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Billionaire Bill Ackman Has 8 Keys to Successful Investing. Only 1 Artificial Intelligence (AI) Stock Met All 8 Criteria.

Motley Fool - Sun Aug 6, 4:30AM CDT

In investing circles, Bill Ackman is a prominent figure. He's the founder of hedge fund Pershing Square Capital Management. Ackman isn't afraid to take big swings, and investors might be surprised to learn that his highly concentrated portfolio consists of just eight stocks.

Ackman is best known as an activist investor and has a number of notable wins to his credit. One of the most high-profile was a $60 million stake in troubled mall operator General Growth Properties, a company on the verge of bankruptcy, which he subsequently turned into $3.5 billion. In 2016, he made a big bet on then-struggling Chipotle Mexican Grill. Since then, shares of the fast-casual restaurateur have more than tripled.

Over the years, Ackman has developed a checklist of eight keys to successful investing, which he had engraved on a stone tablet. He uses these principles to vet his investments. With all the excitement surrounding artificial intelligence (AI) this year, you might be surprised to find that only one AI stock has made the cut and is part of his portfolio.

A person looking at graphs and data on a see-though computer display.

Image source: Getty Images.

The winner is: Alphabet

That's right, the only AI-related stock held in Pershing Square Capital's ultra-concentrated portfolio is Alphabet (NASDAQ: GOOGL)(NASDAQ: GOOG). Ackman took a stake in the internet search giant during the first quarter and holds more than 8 million Class C shares and more than 2 million Class A shares, with a combined value of roughly $1.3 billion.

In Pershing's quarterly investor call, Ackman disclosed that the stake was "20% to 25% larger" than revealed in the regulatory filing, as the additional stake was the result of forward contracts, which don't have to be included in Securities and Exchange Commission (SEC) filings.

Let's run Alphabet through Ackman's checklist to assess how the company made the cut.

1. Simple and predictable business

Alphabet generated $74.6 billion in revenue during the second quarter, most of which was from the company's search and digital advertising businesses. Search is as simple and predictable as it gets. People will continue to conduct internet searches for information, and Google will parlay that into digital advertising revenue.

On a side note, Alphabet has long used AI to boost the relevance of the company's search results and better target its advertising.

2. Free cash flow generation

Even in the midst of one of the worst downturns in more than a decade, Alphabet was still a cash-generating machine. In the second quarter, Alphabet delivered operating cash flow of $28.7 billion, and even after purchases of property and equipment of $6.9 billion, the company's free cash flow came in at $21.8 billion. That's all the more impressive since operating and free cash flow represent 29% and 38%, respectively, of Alphabet's revenue.

3. Dominant company

When it comes to dominance, Alphabet is unmatched. In search, Google is the gold standard with a dominant 92% share of the worldwide search market. Search, in turn, fuels the company's industry-leading adtech business, which accounts for nearly 30% of global online ad revenue, according to data compiled by industry publication Digiday.

4. Large barriers to entry

You don't become a leading search provider, digital advertiser, or cloud infrastructure provider overnight, and even attempting to enter any of those fields would be prohibitively expensive for most would-be competitors. Just imagine the years of AI algorithms to perfect search, even more to effectively target advertising, and the dozens of data centers necessary to run this large and successful operation. Furthermore, each of Alphabet's flagship businesses has economies of scale, another high barrier to entry.

5. High returns on invested capital (ROIC)

Return on invested capital (ROIC) is a hallmark of many successful businesses and indicates that management has a good eye for investing in profitable ventures. There is no specific target for ROIC, but as a general rule, it's best if it exceeds the cost of the capital by at least 2%, and anything above 10% is generally considered strong. With a weighted average cost of capital of 8.8% and an ROIC of 22%, Alphabet's investments tend to yield outstanding returns.

6. Limited exposure to extrinsic risks we can't control

Pershing Square takes a broad approach to analyzing external risks in its portfolio, but one of the key focuses is on good environmental, social, and governance (ESG) practices. These include environmental management, respect for human rights, safe working conditions, strong governance, and business integrity, among others.

Focusing on companies that have a strong track record of appropriate ESG practices helps minimize extrinsic risks. Needless to say, Alphabet is consistently cited for its ESG and sustainability practices.

7. Strong balance sheets that don't need access to capital to survive

The recent downturn was a prime example of the need for a strong balance sheet, and Alphabet's is world-class. To close out the third quarter, Alphabet had more than $118 billion in cash and marketable securities, offset by $26.4 billion in long-term debt and operating lease liabilities. This results in more than $91.5 billion in net cash that can see Alphabet through a wide range of situations.

8. Excellent management and good governance

Since we've discussed good governance, we'll focus on excellent management. The tone of leadership is set at the top, and Alphabet CEO Sundar Pichai is widely recognized as a good leader.

While the factors that measure excellent management are subjective, employee opinions are generally a good indicator. Pichai has been consistently ranked as one of the top CEOs by review aggregation site Glassdoor. He currently has a score of 3.9 out of 5 stars, 72% of employees approve of the CEO, and 90% would recommend working at Alphabet to a friend.

A delightful bonus

AI probably wasn't a big part of what led Ackman to buy Alphabet, but a quick look at the company's valuation suggests that it may have played a part. In the first quarter, Alphabet shares were selling for roughly 3 times next year's sales, near the company's lowest valuation ever. That, along with the listed criteria, made Alphabet too good to resist.

While the stock isn't the screaming bargain it was earlier this year, currently at less than 5 times next year's sales, it's still selling for a song compared to its historical average. The time to buy is now before Wall Street catches on.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Danny Vena has positions in Alphabet and Chipotle Mexican Grill. The Motley Fool has positions in and recommends Alphabet and Chipotle Mexican Grill. The Motley Fool has a disclosure policy.

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