Warren Buffett Is Behind Berkshire Hathaway's Massive Alphabet Investment. Here's What He Likes About the Company.

Last year, Berkshire Hathaway (NYSE: BRKA) (NYSE: BRKB) made a big investment that seemed out of place to many investors who follow the company and its chairman, Warren Buffett, closely. The company bought about $4 billion worth of Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL).

The size of the investment suggested Buffett, who historically avoids technology stocks, was behind the purchase. Since Greg Abel took over as CEO at the start of the year, he has made Alphabet one of Berkshire's largest investments, putting another $23 billion (or more) into the stock. So, it was reasonable to think Abel had used his influence to initiate the position last year.

But Buffett put any speculating to rest. "I initiated it," he disclosed in a recent interview with CNBC. And while he dodged further questions on his investment thesis on Alphabet, he provided an indication of what he's looking for in an investment. Here's what he likes about Alphabet.

Former Berkshire Hathaway CEO Warren Buffett. Image source: The Motley Fool.

What is a good business, according to Warren Buffett?

Warren Buffett's investment strategy boils down to buying wonderful businesses at a fair price. There are two key components to that: 1. identifying a wonderful business, and 2. determining a fair price.

Buffett shared exactly what he thinks makes a good business. "The trick is ... to find businesses that are going to earn high returns on capital for an extended period of time."

Buffett calls out several of Berkshire's longtime holdings as examples. American Express earns a much higher return on equity (which is often what Buffett's referring to when he says "return on capital") than other banks. Buffett points out that Amex achieves its 34% ROE without taking on additional risk relative to other banks that generate returns in the low teens on average.

Why Alphabet fits that definition now

For a long time, Buffett and his longtime vice chairman, Charlie Munger, said they wouldn't buy Google, as the company was known before it changed its name to Alphabet. The two explained at Berkshire's 2012 shareholder meeting that they just didn't understand the business well enough to invest in it.

"I made a mistake," Buffett said with a wry smile when asked why he didn't like the company back then. "But Charlie ... he just pounded the idea that it wasn't a good business just because it was doing sexy things or whatever it might be but it wasn't earning real cash or be expected to do it in a very short period of time."

But Alphabet has blossomed into a massive cash-generating machine. Even after accounting for the large amounts of stock-based compensation, Alphabet is generating substantial cash from its operating activities: about $150 billion over the last 12 months. Alphabet had been using significant amounts of cash to offset stock-based compensation and return excess cash to shareholders through share repurchases, but a major change in the business over the last few years makes it even more appealing to Buffett.

A company generating high cash returns is great, but what's even better is if "it could redeploy it as a business," Buffett said. "It was even better than one that had the ability to earn high returns, but you couldn't deploy the excess capital of those returns."

Today, Alphabet has the opportunity to deploy hundreds of billions of capital into AI data centers. And Buffett believes it's better positioned than any of its competitors to achieve high returns on that investment.

Why Alphabet is set to achieve above-market returns

Alphabet could spend more cash than it generates this year for the first time in a long time. Management expects full-year capital expenditures to be between $180 billion and $190 billion, driven by unprecedented demand for AI compute.

What might give Buffett the confidence that Alphabet can generate strong returns on that investment? Alphabet's full-stack approach to its cloud business.

Alphabet isn't just providing infrastructure for AI developers to run their models. It offers a whole platform with a software layer that makes it easy to create, manage, and deploy new AI-based software. That provides a significant level of differentiation, especially considering its Gemini family of models is among the best in the industry.

What's more, Alphabet designs its own chips, TPUs, which have gained significant traction over the last year or so. It signed a deal with Anthropic to use its chips and plans to sell them directly to select third-party customers in the near future. Using TPUs instead of more traditional GPUs gives Alphabet greater control over its supply chain and one of its highest costs, enabling it to scale faster and achieve better margins.

On top of all that, Alphabet has a massive and fast-growing backlog of contracted revenue. As of the end of the first quarter, Alphabet's remaining performance obligations totaled $462 billion, nearly doubling from the previous quarter. Management expects to realize over 50% of that backlog within the next 24 months, which will push the scale of its Google Cloud business beyond $100 billion in annual revenue.

Alphabet looks poised to produce very strong returns on its invested capital within short order. The opportunity for it to deploy all of its excess capital (and then some) in such an opportunity makes it very attractive to an investor like Buffett.

American Express is an advertising partner of Motley Fool Money. Adam Levy has positions in Alphabet. The Motley Fool has positions in and recommends Alphabet, American Express, and Berkshire Hathaway. The Motley Fool has a disclosure policy.