• Define what this business is:

  • Reinvestment moat?

    • Ie: Big Tech, SaaS, etc

  • Legacy moat?

    • Ie: Pepsi, Coke, McDonald’s

  • Greenfield opportunity + long runways (can also be reinvestment moat)?

    • Ie: Evolution, Adyen, Twilio

  • Capital light compounders?

    • Ie: Autodesk, Adobe, Visa, Mastercard

• Is this business resilient, optional, or both?

  • Nonlinear vs linear revenue growth

• Does this business have an "out of the money call option"?

  • The way NZS Capital defines optionality: "Optionality as asymmetry which is not priced in at current prices." Key factor: NOT PRICED IN.

  • Optionality can be subjective: ie. Is Mastercard optional because it has tailwinds in e-commerce, touchless transactions, micro-transactions, digital wallets, etc? Or is it a legacy moat?

  • Some other simple examples:

    • SQ: CashApp

    • Paypal: Venmo

    • FB: Commerce, VR

    • Google: GCP, YT, Waymo

    • Apple: Cars, AR/VR

    • Sea/Meli: Fintech

    • Wix: Payments

    • JD: spinoffs

• Is this a reinvestment moat? (similar to questions 1-3)?

  • For linear, valuation is much more important

  • For reinvestment moats type of business, valuation is less important

  • This is something to consider also when looking at small caps that show 18% growth but have sort of linear trajectory -> valuation is critical.

  • THINK IN OPTIONS

• Considering valuation, can it realistically outperform Big Tech (Amazon, Apple, Facebook, Google, Microsoft) over a period of ten years?

  • Needs to be a reason to own it

  • Even if you think performance will be similar to big tech, what’s the point?

  • It’s much easier to hold big tech so the risk/reward has to be clearly better than Big Tech

• Is there a clear product-market fit and why?

  • Write out your thesis on why this product/service is needed by the market and any evidence that supports a clear product/market fit

• What is the net margin at maturity and how confident are you of achieving it?

  • Understanding the economics of the business is crucial

  • What are the things that may keep it from achieving the net margin?

    • 1) Competition

    • 2) Profit/Loss statement

      • It's not just about gross margins - it's also about S&M spend. Is there leverage in S&M spend? (ECOSYSTEM CONTROL)

• Even if you like the business, should you own it now?

  • Just because you like a business does not mean you need to own it now

  • Take what the market gives you at any point in time

  • Aka add to current positions if it offers the best IRR and circle back to this stock at a later time when IRR is more favorable AND you will know more about it

• Is this business showing 20% IRR with conservative assumptions?

  • Never ever buy a business that is not <- you will not be able to hold it

  • Even if you miss some stocks, that's OK

  • This is a game of probabilities

• Is this a winner or a second-place business?

  • Own the winners even if overvalued a little

  • Remember, the second place might get better IRR for 2-3 years but will it be relevant in 10 years?

  • If you think this is a second place business: is it actually a second-place business or is it still early and could be a first place business?

  • Is this a special, unique, and differentiated asset?

  • You don't need to buy a business that is dime and dozen

  • How do we find out if this is a "special asset"?

    • Part of it is gut feel

    • Watch Youtube videos of the CEO

    • Read about mission, etc

    • What are customers saying about this business? What would customers do without the business?

• Where in the S-Curve is it?

  • Aka: Is this a "gorilla" stock in the tornado phase?

  • For a growth business, it is critical to understand where the business is in the S-curve.

• Is the end market growing or stable or in decline?

  • Not the product itself but the end-market

  • Businesses in markets that aren’t growing are market share battles, not greenfield opportunities — moats matter more here

• Will you allow this to grow into a very large position if it does?

  • Say this stock does a 10X, will you be OK having this as your largest position if it becomes so?

• Is this a growth business or a momentum stock?

  • Know the line!

• Getting "over the hump": What are the doubts?

  • List out 5 things that could go wrong. If you haven't thought of it, you are not "over the hump".

  • Who are the competitors? Is it crowded?

This is probably the result of a few things:

1) There’s been a notable lack of margin expansion as revenue has scaled materially

2) A focus on M/A and inorganic growth and as a result a neverending increase of its share count

The M&A Model

While the market may not appreciate Salesforce’s latest acquisitions, particularly the price paid for Slack, there’s little doubt that Tableau, Mulesoft, and Slack have been major successes for Salesforce.

Platform, which is comprised of Tableau, Mulesoft, and Slack, now represents the largest segment of their business and is growing at 24% a year, faster than the flagship Sales cloud.

In the most recent earnings call, Salesforce called out Tableau and Mulesoft:

Slack itself grew 39% on a stand-alone basis.

Salesforce Customer 360 strategy of having customers adopt more clouds is working

As a result of their M&A model, Salesforce has seen its TAM continually rise

Breaking down the acquisitions:

1) Mulesoft was acquired in 2018 for $6.5B at 22X sales. It’s hard to find specifics, but there’s some indication that Mulesoft is now over a $1.5B revenue run rate growing around 50%. That means Salesforce acquired it at a little more than 4x current revenue.

2) Tableau was acquired in 2019 for $15.7B. As far as I know, Salesforce has only disclosed Tableau quarterly revenue once, in the April 2020 quarter, and it was $285M though not growing fast. That’s a ~$1.2B revenue run rate, meaning Salesforce acquired it for 13x current revenue. (These are estimate, please correct me if I’m wrong)

3) Slack was acquired for $26.79B in December 2020. This one is most recent and Slack recently announced it is at a $1B revenue run rate but growing over 40%.

The opportunities going forward

In their investor presentation, Salesforce highlights the growing opportunities within each segment, with the TAM of their “Marketing & Commerce” segment expected to compound at 14% over the next 4 years. Keep in mind that while the TAM increased 19% the last 4 years, Salesforce itself has compounded revenue in this segment at 36%, roughly twice the market rate.

While the TAM for Platform has compounded at only 3% in the last 4 years, Salesforce has compounded Platform revenue at 25% and forsees that the TAM compounds at 7% in the next 4 years.

A new focus on operating margins

The highlight of Salesforce’s most recent earnings call, at least for the market, was the emphasis placed on a new, more disciplined approach and a focus on operating margins. The phrase “operating margins” was used over 20 times in the call by CEO Mark Benioff and CFO Amy Weaver, more than quadruple the number of times it was mentioned on the call 2 quarters ago.

The stock

The stock is not terribly expensive here, and while I’ve written before that I don’t do complex valuation and models, my thinking around Salesforce valuation is even simpler. If you think operating margins are going to be around 30-35% at maturity, that means P/S will be around 10 (where it is now), which also means that the returns from here will simply be in line with revenue growth. It’s not hard to see Salesforce continuing to grow revenue 15-20% for another 5 years at least.

This July, Jeff Bezos stepped down as CEO of Amazon, a company he founded 24 years ago, and passed the baton to CEO of AWS Andy Jassy. Aside from the occasional interview about Amazon and AWS, we still haven’t seen much of Jassy. Still, I think the AWS re:Invent 2020 keynote was a good introduction into his mindset and thinking — and right off the bat, you can tell he embodies what Amazon is about.

Here are some highlights from his keynote:

It’s hard for any company to sustain for a long period of time

“If you look at the Fortune 500 just 50 years ago in 1970 you can see that only 83 companies or 17% of them are still in the Fortune 500. If you look at just 20 years ago the 2000 Fortune 500, only half of them are still in that list. It is really hard to build a business that lasts successfully for many years and to do it you’re going to have to reinvent yourself and often you are going to have to reinvent yourself multiple times over. And so, in the last nine months I’ve thought a lot about reinvention and what it takes to do reinvention well. And typically what you see is the desperate kind of reinvention. You see companies that are on the verge of falling apart or going bankrupt deciding they have to reinvent themselves. And when you wait to that point it’s a crapshoot whether you’re going to be successful or not. It’s a little bit like borrowing money. Everyone will tell you that you don’t want to have to be borrowing money when the business is in bad shape because you may not get the rates you want or you may not get money at all. You want to be reinventing when you’re healthy. You want to be reinventing all the time. And so we thought about what are the keys to reinvention and some of it is building the right reinvention culture and some of it is knowing what technology is available to you and jumping on it to make that reinvention happen. So I thought I would share with you today what we see as some of the keys to building that reinvention culture and then some of the things that we see being reinvented as we speak.”

So what does it take to reinvent?

“And I am going to list eight keys that I think are important if you want to build the right reinvention culture. And the first is that you have to have the leadership will to invent and reinvent, and those terms sometimes they are a little different, they are also similar. If you think about it, people often say invention is inventing a new product or service from whole cloth and reinvention is reimagining an existing concept. But if you’re going to reinvent and reimagine there’s a load of invention in there. Just look at what Airbnb has done in the hospitality space or what Peloton has done in the exercise bicycle space or look at what Stripe has done in the payment space. These are huge amounts of invention that has gone into reimagining these spaces. And so if you’re going to be a leader that’s going to reinvent you have got to be maniacal and relentless and tenacious about getting to the truth. You have to know what competitors are doing in your space. You have to know what your customers think about your product and where you sit relatively speaking. You have to know what’s working and what’s not working. And you will always have a lot of people inside the company who will try and obfuscate that data from you. Sometimes they think they are doing you a favor and sometimes it’s for self-preservation reasons but it’s hard to get at that data and you have to be relentless about it. You have to challenge people. Often people who know a lot more about a subject than you do but you have got to get to the truth. And then when you realize that there’s something you have to reinvent and change you have to have the courage to pick the company up and force them to change and move. And part of that is sometimes acknowledging that you can’t fight gravity.”

