valuable to their users.”
Clay Finck (09:39):
So it was quite interesting to read about how Buffett and Munger’s take on Google was and how strong of a business they believe it is. Before diving into Google, Adam points out that when you’re doing this type of research on tech companies, you should find that nine out of 10 times the company isn’t going to be strong enough to purchase. Either the business isn’t as good as it needs to be, the management isn’t as good as it needs to be, or it’s just trading at too high of a price.
Clay Finck (10:05):
So that’s kind of his filter is like most companies aren’t going to make it through his filter. And that’s not a bad thing that you reject nine out of 10 picks. That just means that you have high standards for what qualifies as a sound investment, which will hopefully ultimately lead to high returns for investorsand ultimately beating the market. Now, let’s talk about Google. I’m not sure that I would be talking to you today if it wasn’t for Google. I’m 95% sure that I discovered the Investors Podcast Network back in my college days around 2016, by simply Googling best investment podcasts. I listened to a few podcasts and thought that precedent stakes content on the Investors’ Podcast Network was the best to tune into. I’m really grateful that Google gave me really good search results and allowed me to discover TIP. Every single day, there are about 5.6 billion Google searches.
Clay Finck (11:02):
Think about that. 5.6 billion. The world population is nearly eight billion. So there’s almost a Google search for every single person, every single day. Google also has 10 platforms today that have over one billion users. And most of these platforms are totally free to use. You have Google search, maps, Chrome, YouTube, Gmail, Android, and a few others. Android in particular has nearly two billion users and its software powers two thirds of the world’s cell phones. Plus it’s market share continues to grow. Android also provides their software to cell phone manufacturers for free, and then they sell their high margin apps in the play store to the users of the phones. It’s moat is that it’s a low cost provider of cell phone software. Plus it has high switching costs for both manufacturers and consumers. Moving on to YouTube, it has over two billion users and generates one third of all daily mobile internet traffic.
Clay Finck (12:03):
This is three times that of Facebook. YouTube is yet another classic example of network effects. More content creators lead to more content, which leads to more users, which leads to more ad revenue to give the creators of content, which leads to even more users and so on and so forth. I can’t even think of another platform similar to YouTube with the long form video content that it offers, so YouTube definitely has a very strong moat. Now the core of Alphabet’s business is Google search. Google search’s market share of the search business was 65% in 2011, and today it sits at more than 90%. Over the years, Google has used their ad revenue to make their search engine the best in the industry. This makes it yet another beneficiary of network effects. Charlie Munger, who is 98 years old might I add, said that he has never seen a moat as strong as Google search. Microsoft back in the day spent nearly 15 billion trying to compete with Google search through their product Bing.
Clay Finck (13:07):
It essentially is a joke compared to Google search. Bing’s market share today is only around 3%. I’ve never seen someone pull out their phone and search something on Bing, but apparently there are people out there that do it. Pulling a quote from Adam’s book, “It’s rare to find a single billion user digital platform with moats around it and decades of growth ahead, alphabet has at least three of them”, end quote. For Google’s management. Adam explains that the early founders of Google were brilliant engineers, but not particularly the best businessmen. So Google was not as well run as it should have been for a number of years and that was until 2015, where they brought a new CEO in to oversee the operations. They also got a new CFO shortly after it so it was clear that the management was getting the right people in place to most benefit the shareholders in the long run.
Clay Finck (14:00):
So the business was incredible, the management seemed to be taking things in the right direction as well, let’s move on to the price. Adam did this analysis back in mid 2016, but I would bet that Adam still believes that Google is still worth considering today, despite those superior price appreciation since then. So in mid 2016, their operating margins were around 25%, while Alibaba and Facebook had operating margins around 40 to 50%. And after his research, he concluded that Google was a superior and larger business so it had more economies of scale, so they should at least get to the margins that Alibaba and Facebook have. YouTube and Android at the time were both losing money for the business, and eventually these would be huge profit generators for them. So what Adam ended up doing in his research was approximate true earnings power at the time, and set it equal to Facebook, which was around a 40% operating margin.
Clay Finck (14:59):
So he would project out the revenues three years, multiply the revenue by the operating earnings, which was around 40%. And that gives you your estimated earnings three years out. Then he compares that to the stock price at the time, which is around 735, but he actually took the cash out of that, so it’s really $638 per share after taking out the cash. Then he comes up with a price to earnings multiple of around 17 on the earnings at the time, and then a price to earnings multiple of nine, based on the earnings that were projected three years out. The average multiple of the market at the time was around 20 times. So for less than the market multiple, you could get some of the best businesses on the planet with many years of runway ahead of them. One thing to note here is they didn’t realize their full earnings potential at the time. Management is going to have to get their business in order, and it was going to require some time for it to play out as well as it did for Alphabet.
Clay Finck (16:00):
So really this type of situation attracts long-term investors and not your short term trader. And it definitely did work out very well for Alphabet. I did some quick math, since June 30th 2016, Alphabet stock is up around 222% while the S&P 500 is up 90%. I thought this was just one of the many interesting case studies that Adam lays out in his book. If you haven’t ordered it yet, I can almost guarantee you will not regret giving it a read and check out my episode with him as well, which is episode 196 on the Millennial Investing Podcast. The number one thing I learned from Adam, and if there’s only one thing you take from this episode is to only buy businesses with strong moats. Buffett, does it. Adam does it, and I can guarantee you that’s the right approach when you’re investing in companies for the long term. You want to ensure that they are not going to be disrupted by the competition.
Clay Finck (16:56):
All right, that’s all I had for today’s episode. I really hope you guys enjoyed it as much as I enjoyed reading the book and putting this content together for you all. If you guys have any questions related to anything at discussed during this episode, feel free to reach out to me. My email is Clay@theinvestorspodcast.com and be sure to give me a follow on Twitter, my username is @clay_Finck. Also I’m starting to post some content on Instagram, so feel free to give me a follow there as well. I couldn’t get the same username on Instagram so you’ll have to search @clay.Finck. That’s @C-L-A-Y.F-I-N-C-K. Thanks a lot for tuning in. We’ll see you again. Next time. Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday we teach you about Bitcoin and every Saturday, Saturday we study billionaires and the financial markets. To access our show notes, transcripts, or courses, go to the investorspodcaster.com. This show is for entertainment purposes only. Before making any decision consultant professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.
