Shares of Alphabet (GOOG) (GOOGL) are under selling pressure lately. The stock is down by 13% from its highs of the year due to negative sentiment after the most recent earnings report from the company. On the other hand, the business remains fundamentally strong, and there are reasons to believe that the short-term adjustment in Alphabet is an opportunity to buy a high-quality business for a convenient price.
In order to evaluate if the recent decline in Alphabet is a buying opportunity for investors or if the worst is yet to come in the stock, the following article will be taking a look at the company from a quantitative perspective.
Quantitative indicators alone don’t tell you the whole story behind a stock; you need to understand the business drivers behind those numbers in order to evaluate if the quantitative indicators are sustainable or not.
That acknowledged, making investing decisions based on cold-hard quantified data is clearly a superior approach in comparison to investing based solely on opinions and speculations.
Financial Quality Is Exceptional
Investors are concerned because of the sharp decline in operating margin last quarter, from 27% of revenue in the first quarter of 2017 to 22% in the first quarter of 2018. However, a considerable share of that contraction was due to accounting rule changes. Excluding that factor, operating margin would have been 24.5% of revenue during the most recent quarter.
Alphabet is making all kinds of investments for growth, and this is having a negative impact on margins. However, the underlying decline in margins is not as big as the headline numbers indicate, and Alphabet remains an exceptionally profitable business by all kinds of standards.
Not only that, but the company’s investments for growth are delivering results. Alphabet produced $31.1 billion in sales last quarter, growing by 26% year over year. Growth is even accelerating in comparison to prior quarters, which is quite exceptional for a company as big as Alphabet.
GOOGL Revenue (Quarterly YoY Growth) data by YCharts
The strategy is crystal clear, prioritizing long-term growth above current profit margins. In the words of Ruth Porat, SVP & CFO, during the most recent earnings conference call:
As we’ve talked about on many, many calls, we have been and remain focused on supporting long-term revenue and profit growth, and we think the opportunity set ahead of us is quite extraordinary … We see this consistent, strong momentum globally, and we’re really excited about the still sizable opportunity led by mobile search. And so we’re continuing to invest to enhance the user and advertiser experience, and thereby, extend the growth in our ads business. You can see this also in the trend on the CapEx spend.
As I noted in our opening comments, the investments we’re making there really provide the compute capacity to support our growth outlook, and that’s supporting the opportunities that come out of machine learning and the Assistant. And then we also see extraordinary upside in the newer markets, as Sundar has talked about, most notably cloud computing and hardware. And so we’re investing to support the long-term growth opportunity there. And then finally, when we look at the market opportunity in both self-driving cars and life sciences, our judgment is it makes sense to place the kinds of investments that we are… So at a high level, the approach hasn’t changed. You’re seeing the investments here.
Alphabet is operating in multiple areas with exciting potential in the years ahead, so management is doing the right thing by making all the necessary investments to secure those long-term growth opportunities.
Wall Street analysts are on average expecting the company to make $48.47 in earnings per share during 2019. Under that assumption, Alphabet is trading at a forward price to earnings ratio around 21.5, which is not unreasonable at all for such a high-quality business.
The company ended the most recent quarter with $103 billion in cash and marketable securities on its balance sheet. This means that 14% of the company’s market capitalization is justified by cash reserves alone.
Besides, this massive cash hoard provides abundant financial firepower for Alphabet to make all kinds of investments and acquisitions for growth, and perhaps even return big sums of capital to investors through buybacks and dividends in the future.
Momentum Is Solid
Stock prices reflect not only current fundamentals but also expectations about the future. Some Wall Street analysts are expressing concerns about declining profit margins at Alphabet lately, but the top-line performance doesn’t leave much to be desired.
It’s still too early to tell how earnings expectations will evolve after the most recent earnings report, but earnings expectations over the past six months are clearly moving in the right direction.
The charts below show the average earnings estimate for Alphabet in the current year, next year, and the coming quarter.
GOOG EPS Estimates for Current Fiscal Year data by YCharts
Outperforming In The Long Term And Underperforming In The Short Term
Winning stocks tend to keep on winning over time, and Alphabet has materially outperformed the broad market in the long term. The chart below shows how Alphabet has downright obliterated both the SPDR S&P 500 Trust (SPY) and the PowerShares QQQ Trust ETF (QQQ) over the years.
GOOGL data by YCharts
On a year-to-date basis, however, Alphabet is underperforming both the SPDR S&P 500 and the PowerShares QQQ.
GOOGL data by YCharts
The big question for investors is whether this recent underperformance is just a short-term adjustment or the beginning of a change in the long-term trend for Alphabet.
Considering that the business fundamentals remain solid, the company is growing at full speed, and the stock price is fairly reasonable, I’m inclined to believe that over the years ahead Alphabet will continue outperforming the market indexes.
Putting It All Together
The PowerFactors system is a quantitative investing system available to members in my research service, “The Data Driven Investor”. This system basically ranks companies in a particular universe according to the factors analyzed in this article for Alphabet: quality, valuation, momentum, and relative strength.
The system has produced solid backtested performance over the long term. The chart below shows how the 50 stocks with the highest PowerFactors ranking in the S&P 500 performed in comparison to the SPDR S&P 500 Trust ETF since 1999. The backtesting assumes an equal-weighted portfolio, monthly rebalanced, and with an annual expense ratio of 1% to account for trading expenses.
Data from S&P Global via Portfolio123
The system more than doubled the benchmark, with annual returns of 12.62% per year versus an annual return of 5.95% for the market-tracking ETF in the same period. In other words, a $100,00 investment in the portfolio recommended by the system in 1999 would currently be worth $988,000, and the same amount of capital allocated to the benchmark would have a much smaller current value of $304,500.
Among the 500 companies in the S&P 500 index, Alphabet is currently ranked in position 103. This puts the stock close to the best 20% in the index, and it’s important to note that Alphabet gets relatively high scores in all of the factors except for relative strength.
For investors who are looking to buy a fundamentally strong business, trading at a fair valuation, and going through a price adjustment in the short term, Alphabet looks like a strong candidate to consider.
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Disclosure: I am/we are long GOOGL, GOOG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.