You can’t fight gravity

“If you step back and have conviction that something is going to change because it’s a better experience for customers, it is going to change. Whether you want it to or not, whether it’s convenient for you or not, it is going to change and there are a lot of examples of this. I think if you look at what Reed Hastings and Netflix did several years ago where they cannibalized their own DVD rental business because they saw where it was headed with streaming, I think that turned out to be a pretty good decision for them. I think if you look at Amazon in the late 90s we had this owned inventory retail business which meant we bought all this product from publishers and from distributors. We stored them in our warehouses and then we shipped them to customers. And what we started seeing was these companies like eBay and Half.com that were actually offering third-party sellers’ products and they were shipping the products to customers. And we had this huge animated debate inside the company on whether or not we should support that. And the reasons that we were concerned about it were we just didn’t believe anybody was going to take care of customers the same way that we did. And then also the whole culture was set up to be this owned inventory business. People worried, well if we worked with third-party sellers, how would our publishers or distributors feel? So it was a very hard decision but ultimately, we decided to build a marketplace and offer third-party sellers. And we did it because we know that you cannot fight gravity. It was better for customers. It provided them better selection and it gave them more assortment on price. Now that also turned out to be a good decision for us because we sell more than a half of our retail products through third-party sellers. But you have got to realize that if something’s going to happen it is going to happen regardless of whether you want it to or not. You’re much better off cannibalizing yourself than having someone do it to you and chasing it.”

Talent that’s hungry to reinvent

“The third thing you have got to make sure of is that you have talent that’s hungry to invent. Now this seems fairly obvious. Everybody says I have talent that wants to invent. But it’s not always true. A lot of people who have been at the company for a long time are very comfortable doing things the way they have been doing them for a long time. Have you ever noticed it’s often when you have new blood in the company that they are leading the transformation? And that’s not because existing people can’t lead reinvention. It's just that you’re asking them to reinvent something they built. It’s hard to rip up something you spent a lot of time and energy and dedication doing. And it means you have got to learn new skills and it means that you have got to actually be curious about getting trained on other technologies.”

Solve problems for customers

“Now, you want builders and talent that’s hungry to invent but you want to make sure you guard against the opposite which is that you have people who actually solve problems. That you want people to solve problems for customers as opposed to solving problems because they like the technology and they think it’s cool. And you see this a fair bit. You know if you look in the enterprise technology space there are some providers who are competitor focused. They look at what their competitors are doing and they try to fast follow and one up them. We have a competitor like that across the lake from us here in Washington. Then you have a number of other providers who are product focused and they say look, it’s great that you have an idea on a product Mr and Mrs Customer but leave that to the experts. And that’s the group that you have got to be careful about because they often are building things that they think are cool as opposed to what really solves the problems for customers. At AWS, we’re customer focused. What we build is driven by what you tell us matters to you. And even if you can’t articulate a feature we’ll try to read between the lines, understand what you’re trying to build, and invent on your behalf.”

Speed

“The fifth thing is speed. Speed disproportionately matters at every stage of your business and in every sized company. And I think that a number of leaders at enterprises have resigned themselves that they have to move slowly. It’s just the nature of how big they are. It’s the nature of their culture. They have engineering teams that tell them “Hey look, this is too risky. This is too big a lift.” Sometimes you control those teams into trying something and the first sign of a problem they throw up their arms and say “See.” Speed is not preordained. Speed is a choice. You can make this choice and you’ve got to set up a culture that has urgency and that actually wants to experiment because you can’t flip a switch and suddenly get speed. It doesn’t work like that. You’ve got to build muscle to get speed. You’ve got to be doing it all the time. And there is going to be time… Frankly I think that time is happening right now. It happens a lot more frequently than most companies realize. But there is going to be seminal moments where if you don’t have the ability to have speed you will not be able to reinvent when you need to.”

Don’t complexify

“Now one of the enemies of speed is complexity and you have to make sure that you don’t over complexify what you’re doing. When companies decide to make transformations and big shifts a huge plethora of companies descend on them and providers descend on them and tell them all the ways that you have got to use their products: “You need to use us for this even if you’re using these people for these three things, use for these two.” This company says: “Use us for this.” They don’t deal with the complexity that you have to deal with in managing all those different technologies and capabilities. The reality is for companies that are making big transformations and shifts, it is much easier to be successful if you predominantly choose a partner and you learn how to do it and you get momentum and you get success and you get real results for the company. Then later on if you want to layer on complexity and more providers, you should go for it. But it’s not a great way to start to a reinvention to have too much complexity upfront.”

What it means for Amazon

It’s still too early to know what kind of CEO Andy Jassy is going to be. We don’t know how he views M&A vs organic growth, whether he’s actually going to keep the Amazon playbook of reinvesting all of its profits for the future. It also remains to be seen whether he will pull a Tim Cook and focus somewhat on the stock (dividends, buybacks, splits, etc).

What we do know is that Jeff Bezos was notoriously absent on earnings calls, a tradition that Andy Jassy upheld for his first quarterly earnings as CEO. Because Andy Jassy was CEO of AWS before becoming CEO of Amazon, it will be interesting to see if Amazon becomes a cloud-first business, instead of retail-first, and what that even means if it is the case. Either way, judging by his re:Invent 2020 keynote and his top-level thoughts on reinvention and speed, it’s safe to say Andy Jassy is an Amazonian through and through. It would be shocking for me to see any culture drift under his management.

Source

Of all the IPOs from 2021, there’s something about Coupang that makes me want to keep an eye on it. I don’t have a position and admittedly Coupang is not a business I understand enough to own. Some people get confused when I say I don’t “understand” a business — I know what Coupang does, but what I “don’t understand” is what the economics look like in 5 years, and that alone makes it a no-go for me. It doesn’t mean that I can’t get there, and writing posts like these may actually help.

Bom Kim: All the right values

You can tell founder and CEO Bom Kim is heavily influenced by Jeff Bezos. The ideas and values he laid out in the most recent earnings call are eerily similar to what Bezos has been saying all these years.

Jeff Bezos is known for his maniacal focus on the customers. He famously quipped “Obsess over customers, not competitors.” The last sentence, “leaving all to wonder, how did we ever live without Coupang” actually reminds me specifically of what Bezos said in Amazon’s 2015 letter to the shareholders: “We want Prime to be such a good value, you’d be irresponsible not to be a member.”

This is almost identical to what Jeff Bezos said as a response to an interview question:

How do you define what Amazon is today?

Bezos:

 We start with the customer and we work backward. We learn whatever skills we need to service the customer. We build whatever technology we need to service the customer. The second thing is, we are inventors, so you won’t see us focusing on “me too” areas.

Interestingly, it’s also what Steve Jobs used to say at Apple. “You've got to start with the customer experience and work backwards”.

Again, this is very similar to what Jeff Bezos and Amazon itself have said about valuing Amazon over the long-term: “Our ultimate financial measure, and the one we most want to drive over the long-term, is free cash flow per share.”

This part is actually almost paraphrasing Amazon’s first ever Amazon Shareholder Letter from 1997. Amazon talks about making investments and measuring their effectiveness, aka “iterating rigorously”.

So, while Bom Kim has the right values, I don’t know what to think of the idea that these values are basically recycled and repurposed from Bezos and Amazon. Is it lip service or is it truly internalized within Coupang? It remains to be seen. Ho Nam brilliantly encapsulated this idea on Twitter:

Q2 2021 Results

It’s interesting that even with a good quarter, the market was not impressed and the stock is actually trading at the lowest price since its IPO. Obviously, there are other things at play, including the upcoming lockup expiration (09/07/2021) and a confusing COVID environment with tough comps.

Valuation and general thoughts on Korea

Coupang is now trading at 3x sales, mostly because it is a 1P e-commerce platform with very low gross margins and negative net margins. Gross margins were around 15% in the most recent quarter but would have been a couple of points higher if not for a fulfillment center fire. To their credit, Coupang is investing in and growing its 3P marketplace, a business that would undoubtedly have better end-state economics at maturity.

Coupang also believes that as their 3P marketplace scales, they will have an opportunity to build out their payments business, another potential high-margin business.

So while scaling their 3P marketplace and Fintech business is bullish, the general state of Korea and e-commerce may be less so. First, the population of South Korea is quite small at around 50M people. Secondly, Ecommerce penetration in South Korea is already quite high relative to the rest of the world.

It’s hard to wrap my mind around the idea that the USA is roughly half of South Korea’s e-commerce penetration. Also, despite Korea’s small size, it has the 10th highest GDP in the world at $1.8T. For comparison's sake, Sea Limited is operating in South East Asia, a space with a combined population of more than 600M people and a combined GDP of $4T.

So while Coupang has some things going for it, it will need to find a way to expand outside of South Korea to prolong its growth. Whether they are able to do it remains to be seen. In the meantime, I will keep watching it.

How I value businesses

My valuation work stems from Pat Dorsey’s idea of understanding how the revenue and profits for a business scale. What are the fixed costs, variable costs, and opportunity set? This is really all you need, especially if you are attempting to value a high growth business.

Finding the margin at maturity (using fixed and variable costs)

If you truly understand the fixed costs and the variable costs (aka Cost of Goods) you will have a good idea of where the net margins should be at maturity. Take a 3P marketplace for example. In this example, you know the stated gross margins are around 80% (20% COG). That leaves us with fixed costs — what are they? People, R&D, S&M, etc. Look at the percentages of each against the revenue and determine where they might be at maturity. So for example, if the S&M costs are around 50%, you might predict that S&M will go down to 30% as it scales and more people know about the brand. If that does end up being the case, that’s an additional 20% in profit at maturity.

Here, knowing the business model and and the competitive position is key. You can’t really come up with a margin at maturity unless you understand both of those things.

Finding the 5 year revenue growth

The second part of the equation is understanding how much the company will grow their revenue in the next 5 years. As Pat Dorsey phrases it: “What is the opportunity set?” Is the end market growing at a certain rate and is this business a leader in that market? Again, in order to make an estimate, it is critical to understand how and why the company is growing in the first place. Put in the work to really understand the business model, the moat, and the end market and its competitive environment.

This leads me to my next point. You cannot do valuation work if you don’t deeply understand the business itself and its competitive position within its market. Most of my valuation work is qualitative. Do as much qualitative work on the business as you can before you even attempt to find the IRR. If you do understand it, the number crunching part is easy.

