Warren Buffett Just Did the Unthinkable

Key Concepts

• Circle of Competence: An investor's understanding of a particular industry or company. Warren Buffett famously stated tech companies were outside his circle of competence.
• Moat: A sustainable competitive advantage that protects a company's profits from competitors.
• Magnificent 7: A group of seven large-cap technology stocks that have significantly driven market performance.
• 13F Filing: A quarterly report filed by institutional investment managers with the U.S. Securities and Exchange Commission (SEC) that discloses their equity holdings.
• Large Language Models (LLMs): AI models trained on vast amounts of text data that can generate human-like text, translate languages, write different kinds of creative content, and answer your questions in an informative way. Examples include ChatGPT and Perplexity.
• Zero-Click Results: Search results that provide a direct answer to a user's query without requiring them to click on a link.
• Operating Margin: A profitability ratio that measures how much profit a company makes for every dollar of sales, after deducting operating expenses.
• Free Cash Flow (FCF): The cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. It represents the cash available to the company's investors.
• Valuation: The process of determining the current worth of an asset or company.
• Price-to-Earnings (P/E) Ratio: A valuation ratio that compares a company's current share price to its per-share earnings.

Warren Buffett's Investment in Google (Alphabet)

Introduction of the Investment

Warren Buffett, through Berkshire Hathaway, has made a significant investment in Google (Alphabet), a company previously considered outside his "circle of competence." This move is notable as Google is a "Magnificent 7" company. The 13F filing revealed Berkshire Hathaway purchased 17.8 million shares of Google, valued at approximately $4.3 billion, making it the 10th largest position in their portfolio.

The Debate Around Google's Moat

A central theme in value investing discussions has been whether Google's dominant position in internet search is being eroded. Historically, Google (Alphabet) has maintained over 90% of global internet search queries for nearly two decades, a key driver of its stock performance. However, the emergence of large language models (LLMs) like ChatGPT and Perplexity has sparked debate about the sustainability of this "moat."

Disruption by Large Language Models (LLMs)

The release of ChatGPT in November 2022 marked a significant shift. ChatGPT achieved 100 million users in just two months, becoming the fastest-growing consumer application ever. Research indicates that 80% of consumers now rely on "zero-click results" for at least 40% of their searches. This means that approximately 40% of the time, consumers are turning to LLMs for answers, bypassing traditional search engine links.

This trend directly challenges Google's advertising model, which relies on users clicking on links to generate revenue for advertisers. The shift in search behavior from "search" to "ask" is a critical development.

Financial Data Contradicting the Narrative of a Weakening Moat

Despite the narrative of disruption, financial data suggests Google's moat may be strengthening.

• Overall Revenue and Profitability:

  • As of December 2022 (around ChatGPT's release), Google's annual revenue was $283 billion, with operating income of $75 billion, resulting in a 26% operating margin.
  • In the last 12 months, revenue has grown to $385 billion, and operating income has increased to $126 billion, with an improved operating margin of approximately 32%. This indicates revenue growth and margin expansion, strong signals of a strengthening moat.

• Search Revenue Growth:

  • In Q3 2022, Google reported search revenue of $39.5 billion.
  • By Q3 2025, this figure rose to $56.6 billion, representing a 43% increase in quarterly search revenue over three years. This growth contradicts the idea of a weakening search moat.

• Google Services Profitability:

  • While Google does not break out search segment operating income separately, "Google services" (including YouTube ads and network ads) saw operating income grow from $19.78 billion in Q3 2022 to $33.53 billion in the most recent quarter. This is a 69.5% increase in profitability for the segment over three years, further indicating strength.

Financial Health and Free Cash Flow

• Free Cash Flow (FCF):

  • Google's free cash flow per share has grown to $65 in the last 12 months, compared to $45.9 in 2022 (the year before ChatGPT's release). This metric, crucial for value investors, shows the company's cash-generating ability is robust.

• Balance Sheet Strength:

  • Google maintains a strong financial position with approximately $100 billion in cash and short-term treasuries and only $26.6 billion in total debt. This financial fortress allows the company to withstand competitive challenges.

The Challenger: OpenAI and ChatGPT

While LLMs pose a theoretical threat, OpenAI, the company behind ChatGPT, is far from being a direct competitor in terms of financial viability.

• Financial Burn Rate:

  • OpenAI is estimated to have an annualized revenue run rate of $12 billion.
  • However, the company is projected to burn $115 billion through 2029, a figure significantly higher than earlier forecasts and staggering compared to its revenue. This highlights the immense cost of developing and scaling LLMs.
  • In contrast, Google generates around $70 billion in free cash flow annually.

• Microsoft's Backing and Google's Response:

  • OpenAI has the backing of Microsoft.
  • However, Google's strong financial position provides it with the resources and time to adapt. Google is already integrating AI capabilities, such as Gemini, into its search results, offering ChatGPT-like responses. The company is investing heavily in this area to remain competitive.

Buffett's Perspective and Valuation

• Moat Strength: Buffett's investment suggests he believes Google's moat is not being challenged financially, and in fact, may be strengthening. The data supports this view with increasing revenue, margins, and free cash flow, coupled with a solid balance sheet.
• Valuation: Google's stock is not considered cheap, with a P/E ratio around 27. This contrasts with Buffett's Apple investment, which had a P/E of around 16. Buffett appears to be adopting a strategy of "paying a fair price for a wonderful company" rather than seeking a "fair company at a wonderful price."
• Size Constraint: Buffett's investment decisions are also influenced by the size of Berkshire Hathaway. He needs to deploy billions of dollars, which limits the number of companies that can significantly impact his portfolio. While smaller, potentially higher-return stocks might exist, they are not feasible for such large capital deployment.
• Market Conditions: The generally overvalued nature of the stock market and the size factor lead Buffett to believe that Berkshire Hathaway is unlikely to achieve "eyepopping performance" in the current environment. His Google investment is likely viewed as a "decent investment" that is superior to holding cash or U.S. treasuries.

Conclusion

The investment by Warren Buffett in Google is a significant event, particularly given his past statements about tech. While the narrative of AI disruption has created concerns about Google's search monopoly, the financial data presented in the video strongly suggests that Google's moat remains robust and may even be strengthening. The company's increasing revenue, expanding margins, strong free cash flow, and solid balance sheet paint a picture of a financially healthy business. In contrast, the primary challenger, OpenAI, faces immense financial hurdles. Buffett's decision appears to be based on a thorough analysis of financial fundamentals, a recognition of Google's enduring competitive advantages, and the practical constraints of deploying massive capital in the current market.