Investors Shouldn't Sell Google Shares Because Interest Rates Are Rising

Alphabet's (aka Google's) shares have been selling off recently, together with other technology shares, in response to rising interest rates. But that isn't a reason to sell the company's shares, according to Quo Vadis President John Zolidis.

Interest rates are certainly an important factor in investing decisions. It's the discounting factor in almost every equity valuation model. But the impact of rising interest rates is different for different technology companies, depending on the expected earnings flow.

The effect of higher interest rates is higher for companies that aren't expected to deliver profits at some point in the distant future compared with companies that are already profitable and are expected to stay so in the immediate future.

The crucial factor in technology investing is whether an investment is valued on a business model that has passed the test of the market, is already delivering profits or is based on a promise that it will become profitable one day.

"It is not low interest rates that make technology companies attractive. They are attractive because they are changing the world," Zolidis said. "Of course, it is not sufficient to drive change. A technology company becomes an attractive investment if its innovation is attached to a highly profitable and durable business model.

"Ideally, we want to buy the stocks of companies like this at opportunistic prices, but we don't get scared and sell just because the price of a great company's stock is temporarily too high."

That's an old rule applied by legendary value investors like Benjamin Graham, Warren Buffett and Peter Lynch. In other words, you should buy companies that have a highly profitable and durable business model, when Mr. Market (to use Benjamín Graham's metaphor) is panicking and selling off these stocks.

"Ultimately, our investment will do well if the company delivers on its promise to grow earnings and cash flow," Zolidis adds. "We spend our time evaluating this potential, rather than guessing at whether the ratio of the company's price today is too high or too low relative to earnings expected in the next few months."

A company's earnings and cash-flow growth potential, which eventually enhances shareholder equity, depends on whether the company has a sustainable competitive advantage. It delivers superior returns over a long period — above the opportunity cost of capital invested in the company. And one that takes the right business model to address people's needs and the right "moats" to protect it, preventing the competition from copying it.

Google certainly fits this profile. It's essential to people's daily life.

"It's difficult to imagine, five years from now, a world without Google, YouTube, etc.," Zolidis said. "What about the financials? Google has been very successful using its position in search to generate growth and profits. The company has produced double-digit revenue growth every year for at least the last decade, and its EBITDA margin [a proxy for cash flow] has stayed north of 30%."

Google's economic value added (EVA), the difference between the return on invested capital (ROIC) and the weighted average cost of capital (WACC), is 15%, meaning that Google stockholders earn 15% more than they could earn elsewhere in the market, according to Gurufocus.com estimates. And economic profit has remained positive over the last decade.

Google has a durable, profitable business model. Of course, higher interest rates will affect its valuation, but they won't undermine its business model.

"We don't know if we are at a near-term peak in the valuations investors are willing to pay for growth companies," adds Zolidis. "However, we feel confident that it would be a huge mistake to sell GOOGL shares or shares of other fantastic tech companies [and pay taxes on gains] because interest rates might go to 2% from 1%."

Editor's note: Panos Mourdoukoutas owns shares of Google.