Putting it all together: Finding the IRR

The final part of the equation is to find a fair multiple for business in 5 years. It’s akin to choosing a discount rate for DCF. Obviously, the better the business, and the faster the growth, the higher the multiple will be. I try to keep things simple and use a 30x multiple (a 3% earnings yield) for good businesses. I won’t even look at bad businesses, so that means I use 30x across the board. Some people think that 30 is too high, and it may be so, but to me that doesn’t matter because I am using the same number across the board and investing is really about opportunity cost — comparing IRRs and investing in the businesses with the best risk/reward.

So the equation is simple. First you get the market cap in 5 years:

[TTM revenue * ((1+revenue growth rate)^5)] * margin at maturity * multiple

“Revenue growth rate” and “margin at maturity” are percentages or numbers between 0 and 1.

The part enclosed in brackets is giving you the total revenue in 5 years, and then you want get the earnings from that, multiplied by 30, which in my multiple. That is the market cap in 5 years. Once you have a market cap in 5 years, you’ll compare with the current market cap to find the IRR. So for example, if the market cap in 5 years is $100B and the market cap currently is $50B, that means it will be 100% return in 5 years, or roughly 15% IRR.

Investing is all about opportunity cost

It doesn’t make sense to look at the IRR in absolute terms. Investing is all about comparing the IRR of a business to what you can get in other places. This is the reason why interest rates matter for the valuations of stocks. As interest rates go up, so too does the risk-free return, which is why the valuations for other assets like stocks come down. After all, why invest in stocks if the risk-free returns are similar or higher?

Putting the concept of interest rates aside, you will also need to compare the IRR of one company with other companies. This can also be resolved by adjusting the multiple depending on the business you are studying, which takes us back to the idea of discount rates: the higher the terminal risk in the business, the higher the discount rate, or the lower the end-state multiple.

But even so, you might find two great businesses at different points of maturity, and while you might want to use the same end state multiple, you will need to compare IRR at the end and decide which stock with a 15% IRR you’d prefer to own. And this is where understanding the business and understanding your own personal style comes into play. You can buy both, you can buy the one that is more optional, or you can buy the one with more certainty around its business model and terminal risk.

Nothing is certain

In the end, the IRRs you end up with will most likely be wrong. It’s important to know that nothing is certain in business and investing and you could be wrong for a variety of reasons. The best way to go about ensuring a good result is to pick good businesses. Be right qualitatively about a business and you’re likely to do better than you think.

Resources

I love this Pat Dorsey talk at Google, and it’s been really influential for me in terms of how I value businesses.

“The trend in our North American footprint mirrors our historical track record — we see increased opportunity when the environment grows more complex.”

This explains Adyen’s moat and business strategy well: it’s the intersection of unified commerce with increasingly complex payment requirements and enterprise businesses.

Processed volume was up 67% on the quarter, with net revenue up 46% — the discrepancy between the two is indicative of Adyen’s moat and business strategy, to focus on large enterprises while Stripe focuses mostly on SMB and mid-market. So the end result is a lower take rate, and that trend should continue going forward.

Adyen’s Growth

Existing Merchants:

80% of Adyen’s growth is from existing customers with a very low (<1%) churn. The idea is to sign up customers and have them scale over time; a true land and expand strategy. That churn is so low is indicative of (1) how essential Adyen becomes to the business over time and (2) the switching costs of Adyen’s service.

Adyen called out McDonald’s as a good example of the land and expand strategy:

Enterprise merchants that were onboarded in previous periods continued to drive the majority of volume growth in the first half of the year. By building trusted partnerships with our merchants, we are continuously able to win additional volume. A recent example of the success of this approach is how our partnership with McDonald’s has grown over time. In 2019, we launched mobile transactions in the UK with them and have since expanded to do the same in Canada, the UAE, and additional European markets. 

North America:

North America is a now 22% of the business, growing at 80% as they are taking advantage of multi-channel shopping journeys aka unified commerce.

“Of the regions, North America continued to stand out. The region’s contributions rose to 22% of net revenue, growing 80% year-on-year. This acceleration comes on the back of almost a decade of investments. Starting out, we mainly helped US merchants expand outside the region. Today, we are consistently able to win US domestic volume as we are well-positioned to help merchants solve for the evolving complexity in the North American payments landscape (e.g. shopper preferences evolving towards multi-channel shopping journeys and payment method proliferation). There is significant opportunity with both new and existing merchants — our merchant base now includes household names such as Airbnb, American Eagle, and Slice.”

POS:

“Point-of-sale (POS) volume doubled year-on-year, as it reached €22.8 billion in H1 2021, comprising 11% of total processed volume. The growth of these volumes further emphasizes the increased relevance of our unified commerce proposition. The addition of leading names such as LVMH and The Body Shop underscores this success.”

“An ever-evolving space”

Adyen is investing in the future capabilities of the platform including:

Adyen Platforms:

Another interesting growth vector that was called out in the shareholder letter was “Adyen Platforms”. Adyen platforms was created to make handling payments easier peer-to-peer marketplaces and on-demand services. For more info on Adyen Platforms click here.

Adyen Issuing:

Adyen called out new use-cases for Adyen Issuing — expense management:

The sophisticated controls (e.g. time-, location-, and category-based) of Adyen Issuing support a plethora of use cases. We saw additional applications go live in the first half of 2021 in the realm of expense management. Our Issuing offering allows these merchants to achieve operational efficiency by instantly streamlining these processes. Illustrative is how accounting software provider Visma implemented the product to enhance its software for a broad range of expenses, and how Just Eat Takeaway.com is leveraging the product to build out a new revenue stream, allowing its corporate clients’ employees to order food and beverages without having to submit an expense report. 

Banking:

Following longer-term investments, we obtained multiple licenses in the first half. Notably, we were granted our US branch license. Our European banking license has helped many of our merchants grow, and we see similar opportunities for our merchants in the US. Other improvements include the expansion of our acquiring capabilities in Japan and the UAE. Both are illustrative to how we build driven by merchant demand — our launching merchants in Japan were Microsoft and Breitling, and we moved into the UAE with HMS Host International and Fabergé.

An Interesting Culture

CEO Pieter van der Does has been on record saying that all new employees are interviewed by at least one board member prior to being hired. Apparently, this is still the case despite having 1,954 employees now, with 207 new employees added in the first half of 2021. Whether this concept can scale as they add even more employees remains to be seen, but nevertheless it is very interesting. I don’t recall seeing this idea being implemented in any other business (at this scale) I’ve followed, and it speaks well of what they are trying to build.

The stock

Although I love the business, it’s hard more me to wrap my mind around valuation whichever way I look at it.

Valuation

I don’t really do complex DCF’s but I do look at revenue growth over 5 years, take the margin at maturity from it, multiply by a fair multiple, and then work it back to the current market cap.

I haven’t updated the revenue/profit figures of the most recent half, but prior to that, I was seeing a 6% IRR with some pretty healthy assumptions going forward. After the recent run up, Adyen is at 7.75% of my portfolio. My cost basis is $42.16. I love the business, but I am not adding at these levels. I am not selling either.

Right off the bat, Sea turned in a really impressive June 2021 Quarter of growth with Garena growing 166.8% and Shopee growing 174.1%.

Garena & Self-funding

One of the really interesting things that made me look deeply at Sea in the first place was the model of funding Shopee internally with a really profitable gaming division in Garena. It occurred to me that this was Amazon and AWS, except in reverse chronological order. How interesting.

You can see in the image above from Sea’s June 2021 quarter results that Garena did 62.8% in adjusted EBITDA. I would use “self-funding” with some caution though, because while Sea is using profits from Garena to invest in Shopee, it’s still raising money by selling shares on the open market. Here’s what their share count looks like over time:

Still, I see this as an advantage as Sea is able to use their $175B market cap to their advantage in raising money. Funding Shopee through a combination of Garena’s profits and selling shares is rational and difficult to compete against. Here’s a Twitter thread with a conversation around this idea:

Some questions

1) The “boots on the ground” approach to South East Asia by Sea Limited is in some ways a source of moat, especially with regards to Alibaba/Lazada, but also a source of questions for me. For one, the cultures of each of the countries they operate in are completely different. Who’s to say a challenger that is deeply entrenched within a country doesn’t give Sea a run for their money there? Do the network effects usually born out of leading e-commerce platforms survive country lines over the long term? Who knows?

2) Is Sea spreading themselves too thin by thinking about LATAM — specifically Brazil — with formidable competitors in MercadoLibre, especially now given the markets they operate in are still in infancy? Why not focus entirely on South East Asia? Again, who knows.

3) What gives me the most pause about Sea is the profitability of Shopee, a marketplace that should eventually exhibit some good economics. We are nowhere near that right now, though.

The gross profit for Shopee in the June 2021 Quarter was roughly 18% (!!). To give you some perspective, Etsy and Ebay, two other marketplaces albeit in different markets, each have a 70%+ gross margin. It’s clear that Sea is coming off of a very high fixed cost base, but even more so that it is subsidizing Shopee with free shipping and other customer incentives.

There are some silver linings:

Also, on a consolidated basis, Sea’s gross profit margin has also gone from negative to over 40% in 2 and a half years.

Sea’s take rate has also gone up and is 7.7% now.

Sea is attributing the increased take rate to the advertising and marketing by companies on the Shopee platform.

The stock

The stock is now trading over $320 a share, which a P/S of around 24, expensive on a historical/relative basis, but *maybe* on an absolute basis as well.

It’s a roughly 11% position for me, but I haven’t added recently and my cost basis is $161.71. I plan on holding my shares.

Valuation

I don’t really do detailed models and DCFs, so most of my valuation is back of envelope type. If you assume a 43% 5-year revenue growth, and a 17% net margin at maturity, the IRR is around 10%. Of course, I could be wrong on all of those assumptions. Investing is hard.

Feel free to leave some feedback and anything you think I should correct/add. What do you think of SE stock at these levels?

