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Google (Or Rather Alphabet) Is The Future; Berkshire Hathaway Is The Past; And Berkshire's Core Model May Be Doomed

Summary

There are similarities in structure between Alphabet and Berkshire, but the two could not be more different.

Alphabet's hugely profitable advertising machine supports what we would call a “Quantum Evolution” model.

This is the exact opposite of the Berkshire Hathaway model, which can roughly be summed up as “Leverage insurance float and buy stuff that stays the same.”.

Berkshire’s core philosophy of buying into safe, stable businesses that don’t change is being threatened by rapid shifts in the surrounding landscape.

Google has undergone a major restructuring. There is a new parent company, Alphabet, which splits out all of Larry and Sergey's various moonshot ventures - Google X, Nest, Calico, and so on - which focus on crazy big bets like self-driving cars and human life extension. Google is now a subsidiary of Alphabet.

The most amusing perspective on this came via @tsrandall on Twitter: "The new parent company will be able to pursue new areas of interest that had previously been off-limits to Google."

Joking aside, there are multiple reasons why the split-out makes sense. The new structure allows for more CEO spots, rewarding talented executives. Google itself (now a subsidiary) can get back to focusing solely on search under its new CEO (Sundar Pichai) and protecting the company's near-insurmountable lead in search. Google's original founders, Larry and Sergey, can now focus more on the crazy stuff that holds their attention. And it will now become easier to spin off any subsidiary into its own entity (including the original Google) fairly quickly if need be.

Some have compared the new Google structure to Berkshire Hathaway, even suggesting this new entity is "molded after" Berkshire:

The new structure takes a page from Buffett, 84, whose Berkshire Hathaway Inc. is a holding company for disparate businesses ranging from insurance and railroads to running shoes and ice cream. In the past five decades, he's built one of the largest businesses in the world by eschewing fads, buying when others sell, and taking a long-term approach to investing. Through 2014, Berkshire averaged annual returns of almost 22 percent, more than double the Standard & Poor's 500 Index.

"They look at Warren as a hero and Berkshire as a template," said Steve Wallman, a Middleton, Wisconsin-based money manager who has invested in Berkshire since 1982 and bought stock in Apple Inc. in late 2003. He's not a Google shareholder, but says he wishes he were.

Fellow executives in the technology industry also noted the similarities to Berkshire.

"Google's Alphabet sounds like a 21st-century Berkshire Hathaway, but with a lot of very large venture bets," Jeff Weiner, CEO of LinkedIn Corp., said on Twitter.

~ BloombergBusiness, 'B Is for Buffett' in Page's Plan to Mold Google After Berkshire

There were old references from Google's founders too:

In a letter to potential shareholders in 2004 ahead of Google's initial public offering, Page and co-founder Sergey Brin quoted Buffett when outlining the company's long-term focus.

"Much of this was inspired by Warren Buffett's essays in his annual reports and his 'An Owner's Manual' to Berkshire Hathaway shareholders," the letter said, in the lone footnote at the bottom of the statement…

The comparison is amusing because the two entities could hardly be more opposite.

Yes there are similarities in structure between Alphabet and Berkshire. But so what? Saying that decentralized conglomerates are similar just because of their organization chart is like talking about hedge funds as an asset class. It doesn't make sense. (Hedge funds come in countless shapes, sizes, and areas of focus - the only thing that unites them is performance based manager compensation.)

We concede that it's possible the organizational structure of Alphabet was inspired by a Berkshire flowchart. But that's about as far as it goes in terms of useful comparisons. The interesting thing in our view is that Alphabet is the future; Berkshire is the past; and their core models are radically different. One has a future. The other may not.

As the WSJ reports, Google had $66 billion in revenue in 2014, 89% of which came from advertising on YouTube and search. Alphabet is driven by a gigantic, hugely profitable advertising machine.

This hugely profitable advertising machine supports what we would call a "Quantum Evolution" model:

  • Use cash flow from a central source to fund speculative projects on the periphery.
  • Let rapid evolution take place at the margins (small experiments all around the periphery).
  • Eventually, one or more of the experiments experiences quantum evolution…
  • And becomes a cash flow juggernaut in its own right, overwhelming the original center.

If you imagine a giant circle, Google (the original Google) is at the center of that circle, throwing off huge amounts of cash. That cash is re-invested in all these speculative areas - self-driving cars, smart thermostats, life extension, and so on. Over time, some of these aggressive "quantum evolution" bets - attempts to fast-forward the future - could pay off to the tune of hundreds of billions, or even trillions.

