August 12, 2015 / 9:19 PM / 2 years ago

SAFT ON WEALTH-Making an Alpha-bet or a human nature hedge

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

Aug 12 (Reuters) - Deciding if you want to bet on Alphabet is essentially a choice on what you want to back: Sergey Brin and Larry Page or human nature.

Brin and Page have changed the world and created a cash flow behemoth in Google. Human nature, on the other hand, has created every other conglomerate, which, with the possible exception of Berkshire Hathaway, have a general record of capital misallocation and underperformance.

Alphabet, of course, is the new holding company Brin and Page have created, and will head, which will comprise both Google and their far-flung and growing list of other companies working on everything from longevity to contact lenses that can measure blood glucose in diabetics.

This isn't so much Google, or Alphabet, becoming a conglomerate as codifying how its collection of companies and investments will be managed. The new structure offers certain advantages, freeing the co-founders to concentrate on 'moonshot' efforts while cleaning up lines should it want debt finance.

None of this should be a surprise. Page and Brin have always been upfront about not managing for shareholder value maximization. And last year they created an additional class of shares, one which, as it has no voting rights, will allow them to raise capital and reward executives but lose control over the direction of the company at a slower pace.

So, then, a conglomerate, with all that implies, and one with multiple share classes insulating the founders from the will of shareholders. What, as they say, could possibly go wrong?

Investors in publicly traded companies have a hugely diverging set of options these days, few of them particularly satisfying from a shareholder's point of view. On the one hand you have far too many companies which are giving financial engineering, usually via share buybacks, precedence over investment in their core franchise. That's problematic because investors risk seeing that franchise hollowed out over time as manager prioritize making quarter-by-quarter increases in earnings, even illusory ones, over building.

On the other hand you have the mad builders, of which Alphabet nee Google is a prime example. My reservation isn't whether the core cash flow machine Google, which produces some $20 billion annually in operating cash, is fairly priced.

Instead it is who gets a shot at the fruits of those profits, and how. To want to buy Alphabet, and clearly many do, you have got to be willing to give up a lot of customary protection in exchange for access to their world-changing genius.

TALE OF THE TAPE

While quite a few technology companies such as Alibaba and Facebook have dual or multiple share structures, the man making the most convincing, at least to the market, argument for the conglomerate is Warren Buffett, whose Berkshire Hathaway is just that, and has a long record of success.

Buffett stands in contrast to Brin and Page, offering discipline and patience as a capital allocator where they offer inspiration and 'moonshots'. Warren, after all, would never try to tell you that Dairy Queen will help you live to 150, only that it is a business which can be profitable over the long term if managed well.

So both companies are votes on exceptionalism, Buffett's or Alphabet's.

The rules which make the exceptions in conglomerates and multi-share class companies meaningful, however, are not encouraging.

Conglomerates as a group trade at a structural discount to intrinsic value, a phenomenon which has gone on so long it even has a name, the 'conglomerate discount'. This discount in 2012 stood at about 10 percent, according to Boston Consulting, a bit less than the 14 percent or so average since 1990.

That's because conglomerates have a poor track record of capital allocation, being prone to supporting executives' dreams of empire rather than taking a gimlet-eyed view of return on equity.

A 2012 study by Institutional Shareholder Services, funded by the Investor Responsibility Research Center Institute, found that tightly controlled companies - especially those with multiple share classes - generally underperform over the longer term. (here)

All of this is as unshocking as it gets. Human nature argues that Alphabet, and perhaps even Berkshire Hathaway, will be likely to fall prey to the same shareholder-damaging behavior that undermines the groups of which they are emblematic.

Some might conceivably feel they just can't afford not to be exposed to Alphabet.

I myself am glad they are doing this investing, some of which may lead to exciting or even world-changing businesses. I am gladder still they are doing it with someone else's money. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft) (Editing by James Dalgleish)

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