Giuliano

I started researching the next company I'll cover. Decided to go with Zoetis, any opinions on the company?

For some reason, I feel like the past 10-15 articles have been of much higher quality than the ones I used to write, from a conceptual perspective. Having covered many of the fundamentals principles needed to understand the stock market, let us explore a bit more shady territory. And I believe it’s in these kinds of writings where we can keep developing our edge over other investors. Most of them call it a day once they know the basics, but it’s not in the basics where overperformance lies, or at least for what I perceive.

I’ve been exposing myself to a decent amount of financial literature lately and noticed a peculiar overlapping between almost all of them. Authors and investors of all kinds vividly claim how utterly ludicrous it is to think forecasts are worth something.

“It is absurd to think the general public can ever make money out of market forecasts” Graham

The stock market is an astonishingly complex and adaptive system. The number of variables, actors, disciplines, ideas, concepts, etc, in play is infinite. Moreover, given that at the end of the day it’s individual decisions what construct prices, there’s also history and learning embedded into it, making it dynamic and set to change over time.

We’ll go back to the very first article where we defined what a stock actually is:

“A stock, also known as equity, is a security that represents the ownership of a fraction of the issuing corporation” (..) “As it’s inherent nature of being a productive asset, it’s intrinsic value will theoretically be worth the present value of the future cash flows the stock will produce”

So we arrive to this interesting spot where it’s humanly impossible to realize reliable forecasts, but our returns are subject to what will happen in the future. I’ll approach the issue in two separate manners.

In Terry’s shareholder letter I found a crystal clear way to deal with this inconvenience. I had not yet encountered someone putting this into words. Perhaps it’s the ‘obviousness’ of the concept that has allowed it to remain hidden in plain sight.

“The desire of people to rely on forecasting despite its obvious drawbacks is illustrated by an anecdote from the Nobel laureate and retired Stanford University economist Kenneth Arrow. Arrow did a tour of duty as a weather forecaster for the USA Air Force during World War Two. Ordered to evaluate mathematical models for predicting the weather one month ahead, he found that they were worthless. Informed of that, his superior sent back another order: ‘The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes.”

This is fascinating, so accurately aimed to the heart of the problem I could not help myself but to share it here. It’s impossible to know the future, but that does not unable us from trying to prepare for what can come.

Yes, we are back to this. Upon the reads, there’s a common pattern that almost always arises, even if it’s not explicitly stated. It has also been a somewhat recurring topic in this newsletter, but the fact of me going back to it should only highlight the importance I find in the idea.

The future’s uncertainty is no new thing and there’s a spectacular saying which I’m paraphrasing:

“The older the problem, the more antique its solution”

In the 17th century, life insurance started being a thing. Life insurance policies provided a lump sum payment to the beneficiaries of the policyholder upon their death. However, to become long-term sustainable businesses, they had to somewhat price their premiums in a way that they did not offset the income received by policyholders. This invariably led to trying infer the probability people had of dying at all ages, so they could price them in a way that generated profit.

In 1693, Edmond Halley published a paper called “An Estimate of the Degree of Mortality of Mankind”. In it, he utilizes statistical methods to calculate life expectancy based on mortality tables.

The latter basically attempted to provide insights into what was the probability of people dying at a particular age. Upon all of this, Edmond then estimated the premium for annuities in the life insurance business.

For interested (short, interesting, but kind of unintelligible): Paper

In conclusion, to make a profit and become durable companies, life insurance businesses dealt with the uncertainty of the future by applying statistical models. This doesn’t mean one will always make the right call, but it does mean that, as decisions average and weight themselves up, if done under actual positive expected values, investor should tend towards profitable investing.

GChrome is a free browser used for accessing the internet and running web-based applications. Google began working in Chrome as early as 2006 under the open source Chromium web browser project. Its first version was released in 2008, which was built with multiple free software tools from Apple’s WebKit and Mozilla’s Firefox.

Curiously, Google Chrome also acts as the main component of ChromeOS, the operating system developed by Google in 2009. It derives from the open-source project ChromiumOS and utilizes Google Chrome as the principal interface.

Although most of Chrome’s code comes from Chromium, which is open source, Google licensed Chrome as proprietary freeware. At the same time, Google forked (made a copy and built upon it) WebKit’s rendering engine, which Chrome previously utilized, and created the Blink engine, which it utilizes today.

