Alphabet is a steady grower that has consistently beaten the market.
In a market where countless stocks are trading at unreal valuations or growing at lightning speed, investors may be tempted to load up on these types of stocks. While I’m a proponent of owning some of these names, a well-balanced portfolio isn’t completely levered toward growth at all costs.
This is why I think there is room for companies like Alphabet (GOOG -2.35%) (GOOGL -2.40%) in a portfolio. While Alphabet participates in the artificial intelligence (AI) arms race, it’s not its primary business. I think Alphabet deserves a spot in every investor’s portfolio, as the current business model should provide market-beating returns for years to come.
The Google search engine faces a new competitor
First, let’s look at what just a few percentage points of outperformance each year looks like. Say you invest $500 per month into the S&P 500, which has historically returned around 10% annually. After 30 years, you’ll have $1.1 million. That’s a great run, but if you can get 12% annual returns (which I think Alphabet can do), that number rises to $1.8 million — a 56% increase.
That’s a huge effect just by putting in a bit of effort to identify companies that can barely beat the market.
Alphabet is a company that has done that consistently by being the market leader in internet search through its Google search engine. Google holds greater than a 90% market share in this space, and its dominance is undisputed. This is how Google makes the bulk of its money, selling advertising space on the billions of daily searches.
However, a new challenger has some investors worried. OpenAI, the creator of ChatGPT, is launching SearchGPT, a Google competitor. This may be one of Google’s strongest competitors, but it would have to be unbelievably better to unseat Google from the minds of millions of daily users. It’s a long road ahead and would occur over decades, not quarters.
As a result, I’m confident Google will maintain its dominance for years to come, which will allow it to continue producing year after year of market-beating growth.
But how will it do that?
Alphabet doesn’t need incredible growth to outperform the market
At the end of the day, investors care about profits, not just sales. Although sales drive profits higher, there are other ways to grow profits.
One primary way is share repurchases. When a company buys back its own stock, it reduces the number of shares, so each existing shareholder gets more profit per share. Alphabet has been doing this for a long time and has meaningfully reduced its share count over the past five years.
GOOGL Shares Outstanding data by YCharts
Last year, Alphabet reduced its shares by about 3%. This gives it a near-automatic 3% earnings per share (EPS) growth rate, which means revenue growth doesn’t need to be as fast.
Alphabet has also started paying a dividend, with its annual yield hovering around 0.5%. While that’s not a huge amount, it barely scratches the surface of what it can pay. Over time, this payout will increase and further reduce the required sales growth needed to drive market-beating returns.
Should its dividend grow to a 1% yield, Alphabet maintains a 3% per year share retirement rate, and if its margins stay steady, Alphabet would only need to grow revenue at a high single-digit pace to beat the market. With Wall Street analysts forecasting 13% and 11% revenue growth for this year and next, I’d say it’s well on its way to beating the market.
When you consider that you can buy Alphabet’s stock at around 22 times forward earnings on par with the S&P 500‘s earnings valuation, the stock is perfectly priced for long-term investors.
Your portfolio doesn’t have to double each year to be a successful investor. A simple two-percentage-point beat is enough to achieve extraordinary results.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Keithen Drury has positions in Alphabet. The Motley Fool has positions in and recommends Alphabet. The Motley Fool has a disclosure policy.