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Source

Twilio thesis:

Twilio is a cloud communications platform that allows developers to embed APIs in their software to communicate with their customers. Twilio’s API’s allow a broad range of communications including programmable SMS, voice, video, email, and so forth. Twilio has multiple vectors of growth and several tailwinds happening simultaneously that should allow it to grow meaningfully in the coming years:

Growth vectors and tailwinds:

1. General growth of the economy and businesses that use Twilio. Because Twilio employs a usage-based revenue model, as companies like Wayfair and Nordstrom grow their business, so too will Twilio.

2. New customer use cases. Twilio invests in R&D to find new ways that companies can communicate with their customers. On top of that, companies themselves can come up with new use cases within their software. For example, Wayfair may only send order confirmations at first, and then add password update confirmations, shopping cart abandonment reminders, and so forth.

3. Customer communication is not optional. Every single business, application, website, or software will need to communicate with its customers. Therefore as the number of available apps and websites increases, Twilio will grow. My assumption is that virtually all digital businesses will eventually become Twilio customers, at which point Twilio will be able to cross-sell and up-sell more services to every business in the world. We’ve seen this recently with Twilio Flex, a SaaS call-center built on top of their own APIs, as well as Twilio’s recent purchase of Sendgrid to cross-sell email APIs to businesses already using Twilio’s SMS offering.

Tailwinds:

1. Growing on-demand economy: as Lyft and Uber grow, more customers will need to contact their drivers and vice versa. The same concept applies for AirBnb, Zillow, etc.

2. The shift to digital: more websites and apps means more customers for Twilio.

3. The shift to cloud

Does Twilio have a Moat?

Twilio’s moat is widely misunderstood. Although it may seem like Twilio’s business can easily be replicated because it is just sending standard SMS, I believe this is not the case. 

1. First, channel proliferation is not slowing down. Every day, there are more endpoints for communication. SMS, Email, Facebook, WhatsApp, Voice, Alexa, etc. Twilio’s goal is to cover all means of communication and that is a difficult thing to do. Why would customers work with other businesses if they cover only certain means of communication?

2. Second, Twilio’s super-two network is now available in 100 countries (and a ton of carriers) and growing. This type of availability is difficult to have and requires a lot of work. Why would customers work with other businesses if they cover only certain countries and not all?

3. Third, Twilio’s APIs are most trusted. They strive for 99.999% uptime and deliverability and none of their API’s have ever been killed.

4. Fourth, developers will not switch to another service, for several reasons: (1) Twilio’s 99.99% uptime and availability gives them comfort that their code will work all the time, and switching to another service does not make any sense (2) It would be difficult for other businesses to steal customers given that Twilio probably had the lowest cost structure with all that volume

5. Lastly, and probably most importantly, gross margins are relatively low in this industry but it works for Twilio because of their developer-led go-to-market model and low sales and marketing costs. Competitors would need to outspend Twilio in a low-margin environment with much less revenue. Very unlikely.

But… if you feel inclined, I’d love to have your support so that I can spend more time creating and sharing engaging content about investing and stocks.

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Here’s what you should expect:

First things first:

1. I’m not an analyst: Although I do research and write about businesses on here (sometimes in really long form), I don’t think you should expect to see deep analytical insights.

2. I’m not even in the finance field: Investing in stocks is my passion, and it’s a hobby, but it’s not a profession. I plan on creating and sharing content about my experience as an individual investor, and I’d love to connect with other like-minded individual investors.

3. What you can expect: I plan on writing about businesses I love, sharing resources I’ve found helpful (books, articles, ideas, tweets), sharing my thoughts on portfolio construction, as well as doing in-depth portfolio updates from time-to-time. Hopefully, I am still learning and evolving and I can document it all here.

1. The businesses I love: I focus mainly on finding businesses with high returns on capital with significant opportunities to reinvest; another way of saying a “winner on an S-Curve” or a “reinvestment moat”.

1. I think Technology, (including SaaS/Software, FinTech/Payments, and Consumer/E-commerce Platforms) is a really interesting space to search for these businesses, so that’s where I focus.

   Here are some businesses I love, and if you love these businesses too, then we have a similar mindset:

   1. Apple (AAPL)

   2. Alphabet (GOOG)

   3. Amazon (AMZN)

   4. Facebook (FB)

   5. MercadoLibre (MELI)

   6. Adyen (ADYEN)

   7. Sea Limited (SE)

   8. Evolution (EVO)

   9. Atlassian (TEAM)

   10. Twilio (TWLO)

   11. Shopify (SHOP)

   Here’s my current portfolio as of August 17, 2021:

1. What I love most about investing: The most rewarding part of investing for me is meeting people who love investing as much as I do. It’s all about the journey and the insights shared along the way. Please feel free to connect with me on Twitter (@LiviamCapital) or through email (liviamcapital@gmail.com).

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I don’t know when I wrote this “thesis” but it was probably 4-5 years ago and long enough ago that Google Cloud Platform didn’t even come into my radar, and I didn’t focus on YouTube, Waymo, or things like capital returns. Given the way optionality has unfolded, it’s possible that Alphabet is an even better business now than it was then. It is very short and a bit crude. I’m not an analyst, so keep that in mind.

Thesis:

Google (now Alphabet) is a phenomenal front-of-mind brand name with an extremely wide-moat business that is able to generate substantial amounts of free cash flows, and should be able to do so far into the future. It’s moat, which can be characterized as impossibly difficult to penetrate, is based around several different, and powerful, models working simultaneously:

• Distribution/monetization: The most important thing to know about Google is that it owns 85% of mobile OS market share through Android. This allows it to have the mobile search engine with the widest distribution, and it uses profits from Android to pay for default position on iOS. The same dynamic plays out on desktop, where Google owns Chrome browser which has 67% of the market. 

• Network effect (1): Advertisers want to quickly and easily place their ads online in front of a large network of consumers. Consumers want to find the advertiser’s products and services quickly and efficiently.

• Network effect (2): Google’s search index software is second-to-none, with trillions of pieces of data, gathered over a long period of time, both on the query side and the index side (websites) that cannot be profitably replicated. Customers who want information quickly are able to reliably access this information in fractions of a second.

• Customer loyalty: Google provides reliable information to consumers who in turn trust Google to provide them information the next time (Google is equated with the words “find”, “search”, and even “buy” in the subconscious) without much thought from the user.

• Pricing power: Google is free to the consumer and therefore it is difficult for competitors to steal market share, short of paying these consumers to switch search engines, or paying larger sums than Google to platforms such as iPhone (for mobile) and Mozilla to make their search engine the default over Google. This would be extremely difficult to do given that Google’s extremely large cash flows. Even if competitors were to pay for placement, consumers may still prefer to use Google because of previous habit.

• CPC Pricing: Because Google is the primary form of advertisement for many businesses, to the point of dependency, and because it is an auction based system, CPC tend to generally drift upwards over time reasonably.

• Persuasion of clicks: Probably the most important attribute of Google’s moat, in my opinion, is the idea that they can influence where the user clicks, pointing them away from organic clicks toward paid-for advertising. This can be done through a variety of methods including: font size and color, number of ads per page, location of ads, etc. Furthermore, Google search ads are not meaningfully differentiated from organic search results and are extremely relevant, meaning Google does not have to worry about an inferior web experience if they were to devote a larger portion of the page to ads, unlike Facebook and other social media.

• Superior return on ad spend: Because people turn to Google with a specific intent to find a product or service, Google’s return on ad spend is far superior to other forms of advertisement, which include old mediums like TV, radio, and print, but also newer platforms like social media, where the user’s primary intent is to socialize with friends and remain engaged with the platform itself. This superior return on ad spend keeps advertisers money in Google’s network even if other opportunities exist.

Advertising TAM:

The market size for Google’s Ad product is large and growing, and again, this is happening in multiple ways:

• (1) Google’s ad product is not solely limited to merchants who sell physical goods and thus the market size should not be constrained by the size of online commerce. Google’s AdSense and Youtube products, for example, can be used for general branding purposes of bigger brands like Coca Cola and Disney. Furthermore, Google’s Ad network can also be used to sell non-physical goods such as information, apps, games, and so on. Maps can be used on a local level to drive traffic to stores and restaurants, and all other offline businesses. So, to recap:

• Online merchants who use Google for direct response advertising

• Brands who use Google for general branding (think Diet Coke, Huggies, Crest toothpaste, Toyota, Disney movies, and so on)

• Businesses who sell information, software, services, games, and apps that would fall outside of the umbrella of “online commerce”

• Local and offline businesses who use Google to drive awareness and foot traffic

• Travel (airlines, hotels, accommodation, etc)

• (2) Businesses and marketers are devoting a larger portion of their ad budgets to Google rather than old mediums such as TV, radio, and print.

• (3) New businesses and advertisers are more likely to start advertising a product or service with a highly measurable ad platform like Google. The ease of creating an instant ad campaign even promotes the idea that a business can “do it themselves” rather than hire an advertising agency.

• (4) The prominence of mobile computing devices such as the iPhone has literally kept Google at users’ fingertips at all times, giving users more opportunities to access Google, and driving more impressions and clicks to ads on Google’s network.

• (5) As the outstanding number of websites on the web increases (which is guaranteed), so too will the size of Google’s third party ad network (AdSense), enabling wider distribution of their ad product.

• (6) Even if none of the above were to be true, Google would be able to grow their business by extracting more revenue per user by pointing users away from organic search results to paid advertising through one means or another.

• (7) Google can still further monetize many of their current platforms like YouTube and Maps and should be able to use their ever-increasing cash flows to invest in creating or purchase new platforms to further distribute their current ad product.

• (8) The long-term shift away from brick and mortar to online shopping will continue to push more people to start their search on Google.

• (9) Because Google’s ad product is based around textual keyword search, there is no limit to the number of words and phrases that may be advertised. New business names, websites, products, and services will continue to expand the total number of keywords that advertisers will bid on.

Leadership

I view Google’s leadership as second-to-none. They have displayed time and time again an ability to think extremely long term (think decades). This can be reflected in investments with no apparent short term ROI that have become integral to the business today like Google Maps, Waymo, YouTube, etc.