Google Chrome is monetized in a very similar manner as Android. The product itself is free, but it indirectly fuels all of Google’s ecosystem. Its free nature and high quality user experience allows the browser to continuously capture customers and expose them to all of Google’s ecosystem. This makes Google Chrome an invaluable asset to Google.

“Search is an integral part of Google revenue. That's the biggest area. But it is more. When users have been using Chrome, it tends to drive Web usage up, so it's display ads too, not just search ads. And it's a driver of Google Apps. Google Docs offline works in Chrome. Both Chrome and Android bring together a lot of our services, so they have a huge business value for us.” Sundar Pichai, 2012 interview

The distinctions between Chrome and other browsers are kind of limited. Besides the typical features such as dark mode, what sets apart Google Chrome from other players is:

The second point stated is very relevant for user experience. Google Chrome search bar (which is based on GSearch) is much more resourceful than competitors, mainly due to how fed Google’s algorithm is. It allows things like math calculations, instant translation and it has a very smooth integration with products like Google Sheets and Google Docs.

Chrome’s usage had continuously trended upwards, and rapidly, ever since inception until 2021. On that year, it peaked at 3.2bn users and declined (according to estimates) by 16% in 2022.

Overall, in the period 2009-2022, Google Chrome has grown its users base at a 38% CAGR, going from 40M users in 2009 to 2.7bn in 2022.

After analyzing the product’s usage (its market share will be later discussed), the second indirect revenue stream can be spotted. Google Chrome saves the company multiple billions each year by capturing that many users, preventing Google from paying browsers and mobile manufacturers extra fees. As we discussed in GSearch’s bullet points, such deals can run up to the tens of billions of dollars. This, added to how much it boosts Google ecosystem, proves why Chrome is an invaluable asset to Alphabet.

Operating systems are the mind of electronic devices such as computers, mobiles, tablets, smartwatches. Their task is to coordinate the software and hardware components to act in accordance to what the user is asking for. Furthermore, OS do not have to be re-developed in order to create new apps, the latter can be built leveraging OS infrastructure.

Android is an open-source operating system for mobile devices and a corresponding open-source project led by Google.

It is full of customizable source code that can be ported to nearly any device and public documentation. This means developers can utilize Android’s infrastructure, but changing some parts at will to create custom solutions that better suit their products.

Android Enterprise is a Google-led initiative to enable the use of Android devices and apps in the workplace. The program offers APIs and other tools for developers to integrate support for Android into their enterprise mobility management (EMM) solutions. Android Enterprise offers solutions for financial services, security, enrollment, management and employees.

This is one of Google’s historically monumental acquisitions. The company acquired Android in 2005 for 50 million dollars, but it was still in stealth mode. The first official version was released on September 2008. Google bought it under the following premise:

“Today’s announcement is more ambitious than any single ‘Google Phone’ that the press has been speculating about over the past few weeks. Our vision is that the powerful platform we’re unveiling will power thousands of different phone models.” Eric Shmidt, 2008

Again, Android is open-source and it’s free for anyone to install and use it. The business generates revenue through three different avenues. The first of them allows us to introduce another product Google has, Google Play Store.

Google Play Store is the digital marketplace where all sort of apps can be published. The store was actually launched in March of 2012 with the intention of merging the previously known ‘Android Market’ and Google Services, like Google Music, Books.

As of May 2022, there were over 3.3million apps on Android App Stores. Its open-source approach allows developers to publish their apps in stores apart from Google’s, which explains the following image.

Being the intermediary between developers and users allows Google to cut its piece of every app purchased and every purchase made in-app, as it happens with every marketplace. It is estimated that the company’s take rate is 30% for the first-year subscription and 15% for all subsequent years.

To evaluate Google Play Store’s performance, I selected the number of applications downloaded each year and how many apps were there available as well. Both of them should be helpful to observe how has supply and demand trended over time.

Since the official release of Google Play Store in 2012, the ecosystem went through a 5yr period of rapid growth, followed by a sequential slowdown.

Android makes Google money from advertisements via two different sources.

This turns Android into an indirect advertising source of revenue. By having these set of apps as default, it ‘makes’ Android users utilize them, boosting Google apps usage and, with it, the advertisement revenue they generate.

