We live in an Internet age in which the paradigms around software applications are fast evolving as bandwidth expands, where creative destruction has intensified and accelerated with the emergence of new business concepts like social media and e-commerce. The challenge for investors, as Kerr Neilson explains, is to discern fads from long term winners.
Rather like the disruptive technology of the railways in the 1800s, which spawned a succession of stock market booms, we believe the Internet could prove just as potent at exciting similar crowd behaviour. Think about the power that has now been placed in the hands of the consumer. The smart phone has all the computational power of a super computer of earlier years, but what is critical is that it is at one’s fingertips virtually whatever one’s location.
If you cast your mind back to the turn of this century, there was huge excitement about the power unleashed by browser technology and a resultant commercial war between Netscape and the dominant software provider of the time, Microsoft, with its alternative of Internet Explorer. There was a concomitant land grab for domain names as well as a proliferation of portals (e.g. Yahoo!) and mass adoption of e-mail and instant messaging. The significance of domain names was soon diminished by the indexing of the World Wide Web, the science of which was enhanced by Google search. As bandwidth has expanded, the paradigms around software development and databases have constantly evolved to facilitate the explosion of web traffic. In addition, the way in which people use technology has changed with even the browser now taking on some of the functions of an operating system. A repeated pattern of techno morphing is evident.
The great distinction of this Internet age has been the emergence of new business concepts where the commercialisation of the product or application is often discovered en route with entrepreneurs taking a build-them-and-they-will-come approach. What has not changed, but intensified and accelerated, is the degree of creative destruction. MySpace was soon superseded by Facebook which itself was an Internet iteration of a former paper application at Harvard University.
Before you lose interest in this journey, think about the power that has now been placed in the hands of the consumer. The smart phone has all the computational power of a super computer of earlier years, but what is critical is that it is at one’s fingertips virtually whatever one’s location. Importantly, each phone is uniquely identifiable on the Internet, tantamount to a mobile INTERNET ADDRESS. (In the first year of its introduction, the iPhone sold 14 million of these Internet enabled devices. With the arrival of others, the price has dropped dramatically and it is estimated that at least 1.6 billion people will be thus connected at the end of this year.) It is the power of this device that re-invigorated the creative zeal of developers who are often in the unusual position of needing very little money to make their start.
Being always-on (constantly connected to the Internet) has completely changed the commercial proposition of the Internet. Apart from untethering one from the desktop, the reality of being able to pin point the physical locational of a user allows commerce to change from passive acceptance to active pursuit; one can now actively hunt-down business opportunities. An example of this is PayPal’s new Beacon which allows a retailer to recognise a PayPal member as they enter the store (or pass by) and to transact with a phone swipe or verbal acknowledgement with no credit card in sight. The incumbent card franchises have themselves been evolving near field communications technology to speed up this process, but in this fast moving commercial battle, the challenger has discovered additional attractions for the retailer that may change what was hitherto regarded as an unassailable position of the card issuers.
Similarly, out of Asia are coming potential challengers to existing social networks (Facebook and Twitter) in the form of mobile messaging apps. At the outset they were simply designed to arbitrage the lower cost of data rates versus the cost of phone messaging. By interrogating users’ contacts list, these services very quickly became viral. They have also evolved into commercial platforms where users are induced to buy stickers, of an animated variety; speech and movement, to attach to messages. Further monetisation occurs from selling skill enhancements to mobile gamers, or Twitter-like hosting of firms surfing the user-engagement wave. Names like LINE, Kakao Talk and WeChat have been signing up users by the millions per month and in the case of LINE, winning large user bases as far afield as Brazil, Chile and Argentina - apart from being dominant in Japan, Taiwan, Thailand and Indonesia.
The problem for investors is to discern fad and fantasy from long-term winners. Just when Google looked to be all conquering, there has been the rise of on-phone applications and so-called verticals that allow regular users to circumvent search and instead to click directly on the app of their chosen site. Sites like Tripadvisor for travellers, Expedia for booking flights, Zillow as the most viewed real estate and rental site in the US, OpenTable for restaurant bookings are really old fashioned portals that have established dominant mind share with large aggregations of users. Like the classified pages of old, they are where one goes for that particular speciality. They have often expanded globally by acquisition or fresh starts to gain access to unprecedented large addressable markets. Once established, these businesses have remarkable scale and are generally extraordinarily profitable with concomitant free cash flows. The stakes are enormous which can induce highly promotional behaviour and careless use of funds at that time when the concept seems to have established a toe hold in this precipitous climb to dominance.
The most favoured monetisation approach has hitherto been the sale of advertising space alongside the offer. Quite recently investors were concerned about the loss of revenue because of the migration to small mobile screens from desktops. Revenues from cost per click (CPC) or cost per thousand impressions (CPM) are lower on mobile devices, but with the advent of tablets and the rise of users’ enthusiasm for transacting on smart phones, this concern has dissipated; Google has even re-priced their offer on a blended basis. In addition, the ability of identifying a user’s physical location has given rise to new applications and therefore new revenue sources.
There is constant experimentation with monetisation. Partnerships have been formed between user-originated content providers like Urbanspoon and booking services like OpenTable to share revenues from traffic originated. Strong positions are held by Apple and Google who offer the payment service element for on-line transactions. These app stores currently take a 30% clip from each transaction, which of course is attracting fresh interest from vendors and payment services like PayPal. Group buying sites like Groupon take an even more aggressive cut, but seemingly manage this because of the intensive nature of signing up a myriad of small local merchants who are prepared to deeply discount their product to attract new customers or to balance their offering seasonally. Subscription is an alternative model and music streaming services like Pandora offers users the choice of a fee or interspersed adverts.
This revolution will be accompanied by great uncertainty, opportunity on a global scale and of course, significant risk, both commercial and substitutional. There are already several on-line areas that are witnessing a convergence of offers with participants each looking to imbed the attractive features developed by adjacent competitors in an attempt to create a lock on the customer. The web is highly disruptive by nature with retailing having felt the first cold blasts of price transparency. This may now be taken to a new level with the UK on-line grocer Ocado having mastered an industrial scale pick-and-deliver model which may threaten the price umbrellas that the consumer brands have for so long prospered under. Delivery services in general have huge implications for logistics and the changing use of property which is too complex to examine properly here.
It is still early days with e-commerce still accounting for only an estimated 7% of retail sales. Even in advertising there is still a large mismatch between time spent on-line and its share of the advertising pie. It has already taken its toll on traditional print media, but the rise of the likes of YouTube has still to be fully felt by traditional TV.
The professions remain the last bastion of the old way, but the great power on the Internet is already encroaching on the institutions of higher learning with experiments of algorithmic marking already being undertaken. Will lecture theatres change in function and become collaborative workplaces for students who have ‘studied’ at home?
We are spending a lot of time trying to track down the more interesting companies that will win in this highly competitive frenzy. Apart from the opportunities on offer, it also allows us to understand the vulnerabilities of the traditional players. To mitigate risk, we have a relatively large range of plays, with large exposures only to those entities which span several elements of the game. The Fund’s exposure to the e-commerce element of this opportunity is around 11%* (Google, eBay, Sina, Naver, Baidu, Youku Tudou, Zillow) while a further 11%* is invested in the ‘pipework’ (Cisco, Ciena, Ericsson, Samsung, Intel and Microsoft).
DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.
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