Thesis

Apple is an aspirational brand and a cash flow machine that creates consumer technology that aims to advance humankind. The retention rate of Apple products are unmatched industry-wide, driven primarily by a closed ecosystem that interplays hardware, software, and services in such a way that is very difficult, if not nearly impossible, for other businesses to replicate. It’s moat is wide and deep:

Switching costs:

Although it may seem like switching costs are low for Apple devices, I believe this theory is 100% incorrect and actually flies in the face of basic human behavior and psychology. The consistently high retention rates for Apple devices across all of their product lines is plenty proof; people simply do not leave the Apple ecosystem once they become part of it.

Operating system: Once you become an Apple user it is very difficult to switch to a different system or device for various reasons; most importantly that it requires re-learning a different operating system and software, something most people are unwilling to do because there is no real reason to, but also because Apple’s operating systems (iOS and OS X) are considered to be industry-leading anyway. OS X in particular is different enough from Windows so as to “lock in” into the Apple ecosystem once they start to use Apple devices.

Data, Apps, Music, Messages, Emails, Numbers, Photos, Videos, etc: Apple products, especially the iPhone, are deeply, deeply embedded in every part of the consumer’s life, perhaps more so than any product in the history of civilization. This means that the iPhone is both the creator and recipient of all of a consumer’s data including photos, videos, emails, messages, etc. It would be nothing short of nonsensical and irrational to want to start over on another system or device. It just doesn’t happen.

The average Apple user: Apple has another thing going for it — who the typical Apple user is. The vast majority are relatively affluent people who have a preference for aesthetics and ease-of-use over technology. This user base gives Apple a couple of advantages:

They are not moved by price: it is difficult to win over these users with cheaper iPhones or laptops because money is not their main concern.

They are not overly concerned with technology. Remember, Apple championed the “closed” system when others like Dell promoted configurable and made-to-order systems. As such, the typical Apple user is not moved by memory or hard drive space. They are grandparents who want to facetime their grandkids or teenagers who want to use Apps to communicate with their friends. Convincing them to switch platforms with a larger hard drive or a faster processor simply does not work. Furthermore, Apple’s whole business model revolves around getting very few things absolutely right, and thus virtually all their capital and abundant resources are deployed towards their primary cash cow: the iPhone. Therefore, it is highly unlikely that a competing service or product will be able to create or offer an important feature that iPhone doesn’t have and that Apple is incapable of cloning very quickly.

This combination makes it extremely difficult for other companies to take users from Apple; if they cannot do it with price or with features, can they do it at all? One way would be to focus on the aesthetics of the products — but here too, Apple has built an almost insurmountable lead. Apple relentlessly focuses on designing products that are thinner, lighter, more beautiful, and easier-to-use than other brands and has marketed this concept aggressively. It is now virtually ingrained in a consumer’s mind that Apple has more beautiful and easier-to-use products than competitors and that is a very difficult thing to change because those traits are now synonymous with Apple’s brand. The amount of capital required to produce more beautiful products and outmarket Apple is simply astronomical, given Apple’s current cash position and future cash-flow generation abilities.

Pricing power:

Apple is essentially the only consumer technology business with pricing power. This is a big reason why Apple consistently earns 90%+ of all the profits in the mobile device industry. Competition has intensified over the years and lower priced phones have saturated the market, but price simply does not influence consumer behavior in this market. In fact, staying at a higher price point reinforces the idea that Apple is an aspirational brand and contributes to Apple’s dominance.

Network effects:

Source

Apple stores: Apple operates stores throughout the world, many of them architectural marvels that reinforce the idea of Apple as an aspirational brand. These stores are in major cities and in prime locations and can be viewed in some ways as a natural extension to traditional marketing. Other technology companies have tried to compete by copying the Apple store format, most notably Microsoft and Google, but no one has succeeded yet. One reason is that Apple has been curating the format for more than a decade, but a more valid one is because other companies simply cannot match Apple’s portfolio of consumer products that people love to touch and use. Competitors are faced with the “chicken before the egg” problem when it comes to competing with Apple stores. Which one comes first: the stores or the products? The answer is the products and that is difficult to do because Apple stores themselves are a big reason why competing against Apple is difficult. This gives Apple a powerful network effect of stores and products that is very difficult to break.

The AppStore: Because of Apple’s deep integration of both hardware and software and its direct distribution to the end-user, Apple upgrades users to the latest hardware and operating systems at a much better rate than their competitors like Samsung and Android, resulting in a much less fragmented user base than their competitors. As a result of this and because of iPhone’s popularity, App developers always develop first and sometimes only for iOS. This results in a much larger set of Apps for iPhone users than for other platforms, resulting in a strong network effect of a large number of apps and a large number of users, which seems likely to continue unabated far into the future.  

Future growth

By any measure, Apple shares have traded at a discount relative to the market, and in my opinion there are a few reasons that drive this undervaluation:

iPhone saturation: Investors believe that the market for iPhones is saturated and there is little room for future growth

iPhone revenue too large: Because iPhone revenue is so large and because iPhone accounts for the lion’s share of Apple’s revenue, investors believe that new products and services will probably not move the needle on growth

Hardware business: Investors view Apple as a hardware business prone to disruption and intense competition (much like Nokia before it)

Examining iPhone’s true growth potential

Although smartphones will not experience the same type of growth going forward that it did in the previous decade, investors must remember that iPhone’s market share is still under 15%. That means that 85% of smartphones are not iPhones and that is an enormous group of phones that come due for an upgrade every 2-3 years or such. 

Furthermore, investors do not credit Apple enough for its ability to command premium pricing. In fact, Apple was able to raise iPhone ASP’s (average selling price) by $101, or approximately 15%, from $695 to $795 in the Q4 2017 vs Q4 2016 after the release of the iPhone X. When you account for volume growth, Apple grew iPhone revenue by an incredible 20% YOY, on an already humongous base. It is obvious that Apple can create additional iPhone revenue through innovation and pricing if not through volume.

Primarily because of those two reasons, it it my opinion that Apple will be able to grow iPhone revenue moderately on an annual basis going forward.

Examining growth potential of other products

Apple’s services business includes things like the AppStore, Apple Music, Apple Pay, and so on.

What makes Apple so interesting to me is their fast-growing services business. Although it only accounts for 10% of Apple’s revenue, it is growing at 25% annually and it has virtually double the gross margin of Apple’s hardware business.

Apple is also not given enough credit for their ability to create new streams of revenue. It is my belief that Apple will continue to add new hardware categories that will extend the moat of their ecosystem, and Apple Watch is the first of many examples. 

Risks

In my view, Apple’s biggest risk is Apple itself, not its competitors. Apple’s business relies on two general sets of buyers: upgraders and switchers. Upgraders are people who have Apple products who upgrade to the newest iteration and switchers/new buyers are those who switch from a competitor to Apple, often buying their first Apple device. The issue Apple has and will continue to have is that upgrade cycles continues to lengthen -- meaning the devices are becoming so good that people are satisfied with them for longer periods of time. This places the onus on Apple to continue innovating across all their product lines, and to continue coming up with features that customers want and need -- a very difficult task. Upgrade cycles also depend on the product itself, for example people usually upgrade iPhone every 1 to 3 years whereas iPad may be upgraded every 5 to 10 years. I believe this is a major determining factor of markets in which Apple enters and has dissuaded Apple from entering markets such as TVs. On the flipside, Apple does not typically have large shares of the markets they are in, even iPhone where they had a 13.7% market share as of May 2017, and that means switchers/first time buyers are a much bigger slice of the pie than upgraders are, and I believe that any downside risk from longer cycles will be alleviated and even surpassed by switchers and first time buyers. 

For example, most Mac buyers are switchers and not upgraders, and I believe this will continue to be the case far into the future. There remains a very large opportunity for Apple to bring new buyers into their ecosystem. 

iPhone upgrade cycles: 

iPhone upgrade cycles have appeared to be lengthening in recent years but it’s difficult to tell because Apple has not been transparent about this. Nevertheless, even with a lengthening upgrade cycle, Apple should be able to grow iPhone sales going into the future. Realistically, Apple’s growth to the active installed base is coming from both upgraders and switchers, and as long as that installed base continues to grow at a better rate than the decline in upgraders, Apple will manage to grow.

Management

I view Apple’s management as second to none. There are several key themes that you can clearly see from a long track record of success:

Resisting the institutional imperative: In several areas, Apple has refused to enter markets that don’t make sense for them, even while other companies have done so, including TV’s and Netbooks, to name a few. 

Low level of M&A, especially larger deals: I view larger M&A specially for Apple to be mostly a waste of money and time, and Apple management has always been focused on organic growth, and not on adding revenue through M&A. However, they will often buy smaller businesses mostly for technology or talent.

Extreme focus: Apple’s focus is key to their success -- they focus on only a few key areas and do them really well. Even with ever-increasing amounts of cash, Apple does not overspend on R&D, choosing to focus only on areas where they can make the biggest impact and leaving all else aside. This is also because they can afford to wait while competitors figure out the market, and rely on their brand name to strike with a better product, albeit a bit late, when it’s ready. Underlying the outward facing consumer product, Apple invests in the foundational technology that drives the capability of consumer products forward — and this is probably most important.

Shareholder oriented: Apple’s management is extremely shareholder oriented, with large buybacks and an increasing dividend payout.

How I’ve Changed

As many of you know, there’s been a dramatic shift in my thinking around portfolio construction. Heavily influenced by Buffett and especially Munger, I once swore by concentration, and one of my previous blog posts elaborated on my (previous) thoughts on it: https://liviamcapital.substack.com/p/how-i-approach-portfolio-construction

A few months ago, I read a paper written by Brad Slingerlend (@bradsling) of NZS Capital and as I was reading it I could feel my mind change; it was a formative moment for me. It challenged everything I thought I knew about investing and made me consider that my previous concentration mandate was non-optimal, especially in these dynamic times.

