Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. There's usually no shortage of excitement around the latest Internet startup, but how do you know which firms are here to last and which firms will be more of a flash in the pan? I'm here with Matt Coffina--he's editor of Morningstar StockInvestor newsletter--to discuss how he thinks about investing in Internet companies. Matt, thanks for joining me.
Matt Coffina: Thanks for having me, Jeremy.
Glaser: Let's first talk about how Internet companies build economic moats--build sustainable competitive advantages. What do you think are the biggest factors that can keep an Internet company at the top of the game?
Coffina: Within Morningstar's economic-moat framework, there are really three of the five sources of moat that are at play with Internet companies. The most common is the network effect. This occurs when a service becomes more valuable to both new and existing users as more people use the service. You could think of, for example, eBay (EBAY). The more sellers there are on eBay, the easier it is to find things you want to buy. The more buyers there are, the easier it is to sell things. So, more buyers attract sellers and vice versa.
The second source of moat would be intangible assets. I think branding and consumer habits are actually quite important on the Internet. Originally, people gravitated to Google (GOOGL), for example, because I think the search results loaded faster and they gave higher-quality search results. But nowadays, I think most people just go to Google out of habit. I doubt many people are switching back and forth between Bing and Google on a regular basis to decide who has the best-quality search results at any given moment.
So, that branding really becomes an important factor. And in a lot of ways, a company like Google is almost more of a consumer-products company, at least as far as its source of competitive advantage, than it is a technology company.
And lastly, switching costs: These are relatively rarer on the Internet. But I think switching costs do exist. For example, you can think of building your professional network on LinkedIn (LNKD) or uploading years' worth of photos on Facebook (FB). In switching to a competing social network, you would lose a lot of that content and those connections, which makes people, I think, very hesitant to switch.
Glaser: Other than those three factors, what else drives competitive advantages in this space?
Coffina: So, beyond those official moat sources, I'd say there are five other factors I would look to on the Internet, in terms of drivers of competitive advantage. One is participating in China. The Chinese government really restricts access to foreign websites or to foreign Internet companies to the domestic population. It's called the Great Firewall of China. And this insulates the domestic companies from global competition in a way that few other countries experience.
So, Baidu (BIDU) is one of our largest positions in the Hare portfolio. But Alibaba (BABA) would also qualify or Tencent (00700) as companies that we think have relatively strong competitive positions that are boosted, at least in part, by protection from the Chinese government. Another thing I would look for is free services; usually price is one of the most potent sources of competition. If a competitor can come in and undercut you on price, they can often steal your customers.
But with the Internet, a lot of these services are free. It doesn't cost anything to search on Google; it doesn't cost anything to sign up on Facebook--which takes away price as a driver of competition. Also, I would add user-generated content. So, first of all, user-generated content is often free or close to free. More importantly, it's always relevant, it's timely, it's constantly changing, it's coming from all sources. And the kinds of online businesses that have suffered the most over the last 10 years have been those that have tried to generate their own content, especially the Internet portals like Yahoo (YHOO) and AOL (AOL). User-generated content is usually a much more sustainable business model.
Add in transitioning to mobile. A lot of people are accessing the Internet through mobile devices, first and foremost. Especially in developing markets, they might only access the Internet through their mobile phones. For the most part, established Internet companies have managed this transition pretty well to mobile. So, for example, Google is also the dominant mobile search engine. Facebook has a very strong position in mobile advertising, arguably stronger than on desktops.
And then lastly would be adjacent businesses. And Google, again, is the best example here, where they've combined their ownership of Android to drive search traffic on mobile devices and really lock up that market share. So, pretty much everyone else wants to be like Google in this respect, tying consumers into an ecosystem with multiple products. They keep them using all of those products; they keep them tied into that ecosystem.
Glaser: You talked about Baidu and Google and a few other names there. But who do you think is really the best positioned in terms of competitive advantage on the Internet right now?
Coffina: So, I'd say there are four areas that should be of interest to investors. I'm leaving aside enterprise software that's delivered through the Internet--software-as-a-service model. That's really more on the regular technology-software side. But in terms of just pure Internet businesses, I'd say, first, search engines. The big names here are Google and then Baidu in China.
The second category would be social networks--also, very strong advertising business models. For the most part, I would focus more on the wide-moat names, Facebook and LinkedIn. Those are the companies that we think really have staying power through their very broad networks and how deeply entrenched they've become in our daily lives.
The third group would be e-commerce. The two main wide-moat names in the U.S. would be Amazon and eBay--also, Alibaba in China. That's an area where we think that e-commerce is going to continue to steadily gain market share from traditional retail over time. A few of those businesses through the network effect and intangibles have become strong businesses. And lastly, wide moats are less common, but narrow moats are somewhat prevalent and [there are] even expanding moats, I would say, in online travel booking. So, the companies to pay attention to here are the market leader Priceline (PCLN), but also Expedia (EXPE), TripAdvisor (TRIP), and Ctrip (CTRP) in China. Those, we think, are also benefiting from a secular shift in travel booking toward online travel booking, which is a trend that still has a fairly long runway for growth.
Glaser: Are any of these cheap right now?
Coffina: Yes. There definitely are some names that are on my radar and that our analysts like. I just recently added to the Hare's position in Google. This is a stock that has very rarely traded below our fair value estimate in the past couple of years--and even now, it's trading right around fair value. But I think Google has one of the widest moats in technology, especially thanks to Android and the lock that that has on mobile operating systems--well more than 80% of market share--and then tying that in with search and maps and various other Google products. I think Google just has a very wide moat, and this is a wonderful business at a fair price.
On the e-commerce side, our analysts like Amazon and eBay. Both are trading at pretty decent discounts to fair value. And then on the travel-booking side, Priceline is trading at a pretty steep discount to fair value. Again, only a narrow moat, but we think a positive moat trend. We think the competitive position is strengthening over time. And some of the other travel-booking names like Expedia and TripAdvisor are also trading at discounts to fair value, although they're not quite as steep as Priceline.
[There aren't so many] opportunities on the social-network side, where we think that those stocks are pretty fully valued now as investors have maybe become a little bit too optimistic about their growth prospects.
Glaser: Matt, thanks for joining me today.
Coffina: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
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