In parallel to ads revenue, Google Play Pass was launched on September 2019. It is a subscription service offered by Google to Android users. By paying a monthly fee of $5 or $30 annually, Google offers customers hundreds of apps of all kinds, free of ads and in-app purchases. Included in Google Play Pass, there are games, productivity and creativity apps, educational, lifestyle and utility apps. The apps offered vary depending on the user’s location and the catalogue is constantly monitored and renovated. As of today (1Q 2023), Google has not yet disclosed how many subscribers Google Play Pass has.

After analyzing all integrated features, products and services to Android OS and how does it earn money, a good proxy for its performance may be how has the ecosystem evolved. In line with Google Play, I’ll consider metrics such as users and developers. For the following and almost all charts, keep in mind one thing. Google doesn’t really disclose anything on a yearly basis, so most numbers are rough estimates. Regarding this particular one, it begins in 2011 because numbers were very tiny before, with 9M users and one thousand developers.

Since 2011, users have increased at a 38% CAGR, from 90M to around 3.3bn. On the other hand, Android app developers have increased at a 45% CAGR, going from 50 thousand in 2011 to around 3 million in 2022.

The last chart I’ll be sharing in this Android’s section is each vendor’s market share. Although this is not of extreme relevance, through these statistics, some insights could be potentially inferable. For instance, how much, relatively, does Google pay each vendor for the search engine to be default and how much dependence does Android have in each vendor.

Brief Overview

YouTube is an online video-sharing platform with a mission to "give everyone a voice and show them the world.

History

YouTube was co-founded by three PayPal Mafia members in 2005.

The platform released its beta on May and attracted 30k daily viewers. The official release was in December, with 2M views per day.

Google acquired it on Jan 2006 for 1.65bn and views jumped to 25M.

Business Model

Upon videos as the major foundation, the company has been multiple offerings.

It allows users to upload, view, share, rate, and comment on videos. Furthermore, people can create their own channel to which users can subscribe to.

Distribution Methods

Channel owners or 'Creators' can opt for different ways to upload content:

In parallel, YouTube leveraged the infrastructure they have and launched YouTube TV in 2017.

This is a cloud-based paid over-the-top (OTT) internet television services and has over 70 television networks on it.

Demand for the platform

YouTube has managed to grow its user base at a 24% CAGR since 2010, going from 200M in 2010 to over 2.5bn in 2022.

According to eMarketer, YT was the second social platform in which people spent daily time on, with 45.6mins.

Supply

Very rough estimates, but hours uploaded to the platform per minute has grown to around 500 per minute, peak at which it seems to have stalled.

YouTube channels have also grown rapidly, being around 51M in 2022, up from 35-40M in 2021

How does it make money?

YouTube generates revenue through two major sources, which I'll detail below:

Advertising

YouTube offers brand and performance advertising by embedding advertisements on the land page, allowing sponsored videos and advertising on actual videos.

Subscriptions

Often referred to as ‘UK’s Warren Buffett’, Terry Smith is the founder and manager of Fundsmith. The latter is a fund registered in the United Kingdom and continuously ranks among the most popular equity fund lists. Terry founded Fundsmith in 2010 and has kept an excellent track record, well above averages, having managed to compound returns at a 15.6% rate for the past 13 years. The fund’s assets under management currently stand at 22.8bn pounds.

A few weeks ago, I started and finished reading all of Terry Smith’s shareholder letters (they are not that many). As with Buffett, I’ll try to go over his investment philosophy, or at least the one I interpret from his writings.

Terry has a very similar approach to investing as Warren, in a broad sense. In his letters, he defines his style very simply:

“We continue to apply a simple three step investment strategy:

This quote depicts where his focus is in the many verticals of the decision-making spectrum.

Terry’s definition of what a good company is, lays on the competitive positioning it has, the returns on capital it generates and if it has source of future growth. Companies with a strong moat and immersed in an industry with attractive fundamentals are contendents to achieve these high returns on capital over the long term. The business fundamentals allow them to exist and be achievable, and the barriers the company’s profits are protected with keeps competitors away from taking their share.

“In the Fund we seek to own companies which produce high cash returns on capital and distribute part of those returns as dividends and re-invest the remainder at similar rates of return” Jan, 2011

In his 2020 shareholder letter, Terry goes over an insight derived from Charlie Munger that sheds some more light into the matter.