I highly recommend reading the paper here but essentially it recommends having a portfolio split into two halves; the first with a few resilient & optional businesses and the second with many smaller optional-only positions, while squeezing out the resilient-only businesses. As a result of reading this paper and thinking through its ideas, my portfolio went from 5 positions to over 25.

Portfolio Update

Selling Datadog, Crowdstrike, Snowflake, JFrog, and Cloudflare

I recently sold out of Datadog and CrowdStrike, both of which I still think are phenomenal businesses. Datadog has a large opportunity in observability and APM and its growth is highly correlated with public cloud growth of AWS, Azure, and GCP, which we all know has a very long tailwind. Crowdsrike is a leader in endpoint security which should also benefit in the next decade. There’s no doubt both businesses will be highly cash flow generative in due time. The issue is valuation.

You can see in the chart above that Salesforce IPO’d in 2004 (approximately 17 years ago) at a ~$4/share and ~16 PS and has returned about 29% annually since then or almost 55X (!!), a phenomenal performance. Well, Datadog is trading at a 45 PS and Crwodstrike is trading at 58 PS. You might say, well 55/3 means Datadog would still return 18X in 17 years (~20%). Sure, but that’s only if either of those does as well as Salesforce has for 17 years.

I also sold out of Snowflake, JFrog, and Cloudflare. I like all of these businesses but I’m trying to get supernormal returns, and in my opinion, those businesses promise average returns at best. At the right price, I would certainly be a buyer again.

Recent adds:

Wix, Twitter, JD, Tencent, Baba, Etsy, & 4477 (Base Inc)

Wix:

Wix payments grew 382%, a clear indication of “ROOTMO” given Wix is trading at 16 P/S. Credit @bradsling for the idea of ROOTMO: “resilience + out of the money optionality”.

Twitter:

My hangup with Twitter has always been around monetization. Advertising is a difficult business without scale, especially at the top of the funnel. Well, Twitter recently announced Tipping and Super Follows which will help users monetize their Twitter accounts, hence creating a flywheel of more engagement -> MAUs -> Advertising revenue, etc. Twitter expects revenue to double in three years and the valuation is not demanding. It’s also good to see Twitter moving fast and having some success with new products like Spaces, a Clubhouse clone.

JD:

A Chinese e-commerce powerhouse trading at a very reasonable valuation with two things that I like: 1) exploding EPS and 2) tons of optionality with JD Health and JD Logistics, etc:

Tencent:

WeChat is ubiquitous in China, and Tencent’s core business of gaming, media, advertising, and cloud is formidable. Their investment portfolio may be equally impressive, however. It’s a remarkable business in so many ways:

Alibaba:

A wide moat business growing at 34% with a very undemanding valuation of 26 P/E. Lots of optionality with e-commerce and cloud:

Etsy:

I highly recommend reading John Huber’s thesis on Etsy in the Graham and Doddsville newsletter:

4477 (Base Inc):

This is my second investment in a Japanese business, my first being Mercari.

Thoughts on interest rates and inflation:

I’m certainly not an expert on marco-economics (or anything else for that matter), but I found this paragraph from NZS Capital to be useful in helping me shape my thinking around rates, inflation, and the future:

https://www.nzscapital.com/news/nzs-capital-q4-2020-update

My current portfolio:

These are businesses I love right now, but I change my mind daily. I highly recommend you do your own due diligence. You will not be able to copy conviction.

First things first

It’s important to know that there are multiple dimensions of Google’s search business and a variety of ways to approach getting traffic from a merchant/website standpoint. Technically, you don’t need to advertise to get traffic, but if you are a small business operating on planet earth in what is even a semi-competitive industry, you might not have a viable path forward without ads.

There’s a couple reasons for this: First is that 75% of all Google queries never make it past the first page, and second, well, look at the screenshot below of the organic search results for the query “white running shoes”. In order to rank organically on the first page of this query, you’ll need to displace one of the top 10 results. These are 5 results, but let me know which business you’ll knock out.

Ranking organically on the first page for important queries is almost impossible. Google’s algorithm considers hundreds of on-page signals when comprising its rankings, and page and domain level relevance and intent are extremely important. The issue is that Google learned a long time ago that any business could game the algorithm by having the phrase “buy white running shoes” (intent: “buy”, relevance:”white running shoes”) appear thousands of times on a page, and voila, they would rank on the first page for that particular query.

To combat this, Google introduced the concept of PageRank into their algorithms (more info here: https://en.wikipedia.org/wiki/PageRank). Your page still had to be relevant, but now it had to be proven with social cred -- which in internet terms simply means backlinks. The quantity and especially the quality of links back to a particular page mattered a lot to Google algorithms. This made a whole lot of sense in a number ways: for one it made the system harder to game, and two, it used social signals from around the internet to determine which pages to display for a particular query. The end result is a much better user experience with higher quality search results.

A secondary effect of PageRank was that it now became harder for small businesses to outrank established ones, short of unbelievably savvy and viral marketing. Before you cry foul, just remember that most consumers would rather see Amazon rank organically than a small business based in Missouri, for example. That’s just the way things work.

Text ads

So now that we’ve established that it’s not a viable strategy to create a small business and expect results without advertising, let’s look at the options these businesses have to advertise their product.

The first Google Adwords product was a text-based form of advertising centered around keywords. The underlying mechanics of why brooksrunning.com is ranked first and nike.com is ranked second in the query above is a bit complicated. The first thing to know is that every commercial query on Google results in a real-time auction to determine order of ads. Here again, there are multiple components to how Google ranks ads, with bid on a keyword only one part of the equation. Remember, Google wants to show relevant results, period. Accounting for the highest bids only in the Ads algorithm is a recipe for a terrible user experience.

To make Ad results as relevant as possible for the user, Google introduced the concept of AdRank. Essentially, it is multiplying the advertiser’s bid with the Quality Score (QS itself consists of multiple components, which I’ll explain in a second). The higher the Ad Rank, the higher the page will rank.

Here’s a great graphic on how it works:

(https://www.wordstream.com/ad-position)

What goes into Quality Score? Again, Google wants to show relevant results. Let’s look at the ad results for the “white tennis shoes” again for example. There are multiple possibilities as to why the Ads are showing in the order that they are. First, we don’t really know which keywords either company is targeting. On keyword-based advertising, advertisers can target queries in a few different ways:

1. Phrase match: Google allows you to target a keyword in phrase match format. So for example, you can bid for the keyword “running shoes” and rank for “white running shoes”. Going one step further, you could also target “shoes” and rank for “white running shoes”. With phrase match, you’ll rank for the keyword itself and any other query with words before and/or after the keyword.

2. Exact match: You can choose to rank only for queries that exactly match your keyword. In this case, you’d need to target [white running shoes] exactly to rank.

3. Broad match: This is a very loose match; so if you target white running shoes, you might also rank for the query “white tennis shoes” because they are generally related.

4. Modified broad match: Allows you to rank for words out of order as long as all words you are targeting are inside the query. So for example if you target +white +running +shoes you will also rank for a query like “white nike running shoes”.

You can supplement these match types with negative keywords that block your ad from showing up for certain queries. So for the above example, if I wanted to rank for “white running shoes” but don’t carry Nike brand, I might want to have “nike” as a negative keyword. This helps achieve higher ROI over the long term.

So Quality Score is determined by the quality and relevance of the landing page (the page the user lands on after clicking on the ad) as well as how closely the keyword being advertised matches the user query. So for example if brooksrunning.com is targeting an exact match [white running shoes] while nike.com is targeting a phrase match “shoes”, you can assume that the Quality Score for brooksrunning.com is higher, and thus the brooksrunning.com Ad will rank higher, all things being equal including bids. Because of quality score, it is also possible to rank higher despite a lower bid. Why? Because the CPC is actually determined by dividing the AdRank (remember, this consists of QS and bid) of the next bidder with your AdRank plus 1 cent. The end result is that those businesses with high quality scores, and better relevance, will have much better economics. This dynamic alone helps Google deliver better Ads results as this plays out over time.

Here’s a good graphic explaining that.

(https://engelhemhove.wordpress.com/2018/06/29/the-dominance-of-booking-com-and-hotels-com-on-google-search/)

Shopping Ads

Another advertising option, primarily for e-commerce businesses, is Shopping ads.

Businesses would need to upload a spreadsheet of products and bid on the product itself. This is different from text ads in that the bidding is on the product level. Relevance is achieved by matching the name and description of the product passed in the feed to the user query. The closer the match, the higher the quality score.

Google itself will determine which queries your product should show up for, and although the advertiser has less control, the ROI is higher for Shopping Ads than for Text Ads. The reason is that the picture and price act as a filter for attracting the right buyer. With Text Ads it’s much more difficult to convey your value proposition. Otherwise, the auction mechanics and bidding process are similar to text ads.

Because Google will choose the queries that a certain product will rank for, advertisers can expect Shopping ads to rank for a much wider range of queries, increasing almost exponentially for those products with higher relative bids. Here’s an example of how that works out, form the Google Ads back end itself:

You can see that with a $0.79 bid, advertisers for a particular set of products would get 109 clicks, but with a 3x bid of $2.50 they could get approximately 10x more traffic for ~25x the cost. The reason is that as the bids go up, the likelier the product is to rank for less relevant queries (remember, because of AdRank, if QS score is low, bids will need to be really high to rank). It’s up to the advertisers to find the sweet spot for profitability. Which leads to another note: those businesses with higher gross margins can grow revenue very fast with high bids that competitors with lower gross margins cannot realistically meet.

Display Ads

Another form of advertising is Google’s display business. It’s essentially about showing ads on Google’s partner websites, and bears more similarity to Facebook’s ad business than the other options listed above. While advertisers can layer in additional keyword, topic, and audience targeting, advertisers in this case are bidding to show banners ads on websites. These ads tend to be called “top of the funnel” and are more branded in nature. As a result, the ROI is much lower than Text ads and Shopping ads, and hence the CPC’s are much lower as well.

