The internet can provide secular growth at an attractive price
We hold a long-term bullish view on the internet sector, having been overweight the sector for the last ten years. Two major factors underpin our thesis. Firstly, the internet has and will continue to take market share as it disintermediates old economy competitors by removing the ‘middle man’ given its radically lower-cost business model. The internet is also ever more accessible with speeds increasing and device prices declining. Demographic factors are also a major tailwind as ‘digital refugees’ (the older generation who have not integrated into tech culture as they feel it is threatening and dangerous) age and die, and are replaced by the tech savvy ‘digital natives’ (who view technology as a necessity and have a high level of tech spend).
Old economy casualties from the increasing use of the internet surround us, from struggling newspapers, along desolate high streets to bankrupt video stores and bookshops. We believe the move from the old to the new economy still has a long way to run, as even now the bulk of spending is still done offline. For example, US online sales still represent less than six per cent of total retail sales. Add to this the huge potential of emerging market internet penetration catching up with the West and we have a very exciting growth story.
Bigger can be better
However, history is littered with great ‘stories’ that end up as bad investments. The second (and more important) factor that makes the internet an attractive investment are the large and growing barriers to entry that many internet companies possess. A surprisingly small number of companies dominate the profits of the internet. Scale, brand and network effects are enormous competitive advantages, and as an area of the internet matures one or two players tend to lead.
For example, in keyword search advertising in the developed world, Google generally has over 60 per cent revenue share – and more significantly more than 90 per cent profit share. In retail, it is now incredibly expensive to compete with the distribution infrastructure and buying power of Amazon in the major Western markets it is present in; in China, Alibaba holds an equally strong position. The hotel reservation market, the most lucrative area of the online travel industry, is dominated by websites controlled by Priceline, Expedia and TripAdvisor. The same story is true in internet radio (Pandora) and UK real estate (Rightmove). This we believe really differentiates the internet from other popular growth areas such as cloud computing.
Here, competition is extremely fierce, resembling that which the internet went through during the technology bubble and bust, and we fear a similar outcome for many of these high-flying names. We agree that the cloud is a major change in technology and some cloud-based names, like their internet brethren ten years ago, will emerge from this competitive war as winners but for every winner there will be many losers, and all players seem priced for success.
Mind the hype
Ultimately, however good the story and however strong the barriers to entry, valuations must be taken into account. While some areas of the internet have become rather expensive, most internet companies are highly profitable with price/earnings multiples that are reasonably in line with their earnings growth potential. This again contrasts rather sharply with cloud computing companies. Here, while there is extremely strong revenue growth (accompanied by lots of investor excitement) there is a distinct lack of profits, even when the vast stock options grants that these companies grant to their employees and management are excluded. For secular growth in technology, we strongly suggest that the real profits of the internet are far more attractive than the hopes of the cloud.