Value Investing

IP Capital Partners 2Q17 Commentary – Moats

IP Capital Partners commentary for the second quarter ended June 30, 2017.

Investors were excited about the Brazilian market. With greater rationality and reforms moving forward, the economy was stabilizing, inflation and interest rates were in free fall, and the local index and exchange rates kept rising. Some were convinced that the real’s appreciation against the dollar still had a long way to go. It seemed too good to be true.

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Profound reforms about to pass with no last-minute dropouts among “allied” parties from the government’s base? Would there be no deadlocks for endless questioning in the judiciary branch? With several categories certainly upset about losing privileges, would there be no backlash from public interest groups? In other words, would the “system” really accept these important changes because of the basic arithmetic and public accounts’ logic that underpins them – without any of the mayhem we have grown accustomed to expect?

As skeptical Brazilians, while obviously hoping for the best, we were prepared for the worst. Based on historical standards, the recent entanglement wasn’t exactly a surprise - just another sad chapter in our history, brought upon by the materialization of widely known risks.

With the local market upheaval, we were able to deploy some of the funds’ cash. We slightly increased our investments in Itau/Itausa and B3 (result of the merger between BM&FBovespa and CETIP). In addition, the funds’ foreign currency exposure – which we had increased in favorable moments during the first months of the year – was partially reduced as the dollar appreciated against the real.

Another important change in the first half of 2017 – between February and March – was the increase of our stake in Alphabet (the holding company that controls Google), which we will describe in greater detail in this report.

Outlook

The low volatility in the U.S. stock market, largely influenced by still low interest rates and abundant global liquidity, should not be mistaken for low risk. After the appreciation of recent years, it is only natural that the U.S. market should be more vulnerable to shocks and price corrections.

The same liquidity that reduces volatility in the developed world also attracts funds to emerging markets, cushions shocks like the ones Brazil has experienced in recent years, and helps companies maintain higher-than-usual leverage, among other indirect consequences. At some point this tide will turn, with important consequences for many markets.

Having said this, it is also true that sitting out on the truly exceptional businesses tends to cost dearly. What kind of crisis would it take for a conservative investor to “reach for a bucket”? A 25% drawdown in the S&P500? Maybe 30%? Well, around two years ago, Alphabet’s shares traded at levels around 30% lower than today. Berkshire Hathaway was 17% below current levels while Amazon, Thermo Fisher and Danaher were 55%, 25% and 18% lower, respectively. In all these cases, the increase in the value of these companies was such that nowadays, at prices of only two years ago, their shares would be trading at very attractive valuations – even more so in a low interest rate world. To mention just one example, which we will discuss in further detail below: Alphabet, at prices of two years ago, would be trading at only 13x its 2016 earnings1. In practice, we would see a drawdown of this magnitude as a tremendous buying opportunity rather than a risk of permanent loss. Not investing in such special companies for fear of a price correction is usually a recipe for regret.

Our goal, therefore, was and continues to be to obtain superior returns over time, searching for a balance between attractive and conservative investments and cash available to be deployed at times of pessimism and crisis - but always making sure that we are not excessively conservative, which would prevent us from participating in the growth of remarkable companies.

Alphabet

“Our mission is to organize the world’s information and make it universally accessible and useful. We believe that the most effective, and ultimately the most profitable, way to accomplish our mission is to put the needs of our users first.” – Alphabet’s S-1 form

“Our value proposition to marketers of all sizes is simple — Google can help you show the right ads to the right people at the right moment.” – Sundar Pichai, Google’s CEO

One of our first investments abroad after the creation of the BDR3 market in 2012 was Google (currently a subsidiary of Alphabet). The shares appreciated quickly and we exited the investment at the end of 2013. We watched from the sidelines for around two and a half years, in which the company continued to grow rapidly. In mid-2016, seeing that the shares had not accompanied the colossal evolution of the business, we began a new investment, which we increased at the beginning of 2017. We currently hold a mid-sized position.

Advertising in the Internet age

Approximately 90% of Google’s revenue comes from advertising. The company is a pioneer in a secular trend: digital ads in which consumers’ attitudes can be measured.

With the mass adoption of the Internet since the 90s, the advertising world has gone through its own revolution. Until then, advertising was essentially an exercise of creativity. Professionals came up with high-impact concepts to promote a product, created an ad and distributed it repeatedly on the radio, newspapers and TV. Communication channels fought over who would reach the greatest number of people, who received exactly the same message, regardless of their particular interests. The campaign’s impacts were measured indirectly and imprecisely, usually based on consumer opinion surveys.

On the Internet, after a successful period for portals such as AOL and Yahoo, it became clear that the first model to truly win would be Google’s. In 2000, the company created AdWords, a system in which advertisers pay to show small ads to users of its search service. The factors that determine where and when an ad appears are i) the relevance of the ad to the user’s search, ii) the amount the advertiser is willing to pay (in an auction system), iii) the quality of the ad and iv) the quality of the page to which the ad directs the user.

The first point – the relevance to the search - in itself already makes the AdWords system completely different from traditional media. The ad only appears when the user expresses explicit interest in a particular subject. Another fundamental difference is that the advertiser only pays when the ad is clicked, which reinforces the connection between the advertiser’s investment and the user’s behavior. With the evolution of systems that track users’ online attitudes, it became possible to monitor them until the time of purchase.

As a result, advertisers have definitive proof that their investment has paid off.

This basic concept is at the heart of the money-making machine Google has turned into. By delivering the right ad to the right person at the right time, every dollar spent on AdWords produces easily measurable results. The success of AdWords, coupled with Google’s leadership in usability and technology, solidified the search engine’s dominance, outstripping rivals like AltaVista to become the biggest gateway to the Internet for billions of people.

With the ease of assessing user attitudes, advertisers have increasingly adopted ROI measures to determine the size of their advertising budgets. As returns were - and still are - high, Google has captured an explosion in online ad spending. The result can be seen in the graph below:

IP Capital Partners

Over time, creative talent has given room to statistics in advertising agencies. Campaigns are designed in an increasingly scientific manner, with thousands of variations evaluated iteratively.

Large advertising conglomerates such as WPP have updated their business model, giving emphasis to digital agencies, some of which are solely dedicated to the search service.

In the last 17 years, both AdWords and Google Search have evolved a lot, but the core concept has remained the same. In this period, Google has absorbed an increasing share of advertising revenues in the world, especially superseding print media. The graph below, designed by venture capital firm Andreessen Horowitz, clearly shows what happened.

IP Capital Partners

Believing in Google’s revenue growth means, to a large extent, a bet on the continuity of this share gain. There are essentially two elements required to make this possible:

  • The ability to attract users with interesting and useful services.
  • The ability to offer productive tools to advertisers – connecting them to the right users at the right times – in order to capture more of their advertising budgets.

We will analyze these two points below.

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