Because of the enormity of the internet, and the prevalence of Google’s AdSense product, advertisers can get a whole lot of traffic from Google Display ads. The quality of traffic is debatable, but again, because Google Ads are auction based, the CPC’s usually end up being where they should be.

Additional Layering

Advertisers have the option to layer some other strategies on top of what’s mentioned above. This includes having a bid modifier on devices, specific locations, specific audiences, hours during the day, etc. The level of advertiser control is extremely granular.

Bid modifiers on devices is an important consideration given that more than 65% of all clicks are now on mobile and conversion rates still lag desktop. Google allows advertisers to apply a negative modifier to normalize bids across devices while still giving you data on cross-device conversions.

Advertisers can easily push their campaigns to YouTube by checking a simple checkbox. Obviously for video ads, it would require creating video/content, but nonetheless, advertisers can access Youtube very quickly. In fact, the ability to push campaigns out immediately to Google Search, partners, and Youtube is done with a few checkboxes on campaign creating.

Machine learning

Recently, Google has invested a lot in machine learning, with the idea to help advertisers automatically achieve higher ROI across all their campaigns. Advertisers can use Google’s machine learning algorithms in multiple ways. First is to give Google a little bit of control over the bidding process and allow them to bid on the ads based on an ROI the advertiser would like to achieve. Google will begin to serve ads and then continually learn over time, differentiating bids in real time by taking into account keywords, products, conversion rates, browser information, device information, location of user, previous conversion data of the user, and so much more.

“Smart campaigns” takes this idea to another level, effectively giving Google complete control of the campaign and bidding process and allowing Google to determine where and when to show ads to achieve the highest possible ROI. This might include showing ads in partner websites and YouTube, and blurs the lines between the search, shopping, and display businesses.

Essentially, with a single click of a button, Google will do everything to get the most possible conversions at the highest possible ROI. Google is actively trying to convince advertisers to merge their current campaigns to “Smart Shopping”. For new advertisers with little experience and little time it makes a lot of sense to give it a try from the get-go.

Data

One of the really powerful things about Google Ads is an almost instantaneous feedback loop. The data on the campaigns filters in almost immediately and advertisers can make changes to their campaigns, messaging, website, products, pricing, and ads quickly.

The data itself is incredibly precise. Advertisers can see the exact queries, costs, conversion rates, and so forth. Advertisers can also see their impression shares relative to other advertisers in a particular campaign.

The data itself is given in tables and charts and advertisers are able to compare the data with previous time periods. It’s an incredibly intuitive backend tool for creating and managing campaigns and using the data to adjust on the fly.

Competition

This leads me to my last thoughts, particularly about competition in the advertising space. Google owns intent when you consider its Text ads and Shopping ads. Although Facebook is obviously its nearest digital advertising competitor, Amazon is the only other business that can match Google’s conversion rates, and may actually be higher.

What makes Google a better advertising business for merchants is that it’s strictly a CPC model whereas Amazon is a CPA + CPC model. Remember, advertisers on Amazon are third party businesses that pay Amazon a cut of the acquisition. Certainly, it’s getting harder and harder to rank organically on Amazon and some third party businesses are forced to spend on advertising there. The question becomes how much margin in addition to the acquisition cut they are willing to forgo.

Another thing to consider with Google Ads is that it encompasses a wide range of industries whereas Amazon focuses mostly on retail. The full scope of Google Ads is wide and retail is just one vertical. Travel is another large segment of Google Ads, including flights and hotels. Digital services and software and local services such as restaurants, therapists, doctors, lawyers are other examples.

Facebook is a formidable foe. If Google dominates the bottom of the funnel then Facebook absolutely dominates top of the funnel and branded advertising. What’s interesting is that while Google is swimming up the funnel with display and Youtube, Facebook is trying to get closer to the purchase point with Facebook Shops and various payment initiatives. So in a sense they are complimentary advertising products but converging at the same time. What makes Facebook especially impressive is the unbelievable understanding and targeting of people and demographics, to the point of surgical precision. On top of that, their Ad formats are second to none with rich full-screen mobile ads.

Bing is another competitor, albeit to a lesser degree. The ad formats are essentially identical to Google and this is done on purpose. In fact, Bing allows you to import Google campaigns with a click of a button or even allow it to import campaigns on a predetermined schedule. Nevertheless, there are still certain things that make Google ads much more powerful.

Bing is not just not quite as well rounded as Google. Data collection and presentation -- including charts -- on Bing feel like it is 5-10 years behind Google. Secondly, the underlying machine learning and to some degree, Artificial intelligence that makes Google Ads so powerful is missing in Bing.

For example, Bing copied a Google feature with “close variants” keyword matching. The issue is Bing has a very loose definition of what “close variants” actually means, and in some cases advertisers may find that they’re paying for unrelated keywords, resulting in much lower ROI. This is probably because Google understands user queries a whole lot better than Bing does.

Critical options and settings are missing in Bing. Negative keywords don’t work effectively in some cases. Bulk changes are needlessly difficult. The bottom line is that there are a whole set of issues on Bing’s backend that make it an incredibly frustrating experience for advertisers. The end result is that the ROI is consistently below what can be achieved on Google. Combined with a much smaller user base for Bing search, advertisers tend to focus on Bing much less. Remember, Google Ads is Alphabet’s core business and they continue to innovate to separate it from the pack.

Innovation

Having said all that, Google continues to innovate around it’s ads business. For example, last year they announced Gallery ads, basically allowing business to add images to Text ads. To an outsider this may seem like a minor thing, but images make it easier to convey the value proposition and if that leads to higher ROI, that will lead to more spend on Google Ads. Underpinning ad campaigns with machine learning and artificial intelligence is a huge opportunity that can lead to higher ROI for advertisers as well, so Google is investing there as well. Overall, I would expect Google to keep innovating and providing advertisers with amazing tools to reach new customers.

I spend a lot of time thinking about portfolio construction. Specifically, I focus on three things:

1. How many companies should I own?

2. Which companies are worth owning and why?

3. How much cash should I have?

Before you answer each one of these questions, I can’t stress how important figuring out your own personal long-term hurdle rate is. It will absolutely inform your strategy for investing. For example, if you’re looking for a 5% annual return, you might as well invest in an index fund. There is really no purpose to picking stocks yourself. 

My personal hurdle rate is 20%+ annualized over a very long time. Whether or not I can achieve it is debatable, but it certainly is the goal. I work backward from there, and every decision I make is to help me achieve that 20% annualized rate.

How many companies should I own?

It goes without saying that the more companies you hold, the more difficult it is to attain a high return, if only because by definition your total return is the average return of all stocks in your portfolio. Having said that, the more diversified you are, the less risk of permanent loss of capital. In terms of risk mitigation, 30 stocks is the cutoff; there is no risk reduction benefit for any additional stock in your portfolio. Really it’s about striking a balance between maximizing returns and minimizing risk.

On the other hand, reducing the number of holdings in your portfolio has some intangible and indirect benefits that people can’t really quantify and therefore don’t focus on. Concentration is a forcing agent that makes you choose to invest in only the highest quality businesses, perhaps subconsciously. Your bar for investment will become much higher and you will find yourself saying “no” much more often than “yes”. 

On Twitter particularly, everyone has an opinion on every stock. There’s people posting astronomical 6-month returns and it’s easy to feel overwhelmed with new ideas and unsure about your own process. Yet calming your mind and saying “no” to a million different ideas is a critical component of successful investing temperament. You don’t need to have an opinion of every business. You need the time to focus on very few ideas, and in turn, this will enable you to have the confidence to own just a few businesses for a long time.

Which companies are worth owning and why?

Knowing your own temperament and your investing goals is key. Because I want to concentrate my holdings and hold for a very long time, I look for quality businesses with lots of reinvestment opportunities. I say no to basically everything else, including deep value, special situations, turnarounds, etc. I also say no to any industry or business that is “swimming against the tide” or in a competitive industry with commodity type products. 

So for example, I view Coca-Cola as swimming against the tide with regards to sugar consumption in the world. Same for consumer packaged goods companies. I view airlines, car manufacturers, and retail as competitively-pressured and commodities, so I won’t even go there mentally. I also stay away from stuff I’m not smart enough to understand like banks. I also generally stay away from businesses that are struggling to grow or growing along with GDP. In general I do not care if any of these types of businesses are undervalued, buying back shares, or have a high dividend yield. I just say “no” immediately.

As a result, my pool of potential investments is quite limited at the onset. I like it this way, because it allows me to focus all my time on very few businesses.

In terms of the key attributes of businesses I like: I’m looking mostly for high returns on capital and a long runway, protected by a wide or growing moat and run by able management. Then it comes down to valuation work, and I like to keep this simple. Doing DCF’s and attempting to predict valuations to the nth decimal does not really add any value for me. I just try to predict as reasonably as I can the annual revenue growth over 5 years and then take the net margin using the net income margin at maturity, and then slap a fair multiple on it. I look at it conservatively using a few different inputs and make a determination whether or not it will help me achieve that 20% goal.

Finding businesses at the intersection of quality and reasonable valuation is a simple concept but it’s not easy to find, which is why I own very few businesses. There are some businesses I know and love, yet don’t own because the current valuation does not realistically support a 20% annual return from that moment. There’s no shame in saying “no” or “not yet”. Again, I don’t want to dilute my returns for the sake of adding a new holding and/or risk prevention.

Sometimes a stock I own will run up to where I don’t see a 20% forward return at current prices. I generally do not trim my holdings for any reason apart from the quality of the business deteriorating. There are several reasons for that: (1) capital gains taxes (2) the equity is still showing an acceptable forward return and cash does not and (3) I would have to redeploy the money somewhere else and I might not have a better option.

How much cash should I have?

I generally do not keep much cash, if any. The reason is that cash drag is a real thing and even if my holdings are a bit expensive they are usually still showing decent forward returns at any given point in time, and as we all know, cash doesn’t have a positive return. At times, I have been able to hold cash for a month or two, but that’s about as long as I have been able to go.

Whenever I have cash I just add to my best idea which is usually a holding I already have.

