"And, by the way, the bulk of the billions in Berkshire Hathaway has come from the better businesses. ... And most of the other people who've made a lot of money have done so in high-quality businesses."
-- Charlie Munger
At Tier 1 Investments, a Motley Fool Rising Star Portfolio, I seek out and invest in elite businesses. These include companies with the most valuable brands, best management, superior products and services, and strongest competitive advantages. I call these businesses Tier 1 enterprises, and Google (Nasdaq: GOOG ) fits that description perfectly.
A dominant brand
Do you "Internet search" something, or do you "Google" it? When the name of your company becomes a verb, it's a pretty good sign that you've built a dominant brand. When a business earns that level of mindshare with consumers, it becomes incredibly difficult for competitors to dislodge it from its leadership position. Millions of search users around the world have developed a level of trust with Google that decreases the likelihood that they will make the switch to competing products. That's because search competitors such as Microsoft's (Nasdaq: MSFT ) Bing will not only have to match Google's capabilities but also significantly surpass them to lure users away from their trusted Google.
Superior products and services
Google has earned this level of trust among its users because its search engine consistently delivers more accurate and relevant results than its competitors do. This advantage has allowed Google to build a massive user base for its search products. Advertisers, eager to reach these potential customers, bid to have their ads placed on the top and to the right side of Google's search-results pages. When users click on these "sponsored links," Google collects the "winning bid" as ad revenue from the advertiser. While the fee Google collects on each click may be small, there are billions of Internet searches conducted each year. And those billions of searches have resulted in billions of dollars that now fill Google's coffers.
Google's ad links appear not only on its search pages, but also on third-party sites that take part in its AdSense program. AdSense allows the owners of websites to monetize their content by allowing Google to populate part of their Web pages with ad links. Google gives content publishers about 68% of the ad revenue it collects from these links, and it keeps the rest, creating a win-win for Google and its partners.
Google's services go well beyond search. Products such as Google Maps, Gmail, and YouTube continue to delight customers. DoubleClick, an Internet display-ad business Google purchased in 2008, is a market leader. And Android, Google's smartphone operating system, is also currently a market leader, with an estimated 850,000 activations per day. These products lure people into Google's ecosystem, increasing its user base and making its network even more valuable to potential advertisers.
A deep and wide moat
Google has numerous competitive advantages. In fact, referring to Google's search business and the inability of competitors to make much of a dent in its market share, Charlie Munger has said that he's "probably never seen such a wide moat" as Google's. In regard to search, we've already touched on the power of Google's brand with users, but its informational advantage may be even more powerful. Google collects and analyzes user data including search history, website viewing history (via DoubleClick's tracking cookie), and even email history (through Gmail). These functions have led to privacy concerns, but they've also given Google the ability to better target its ads, thereby offering more relevant ads to users and increasing the return on investment for its advertising partners.
Other competitive advantages not to be overlooked are Google's fortress-like balance sheet and incredible cash-generation abilities. Google has more than $37 billion in net cash, and the juggernaut earned more than $11 billion in free cash flow in the past year. This war chest will allow Google to keep making new acquisitions and fund its research and development program, which should continue to fuel Google's growth.
Google co-founders Larry Page and Sergey Brin have been with the company since they created it in 1998. Eric Schmidt was brought on in 2001 to serve as CEO and to provide experienced leadership to the brilliant, but much younger, Page and Brin. This three-headed leadership team served Google well for a decade, helping the company become one of the largest and most profitable in the world. But in April 2011, Schmidt stepped down as CEO and took the title of executive chairman. In his words at the time, "Day-to-day adult supervision no longer needed!" Page would once again be named CEO (he served as Google's chief executive from 1998 to 2001), and at age 38, he will probably remain in the position for many years to come. In addition to overseeing day-to-day operations, Page will lead Google's product-development and technology strategy, while Brin will focus on new products and innovation. With each of Google's leaders in a more clarified role best suited to their strengths, this new management structure should serve Google well.
As dominant as Google is, investors should still not overlook its competitors. As I mentioned, Google competes with Microsoft in search, as well as several other key areas such as Internet browsers; software applications; and PC, smartphone, and tablet operating systems. An even bigger and more threatening competitor in smartphones and tablets is Apple (Nasdaq: AAPL ) , with its hugely popular and highly acclaimed iPhone and iPad product lines. What's more, Apple is one of the few companies in the world that can compete with Google in terms of innovation and brand power. But perhaps one of the biggest threats to Google is Facebook. That's because much of Facebook's network is closed off to Google's search technology and ad system. Even more disturbing is that Facebook could potentially serve up ads to its 800 million-plus users based on the recommendations of their personal networks, rather than on Google's algorithms. This could be a disruptive force on one of Google's main sources of revenue; however, I expect Facebook to have less of an impact on Google's business than more fearful investors currently believe.
While it's true that Apple, Microsoft, and Facebook are legitimate threats to Google, they may also benefit the company in one critical aspect: government regulation. This is an important point, because I believe that the biggest threat to Google is government intervention in regard to its position as the dominant Internet search provider. Many governments around the world have voiced concerns with the amount of information Google collects on its users, as well as the power it has over advertisers. If these governments see other tech titans as legitimate threats to Google, they may be less likely to bring punishing regulation upon the company.
Valuation is both art and inexact science, especially for a dynamic growth company like Google. But using what I believe are conservative estimates, I arrived at a valuation of more than $700 per share. On a relative valuation perspective, what's interesting to me is that we're in a market environment where some of the best businesses are trading for substantial discounts to their expected growth rates. Google is one such example, with a consensus earnings-growth estimate of 18% over the next five years, but with a forward P/E multiple of only 14. In time, I expect this dynamic to revert to a more normal situation in which premium businesses trade with premium multiples, or at least multiples more in line with earnings growth rates. If that happens, investors who buy shares in Google today will be well rewarded.
The Foolish bottom line
Google is one of the premier companies in the world, and with its current share price down about 10% from the highs of the year, I believe now is a great time to buy. This is the type of opportunity I look for at Tier 1 Investments, and so tomorrow I will be buying shares and adding Google to my Rising Star Portfolio.
If you're more interested in stocks that are less well-known than titans like Google, we've prepared a special free report named "3 Hidden Winners of the iPhone, iPad, and Android Revolution." The report details three under-the-radar companies that are poised to benefit tremendously from some of the same trends behind Google's success. Get your own copy of the report -- it's free!