“‘Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return— even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result’ (emphasis added)”

Another common pattern that arises in many of his letters is how often he states the average foundation date of the portfolio’s holdings. The Lindy effect stands for a very curious idea, it basically proposes that the longer the period something has survived, the longer its remaining life expectancy. Perhaps what Terry intends to transmit by writing the average foundation date of the companies is the true resilience embedded in their business models. There are over 10 quotes like these throughout the 13 years of writings:

“The average company in our portfolio was founded in 1883” Jan, 2011.

One last thing I’d like to emphasize in this step is the attention Terry pays to a company’s management. Capital allocation skills are crucial for a company’s success. This group of people are the ones in charge of deciding what to do with the money generated by the company shareholders own. Given the broad range of possibilities one can do with cash, it’s in management’s capital allocation skills where our potential for compounding gains relies.

“Some 80% of the gains in the SPX over the 20th Century came not from changes in valuation, but from the companies’ earnings and reinvestment of retained capital” Jan, 2020

To finalize, a clear table on how he illustrates the fact of the fund owning good businesses:

The price we pay for an asset is a 100% correlated with the investment returns we’ll get. Buying a great company can turn out being not a great investment if we pay far too much for it.

“We regard the greatest risk for our investors after the obvious potential for us to buy the wrong shares or pay too much for shares in the right companies, as being reinvestment risk” Jan, 2012

“deploy most of my time and effort on things I can control. Two of those are whether we own good companies and what valuation we pay to own their shares” Jan, 2017

“We are not simply hoping to on-sell the investment at a higher price” Jan, 2011

Only over the long run can an investor truly benefit from a company’s superior fundamentals, hence the first reason for which the third leg of Terry’s strategy is “Do nothing”. On this front, I can introduce another component that makes up a huge part of his overall strategy, not trying to time the market nor operate based on forecasts, acknowledging the futility of doing so.

Keep in mind this is only one quote. Portfolio turnover oscillated between -3 and 9% approximately, most of years being between 2-5%. (Ranges are my own estimates as far as memory goes)

I published yesterday a complete (at the reasonable point) breakdown of all Google business units. Hope you enjoy it!

As usual, we have to first ask ourselves if it’s actually useful to rebalance a portfolio. I always try to be as impartial as possible when thinking of these topics, I intend to state both logical sides.

There are a few things in favor of rebalancing. Mainly, periodically (monthly, quarterly, daily, yearly) rebalancing a portfolio ensures that the owner is in complete comfort and calm (allegedly). Secondly, it removes emotions from the process. Rebalancing goes in line with the investment plan designed (in a rational state) and setting it in advance makes your future self avoid acting based on momentary irrationality.

To the contrary, rebalancing also counts with some disadvantages I notice. Winners will continuously tend to exceed the threshold established and rebalancing would imply us to sell that excess and add it to companies that have gone below their desired weight. Consequently, in many scenarios, it can turn to a potential “trimming winners and adding to losers” strategy. Rebalancing assumes the weights established are ideal, because one would implicitly be reallocating capital based on these arbitrarily selected weights, leaving no room for mistakes in the weight selection process.

It's important to keep in mind most (I think) professional portfolio managers include in their portfolio several asset classes (bonds, stocks, currencies, etc). They also, in most occasions, build clients’ portfolios by assigning weights to each particular asset class and get exposure to it through diversified vehicles. The weight assignment is done with a particular ‘risk objective’ (standard deviation objective). If the investment policy agreed by portfolio manager and client establishes this risk objective, it’s appropriate for PMs to rebalance portfolios.

Since most portfolio managers follow an asset (in the actual sense) allocation approach, it seems correct for them to rebalance. They do not have intrinsic or fundamental single position risk. However, if an investor has a portfolio fully built with equities, he/she does have a unique position risk (not under volatility parameters). This risk literally depends on the fundamentals of the different and unique companies. By rebalancing, we would be de-estimating such intrinsic characteristics.

Two quotes I found on this business unit:

“2021 was also a year for Platform milestones, Google Workspace grew to more than 3 billion users globally, we reached more than 5,300 public apps in the Google Workspace Marketplace, and we crossed over 4.8 billion apps

installed (up from 1 billion in 2020)!”

“Google Workspace is now used by more than eight million businesses and organizations worldwide” Q3 2022

Management also mentioned in every single quarter for the past 4 quarters that Google Workspace has been seeing a lot of traction, increasing both users and average revenue per seat.

Some short keynotes on the most wisdom-loaded letters, 1982-1986.

1982

1983

1984

1985

1986