It’s also impossible to predict the market’s short-term movement so trying to find a bottom is useless and a waste of time. Again, I try to focus all my energy and time on knowing the businesses I know and a few others too.

Summary

• Know what your hurdle rate is and work backwards

• Diversifying decreases risk but concentration has a few important benefits

• I say “no” to almost everything

• Focus on just a few quality businesses with lots of reinvestment opportunities

• I don’t trim and I don’t carry cash

Source

Close your eyes and imagine a business that counts more than a quarter of the world’s population as a customer, with most of them spending 1/12th of their day using its products. Imagine also that this product is completely free to these customers and always will be. Also consider that this company requires no real capital to run their business, no real marketing to attract new customers, and has no real competitors. Finally, imagine that this company is in one of the largest industries in the world. What you’re thinking about is Facebook.

Facebook’s mission is simple and clear: to connect the world and to build community. Almost 3 billion people (more than 1/3rd the population of the world) interact with a Facebook product on a monthly basis, and 2.25 billion interact with the brand on a daily basis, creating one of the most powerful network effects in the history of humankind. Facebook leverages this user base into an advertising business that is able to generate otherworldly amounts of free cash flow, and considering the size and growth rates of the digital advertising industry, this will continue for a long period of time. Facebook’s moat is as wide and deep as they come: a network effect that includes almost every internet-connected person in the world. As is the case with network effects, it’s moat gets stronger as each additional person uses Facebook. 

The “network effect”

Facebook owns four of the world’s most popular communication and social networks: Facebook (the “blue app”), Instagram, WhatsApp, and Messenger. More than 2.25 billion people open at least one of these apps on a daily basis. 

More than 140 million businesses use Facebook, of which only 8 million use Facebook Advertising products. 

On the engagement side of the network there is an obvious network effect. The more people in the network, the more value each individual person will get out of the service. But Facebook is also a two-sided network of users and advertisers, and to me, this is the main source of competitive advantage. Not only does Facebook have the largest network in the world, it also knows the most about every single person in the network. This is because Facebook asks for and receives more information directly from the user than other networks do, but also because Facebook collects information indirectly from browsing history/cookies on the internet as well as your behavior on its platforms. 

The end result is that advertisers have access to a network of about 2.25 billion daily active users with unmatched targeting capabilities and a variety of different ways to advertise to them. To put this in perspective, Twitter has 187 million daily active users and much less information about each, and an ad product that doesn’t come close to what Facebook offers. 

The overlap of Twitter users (or any other network) and Facebook users is another important point to consider. 140 million businesses on Facebook means most are small businesses in the long tail, and these small businesses don’t have infinite resources. Much like Google Search ads, Facebook ads are do-it-yourself but it is not trivial to make it work from an ROI perspective. As a result, the very large majority of businesses will commit themselves to advertising on one social media platform only, the largest one with the best ad products. 

Threats to the network

Some may think that people will just naturally stop using Facebook or Instagram when they get less utility out of it, or when they eventually get bored of it. In my opinion this is not likely. The reason is that most of Facebook or Instagram usage is to fill free time. Everyone has those moments during the day — train rides to work, long waits for a doctor’s appointment, eating lunch alone, putting your child back to sleep, long and boring car rides in the back seat, and so on.

To stop using Facebook would be to replace it with doing nothing, and this is an unacceptable and maybe even irrational choice for the wide majority of people, especially because people have mobile phones at their fingertips at all times. This, along with Facebook being completely free to all users, is why users overwhelmingly choose to stay on Facebook month after month. It would require a seismic shift in human behavioral patterns, happening to all users at once, to materially affect Facebook’s user counts.

Theoretically, other emerging networks like TikTok could erode the moat. TikTok and other platforms -- like Snapchat and even Youtube to a lesser degree -- are competition to Facebook and Instagram because if you are engaging with one platform then you aren’t with the other. There’s a few things worth considering though: Facebook was already competing with everything else you do during the day, including eating, sleeping, and watching Netflix. More TikTok engagement is not cutting only into Facebook engagement -- it’s cutting into everything else you’re doing during the day as well. Secondly, TikTok skews (very) young: about 70% of all users are under the age of 24 and 32% of users are under the age of 19, whereas under 10% of Instagram users are in that age group. The average age of Facebook blue app users is 40 years old. If anything, TikTok -- both in spirit and in target demographic -- competes more directly with Snapchat.

Competing with free

In some ways Facebook is misunderstood. 

They have been mired in one scandal after another over the past few years, from privacy and security to hate speech and human rights. It’s important to remember Facebook is just a reflection of society itself, and not the other way around. If anything, Mark Zuckerberg and Facebook have threaded the needle well, balancing between fighting for free speech and fighting against hate speech. On top of that, they have invested extremely aggressively in AI to prevent election interference and also hate speech. That’s another competitive advantage for Facebook -- any network that hopes to get to Facebook’s scale will surely be dealing with the same societal issues, but without the many years of having invested in AI systems and machine learning to deal with it. 

What’s most misunderstood about Facebook is the model itself and how large Facebook’s total addressable market actually is. The writing has been on the wall for years but hardly anyone has noticed -- and it should be clear with their more recent announcements (Shops and Libra). Facebook is trying to disintermediate every large consumer internet business with “free”, including Netflix, Ebay, Match, Shopify, Paypal, and Spotify.

Ebay charges marketplace sellers a 10% fee? Make that free.

Match charges users to find dates? Make that free.

Paypal charges people for transferring money? Make that free.

Shopify charges companies for their websites? Make that free.

Netflix charges users to watch movies? Make that free.

Spotify charges people to listen to music? Make that free, too.

Now that Facebook has reached this scale, look for them to enter adjacent businesses and don’t be surprised when that service is free, all funneling into their already huge advertising business. I expect Facebook to continue it’s remarkable growth and I think public perception of them will change in time.

Source

Because Alphabet and Facebook are such a large part of my portfolio at around ~55%, I’ve been asked to share my thoughts on each in long-form format and without the constraints of Twitter threads. I’ll try to explain as best as I can what makes them so special to me, and why I likely won’t sell either anytime soon, starting with Alphabet today.

Alphabet: An embarrassment of riches

Alphabet is a holding company, of which Google is one part — and this includes Google Search, YouTube, Android, Play, Maps, Gmail, GCP (Google Cloud Platform), Ads, Pixel & hardware, and more. Alphabet also owns Waymo, an autonomous driving business, as well as Verily, CapitalG, and basically all of their other moonshots / other bets.

When you evaluate Alphabet as an investment, it’s important to know a few things. First, Alphabet is primarily a digital ad business, which accounts for a large majority of their total revenue. This ads business includes Search, Network Partners, and YouTube. There are several reasons why this Ads business continues to grow year over year.

First, Alphabet owns Android which accounts for 85% of mobile market share and Chrome browser which accounts for 70% of the desktop browser market share, both of which Google is the default search engine for. This distribution of their search product, as well as the resulting monetization of it, allows Google to pay Apple (the remaining 15% of the mobile market share) to make Google the default search for iPhones. As a result, Google has been able to achieve and maintain 90% market share of their search product for years.

This is important because on one side, it allows Google to aggregate demand and on the other side, advertisers want to be able to access the most possible consumers at once. That alone allows Google to have a wide moat, but the word “wide” doesn’t even begin to do Google’s moat justice.

Because there is intent behind each Google query, it turns out that Google’s ROI is the highest of any current form advertisement. On top of that Google offers advertisers additional ways to target specific queries, locations, device types, and on and on. It is a remarkably effective form of advertising and it is based on a real-time auction; it turns out that costs per click end up being right where they should be to keep businesses profitable. Because the ROI is so high, this is the last form of advertising that will be cut during a recession.

On top of that, any small 1 or 2 person business can easily set up a Google Ads campaign and get started right away, whereas before Google you’d likely have to choose between a local newspaper with limited circulation, magazine, radio, or TV, which for most small businesses was costly and out of the question. So when you look at market size, you need to understand that while Google is taking share from traditional advertising, it is also making the total advertising pie larger.

So why can’t Bing, Twitter, Snap, or even Facebook take share? Well, a few reasons. First, when you have a high ROI form of advertising, you want to maximize it and put as many dollars towards it as you can — you commit to the platform. Even if some other ad company were to come along, you would not split your budget. Maybe you would add to your total ad spend, but you would not subtract from your Google ad spend. Secondly, although anyone can start Google Ad campaigns, it does take continued commitment, time, and effort to get it right. It’s a tough sell trying to convince a business so focused on Google Ads to commit the same energy towards another platform when they know that everyone on that other platform is using Google for search anyway. Digital Ads really is a winner take all market, and as a result Google and even Facebook will continue to have a very large part of this (still growing) market.

The Next Leg of Growth

YouTube is part of their advertising business and is still growing around 35%, though gross margins are lower than Search because of the revenue split with creators. Local ads and Maps is still in infancy and could add to revenue growth in the mid-term.

Google Cloud Platform is a small part of their revenue but growing over 50% a year at an over $10 billion run rate. This includes their platform as a service, as well as their SAAS business which includes G Suite. Given the size of cloud, this probably will be a huge business in time.

The jury is still out on their hardware business which includes Pixel phones, Pixel buds, and hardware for the home including Nest. I would not count them out longer term given Alphabet’s investments in ambient computing and AI, and their intent to weave these technologies into their hardware lineup.

Longer term, Alphabet has set itself up nicely with some key investments, including Artificial Intelligence, Machine Learning, Autonomous Driving, Healthcare, and so much more.

I really believe that Alphabet is in one of the areas that is essentially market-size un-constrained, as Jeff Bezos likes to say.

At best, the market seems to completely dismiss Alphabet’s long-term bets, and at worst it holds it against them. Amazon on the other hand gets praise for thinking decades ahead and the market has always rewarded them with an extra generous valuation.

Given that Alphabet recently appointed Sundar Pichai as the new CEO, I really do believe we are close to an inflection point where the market will (1) start to give Alphabet their due credit for the embarrassment of riches in its portfolio and (2) start to appreciate their long-term thinking.