Doubters think huge innovation bets are a waste of effort. But when a quantum evolution bet pays off, the results can be incredible. Consider Amazon.com, which spent most of its life as a cash-burning e-commerce business. Now, thanks to the stunning profitability of Amazon Web Services (AWS), Amazon is viewed as a cloud computing business with a marginal breakeven e-commerce business attached. It's not inconceivable that, 10 or 15 years from now, Alphabet could be viewed as a self-driving car business or life extension medical technology business, with a modestly profitable search engine attached.

This "quantum evolution" model (focused on accelerating the future) is robust to the degree that the central cash source is robust (and the Google search engine cash cow appears quite robust, mainly because Google's engineers maintain a pace of innovation and improvement faster than any competitor could realistically match). And the quantum evolution model is failure resistant due to the fact that such a model expects routine failure, and allows for routine disappointment, in exchange for cultivating that opportunity to ultimately score with a moonshot that works. The ability to fail is built into the system, as a form of flexibility and resiliency.

This is the exact opposite of the Berkshire Hathaway model, which can roughly be summed up as "Leverage insurance float and buy stuff that stays the same." To point out more differences:

Berkshire says "never lose money." Alphabet is willing to lose significant sums via calculated risks.

Berkshire focuses on businesses that stay static and don't change. Alphabet drives change.

Berkshire focuses on past stability. Alphabet focuses on future possibility.

Berkshire intrinsically fears uncertainty and change. Alphabet embraces uncertainty and change.

Here is an interesting thought experiment. If you had to put your net worth in a blind trust 100% invested in one of these two conglomerates - Berkshire Hathaway or Alphabet - for the next 20 years, which would you choose?

Alphabet seems the no-brainer choice. Alphabet has dozens of ways to invent the future, and only needs one or two moonshots to pay off. Berkshire, meanwhile, faces peril at every turn. Some of Berkshire's core drivers, in fact, are under direct assault from Alphabet itself. For example:

Car insurance. Berkshire derives huge revenue, and "float," from its various insurance businesses, with GEICO the crown jewel. It is not implausible that self-driving cars could completely gut the car insurance business.

Soft drinks, fast food, and unhealthy consumer goods. Coca-cola, Dairy Queen, Kraft macaroni and cheese… Berkshire is heavily invested in food that can barely be considered food. Tastes are changing here as nutritional science reveals just how awful most of this stuff is, and technology better enables production of healthy stuff (with consumer tastes shifting).

Railroads. The health of the railroads is tied to physical transport, and especially the transport of energy resources like oil and coal. 3D printing and localized manufacturing are a big threat here. And solar phasing out fossil fuel use.

Utilities and related "old school" energy bets. Big, hulking, heavily regulated status quo players are subject to the threat of alternative energy inroads. Investments in old established cash flow generators like Exxon and Suncor (oil sands) are further exposed to pressure from alternative upstarts (whose valuations are too speculative for Berkshire to touch) and major transition away from traditional energy sources.

Gigantic financial institutions. Silicon Valley is coming for the megabanks. Many of their services will be undercut by rapidly improving technology. Mortgages, life insurance, basic services - all ripe for technology upgrades that hammer legacy players by squeezing profit margins, giving greater benefit to consumers at lower cost.

Antiquated technology. In one of his classic worldly wisdom speeches some years ago, Charlie Munger specifically referenced IBM as a good example of a company Berkshire would not buy because they don't understand the vagaries of the technology landscape and don't want to mess with it. Many years on, what does Berkshire do? They buy $10 billion worth of IBM… and wander into the middle of the cloud wars (which IBM is losing badly). Say what?

Generational preference shifts. How many millennials give a rip about American Express?

Broadly speaking, we would argue that Berkshire Hathaway was a brilliant creation, ideal for its time - a conglomerate vehicle leveraged to the powerhouse growth of the United States economy all throughout the 20th century. Buffett's central insight was being a value investor when value investors hardly existed… with willingness to make huge bets when the time and price was right… while brilliantly leveraging the power of insurance "float" through exposure to the longest and strongest economic tailwind (the growth of the US economy) that the world had ever experienced.

But now Berkshire's core philosophy is deeply exposed. If your game plan is to buy into safe, stable businesses that don't change… then what happens when the whole landscape is rapidly shifting?

Everything about Berky seems to make a virtue of sameness and stagnation. That's great when you truly have the "moats" to defend your franchises, and when the pace of technological change is a friendly dawdle. But happens when your moats are breached, your whales are beached, and you don't know what to do?

Berkshire Hathaway, like Saudi Arabia, will be around for quite a long time. But the aversion to innovation, and embrace of stagnation and sameness as antidote to risk, could become huge liabilities in the not too distant future. Google - or rather Alphabet - is working hard to make the self-driving car revolution happen in five to ten years time. Wall Street houses are already talking about it.

Maybe a multi-decade spread trade is in order: Long Alphabet, short Berkshire…

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.