It was an OK week with the portfolio making steady but not spectacular progress, rounding off a solid month. The most interesting development was that I bought into my first US company, the tech titan Google.
I sold two positions in On the Beach and Churchill China, both for around break even. There was no major reason for these sales. They were simply a case of selling out of weaker positions to add to other existing holdings that looked more promising. In the case of On the Beach I found the recent trading update a little uninspiring.
I used some of the proceeds to buy an initial position in Alphabet, Google’s parent company, after it issued a fairly substantial quarterly ‘earnings beat’. Alphabet is one of several shares added very recently to the watchlist, following the extension of my coverage to the US. It is quite a different proposition to stocks I have previously invested in, being about 100 times larger in market capitalisation than my next largest current investment (NMC Health).
I am yet to research many of the new US shares on my watchlist in much detail. Consequently, in this case I took the opportunity to buy Alphabet immediately following the earnings release and have had a more detailed look into its quality afterwards. Having now done this while writing this post, I’ve noted more carefully some of the risks Alphabet faces and am a little less enthusiastic about its long term prospects than I was at the time of purchase, but still enthusiastic enough to continue to hold while momentum is good.
Google needs little introduction, but its parent company Alphabet carries out a fairly diverse range of activities beyond online search, including driverless cars, life sciences, internet and cloud services and ‘smart’ devices (thermostats etc.) More than 90% of revenues still come from its pay per click advertising services, such as AdWords, but the significance of its other activities is slowly growing.
Google operates in a two sided market, providing services to its users on one side (online search, gmail, android, chrome etc.) and then earning money through seeking access to these users to advertisers on the other side. As well as its own services it earns revenue from Google network members, who also show its advertisements for a share of the revenues.
As an aside, I found Alphabet’s last annual report very well written, candid and to the point. It was really quite interesting, especially the high level discussion of the growth drivers and risks it faces.
- Business economics: Google makes high margins (currently 24%) and decent returns on capital (around 15%). However, these metrics have been declining slowly in recent years, in part as a result of a shift in consumers to using mobile devices rather than desktops and the need for Google to pay ‘distribution partners’ to access this traffic. Google also invests very large amounts in R&D to continually improve its products to maintain their competitive advantages and to find new growth opportunities While I think Google is likely to remain highly profitable for some time yet, the relatively modest and slowly declining returns on capital do hint at some of the risks it faces in a dynamic and evolving market.
- Track record: Google has an excellent track record of growth in revenues, profits and cash flow. The share price has appreciated fairly steadily since it listed.
- Competitive advantage: the strength of the competitive advantage of Google’s online search is fairly clear. It has a pretty dominant position in this area. However, as an advertising channel, online search faces competition in a broader dynamic sense from the different ways in which consumers can access information, in particular as mobile devices and digital social networks become more important media. Because of this, Google is being forced to share its revenues to a greater extent with the other tech giants. More broadly, Google is forced to invest heavily in R&D and high quality staff to stay one step ahead of possible disruptive technologies. The flip side is that Google is well positioned to do the disrupting itself. Overall, while Google perhaps does not appear quite as all powerful as it did a few years ago, I’m satisfied that it has a sustainable competitive advantage that will endure for a good while to come.
- Growth prospects: I think the key point is that there is strong secular growth from consumers searching online more and more that is likely to continue for a long time yet. I think this means that Google is likely to be able to continue to grow profitably for some time yet despite its already huge size. Increasingly I would expect growth to come from more developing countries as these increase their use of online. The proportion of revenues Google earns outside of advertising is also increasing and in the longer term there appears to be plenty of possibility for further growth here. If Google does too well it will increasingly face regulatory risk but I’m not overly worried about this at the moment.
Momentum is excellent. I bought just after Google issued a substantial positive earnings surprise that resulted in the share price breaking out to new highs. I think the valuation looks reasonable or perhaps moderately cheap, given growth prospects.