Stock Investment – Lesson 5

Google was founded by Larry Page and Sergey Brin in the year 1998. They wrote web crawlers which indexed the contents of the web and allowed users to search the internet for free. In essence, they built a free search engine.

But by then, there were already two search engines Lyco and Alta-Vista that were in operation since 1994. They had a 4 year head start when compared to Google.

Cut to 20 years later, Google is the undisputed king of the search market. It owns close to 70% of the market share with its closest competitors – Microsoft and Yahoo, owning about 19% and 10% market share respectively.

Google’s parent company Alphabet revealed that it had total revenues of $110.8 billion for the 2017 fiscal year, up from $90 billion in 2016.

Clearly, Google is a monopoly.

But, how did this happen?

Think about it and reply to this email.

As I said, it’s a practical course.

Do practice..

Dig information

And reply whatever you found (not whatever you assumed)

Continue reading after doing your research..

Good businesses generate good return (10 to 15%) on capital but great businesses generate high return on capital (100% and more).

In order to protect the high returns on capital from competition, the companies should have a structural competitive advantage.

Warren Buffett refers to this concept as Moat.

Coming back to the above example, Google’s moat was its search algorithm called PageRank which was way superior compared to its peers. What Google’s algorithm did was to find needles in haystacks by consistently delivering the most relevant results as the top hits to a search query.

By focusing on one thing ‘Search’, Google made its search engine 10X better than its competitors.

What happens when you have a product that is 10X better?

Customers came in thousands and started using its search engine. Thousands became millions & billions of users and Google gained market share and monopolized search.

In order to further strengthen market share, Google added several products like Maps, Android, Chrome, YouTube, and Playstore each of which have a billion users. On seeing this advertisers rushed in to spend money on its platform, bringing Google huge revenue and high returns on capital.

If you would have invested $1000 at Google’s IPO in 2004, your investment would have been worth around $ 22,000 (as of year 2018) generating a massive 2100% ROI.

That’s the impact of strong moats for companies and its shareholders.

If you can find a business that generates solid returns on capital and has at least one moat from the following, you have found yourself a likely winner

  1. Intangible asset
  2. Customer Switching Costs
  3. Network Effects
  4. Cost Advantages

Intangible assets

.. means having moat in the form of brand power, patents, or regulatory licenses.

For example – Apple has a strong brand name, patents, and a huge market demand that give it a wide moat which acts as barriers against other companies.

That’s why Apple is a trillion dollar company and has generated huge profits year after year, making great returns for its investors.

Other simple examples of businesses with brand power as moats are Maruti, Colgate, Fevicol, Marico (parachute, saffola are its famous products) which have huge recall value in public memory.

Coming to regulatory licenses as a moat, government licenses are required to start certain kinds of businesses. The business of manufacturing, purchasing, and sale of beverage alcohol (spirits and wines) is a good example. Regulatory licenses are not at all easy to get and hence it will be a huge barrier to entry for competitors.

Do you think it is easy to displace United Spirits and United Breweries (their products – Kingfisher, Royal Challenge etc)? Any competitor has to get hundreds of regulatory approvals first which itself is very time consuming and then follow it up by capturing the market share.

Customer Switching Costs

A good example for this category of moat is banks. You see for the past 10 years I have not changed my bank. If you ask around, most people once they open an account with a bank, don’t bother to change the same.

This is because of a psychological bias called status quo. Essentially, we prefer to keep things the way they are.

Also most banks, especially private sector banks, are difficult to differentiate on their service. Yes, there are some banks that offer better interest rates than other and it takes only a few days to open an account in another bank, but that would mean that you would have to update all the records like salary, business, bill payments, loans with the new bank information which is a time consuming process.

Again status quo in play.

As you can clearly see there is a cost associated with switching banks. This is a huge competitive advantage and an enormous moat.

In January 2009, HDFC was trading at Rs 185. Today, the same is trading at Rs 2265, which means it has delivered 12X returns excluding the dividend income.

Let’s take another example, Yes Bank. In the same time period, the stock has delivered 22X returns excluding the dividend income.

Network Effects

Network effects as a strong competitive advantage can be seen in marketplace platforms like eBay, Amazon or social media companies like Facebook, Twitter, Instagram, LinkedIn.

Take eBay/Amazon for example.

First, buyers attract sellers to the marketplace platform. With more sellers, buyers are more likely to find any product they are looking for at a desirable price, which increases the number of buyers. This in turn, makes eBay/Amazon more attractive to sellers and the cycle continues.

A competitor will need to build a large two-sided network of buyers and sellers before it can effectively compete with eBay/Amazon.

Similarly, Facebook, Linkedin and Twitter have powerful network effects working in their favor. Members join these networks because other members are in this network.

It is going to take a long time for the competitors to build a network with millions of users from scratch.

A $1000 investment in Amazon after its 1997 IPO would be worth about $865,000 as of year 2018.

A $1000 investment in Facebook after its 2012 IPO would be worth about $ 5,000 as of year 2018.

Moats in play.

Cost Advantages

Many companies build this category of moat by being able to produce goods at a lower cost compared to their competitors. This gives them better profit margin leading to higher earnings essentially making the stock very attractive.

Companies are able to obtain such cost advantages due to their huge scale of operations. The larger the business the more the cost savings.

Can you think of any Indian companies that have built such strong economic moats in the form of cost advantages?

Investing successfully is not so hard. It’s about finding out companies with strong moats and buying them when the price is right. In my next email, I am going to shatter the myth that you need some genius IQ to become a successful investor. Instead, you need an ordinary IQ but extraordinary temperament to become successful.

If you do not research yourself then becoming a value investor is difficult task.