I believe that online advertising offers significant value compared to traditional advertising because online advertising can be tracked very easily. Internet advertisers can track the click-through rate on their ads and how many of those clicks convert into a sale. This gives instant feedback on the ad’s return on investment. Advertisers can optimize their advertising budget to maximize their profits and split-test different ads and landing pages (the webpage that the ad points to).
A second feature of online advertising is that it can be highly targeted. Companies can advertise based on search phrases such as “where to buy ______”. This can connect merchants of very obscure products with the people looking to buy them. Search advertising is more valuable than other forms of advertising as people use search engines to research their purchases. Based on the keywords in the search, the search engines are able to deliver extremely relevant advertising. Some niches such as legal services for mesothelioma sufferers (an asbestos-related disease) can have advertisers paying a few dollars for a single click. Other forms of online advertising (e.g. Myspace, Facebook) are not able to get such high rates as it is more difficult to target advertising. Facebook advertisers are limited to discriminating based on the user’s stated city/town, age, sex, likes, education, employer, etc. It is unlikely that a mesothelioma lawyer can find clients through Facebook advertising.
The shady side of online marketing: affiliate marketing and SEO
Let’s take a look at web hosting. Customers will often search Google to research different web hosts. The paid (and also unpaid) portion of Google’s search results will list many “independent” review sites. What many customers do not realize is that many of these review sites are not independent at all. An affiliate marketer is behind the site and he/she receives a commission for every sale that they generate. Their “review” site might list 10 different web hosts. The marketer will play around with the rankings to maximize profits. It’s unethical and it works. These marketers run many empirical tests to figure out what works. Other marketers mercilessly copy/steal the best techniques. This is the crazy and shady world of affiliate marketing.
There is also the world of search engine optimization (SEO). Various marketers (some legitimate) will try to game Google’s search listings so that their site shows up first in the organic (non-paid) search results. This would allow them to receive free advertising courtesy of Google. There are ethical and unethical (“blackhat”) methods for ranking highly in Google’s search results. All search engines have to improve their algorithms to counter the methods of blackhat search engine optimization. One blackhat method that no longer works is to get a huge number of links to point to your website. Blackhat marketers counter these efforts by making their linking patterns harder to discriminate from legitimate links (e.g. using unique IP addresses, spreading links out over time, getting/buying links from relevant websites with authority, etc.). There is a battle going on between blackhat marketers and the search engines. Coming up with the technology to counter blackhat SEO is a barrier to entry for new search engines. This battle adds a layer of complexity as you also have to find the right balance between blocking blackhat sites and reducing the number of false positives.
What makes for effective advertising
As far as the fake review site format goes, there are two popular formats. One format lists 10 different services/products and ranks them. Another format is the fake blog. There is special code on the site so that a web user searching from Toronto Canada will stumble on a blog by a blogger also “from” Toronto Canada. (This is all based on the web user’s IP address used to access the affiliate marketer’s site.) The language and tone of the blog will be similar to the target audience’s. There will be comments from “random” strangers that demonstrate social proof, saying how great XYZ product is. The blog post itself will be written in a way to garner credibility. They are never blatantly one-sided as people can see through that. The most important underlying principle is the power of the “unbiased” and “independent” review.
Of course, there is a legitimate way of advertising. Simply putting out a great product or service is wonderful advertising in itself. Customers will post positive comments about the product/service on message boards and their own blogs. These posts can show up in search results. These posts may have links to the merchant’s website, improving the merchant’s ranking in search engine results. And having many satisfied customers will lead to many legitimately unbiased and independent reviews.
Capitalizing on earnings misses
Search engines like Google are constantly trying to figure out how to make its product more useful to its users. For many searches, Google will not show any advertising at all as it feels that users would benefit from not having to read irrelevant ads. Sometimes Google will change the way advertised results are chosen (e.g. how the #1 spot is chosen based on relevance, click-through rate, and price per click) and this can throw advertisers’ ad campaigns into disarray. Because their ROI drops, they will cut back on their advertising spending and this can cause Google’s quarterly results to temporarily drop. This happened once in the past. If Google’s earnings unexpectedly drop in the future, look at the blogs of affiliate marketers and see if they are commenting on whether Google changed their algorithms and threw their ad campaigns into disarray.
Google versus everybody else
Google is the most important online advertiser because (1) its traffic monetizes extremely well and (2) it has almost all of the English-speaking search market.
Other search engines predominantly get their traffic because it is the default search engine in the user’s browser (and he/she was too lazy to change the default or didn’t bother to type in google.com) or because they installed a toolbar where the search engine is the default. Microsoft’s Internet Explorer is a valuable asset as it drives many web users towards Microsoft’s Bing search. However, Bing market share is a small fraction of Internet Explorer’s market share. So the real key to having search market share is to have the best search engine, which is what Google has.
My opinion is that having the largest market share gives a huge profitability advantage. Marketers will spend the most effort on the most important search engine as it has the greatest volume. More fine tuning of ad campaigns leads to a higher ROI on ads which leads to higher advertising spending. Having the most popular search engine also allows for R&D costs to be scaled across more users. These are natural economic forces that work highly in favour of Google. Other search competitors may try to buy search traffic (through being the default search on browser toolbars and sites like Facebook) so that they might benefit from similar economies of scale and hit a critical mass. So far, Microsoft Bing has been fairly unprofitable so their strategy seems to be failing.
However, having dominant market share is not necessarily an economic moat. Technology can change very quickly and a previously unknown company can become the market leader in only a few years (this is what Google did to Yahoo’s directory and Altavista’s search). Capital is not a barrier to entry as there are venture capital firms which will fund new search engines such as Cuil. Unfortunately for Cuil, it did not live up to its hype and died a quick death.
For the Google Display Network and AdMob network, we serve ads based on the content of sites you’ve viewed or the application you’re using on your device and may also use other partner data to target ads. For example, if you visit a gardening site, ads on that site may be related to gardening. In addition, we may serve ads based on your interests. As you browse Google sites or websites that have partnered with us or use and download applications on your device, Google may place cookies or anonymous identifiers (see more on anonymous identifiers below) in your browser or on your device to understand the types of pages visited, content that you viewed or applications on your mobile device. Based on this information and/or anonymized partner data, Google associates your cookies or anonymous identifiers with relevant interest categories and uses these categories to show interest-based ads. For example, if you frequently visit travel websites, Google may show more ads related to travel. Or, if you download a golf application, Google may show you ads related to golf. Google may also show you ads related to the content of sites in your recent browsing history. Google can also use the types of pages that you have visited, content that you have viewed, or applications on your device to infer demographics like your gender and age category. For example, if the sites that you visit and applications you download have a majority of female visitors (based on aggregated survey data on site visitation or application usage), we may associate your cookies and anonymous identifiers with the female demographic category.
In addition to ads based on interest categories, Google allows advertisers (including Google) to show you ads based on your previous interactions online or in applications, such as visits to advertisers’ websites or applications. For example, someone who visited the website or shopping application of an online sporting goods store can later receive ads about special offers from that store.
I believe that many online advertisers have hidden upside in figuring out how to monetize its traffic better. Facebook has this hidden upside to some degree as it figures out how to gather more information on its users. From an investment standpoint, I do not believe that it is easy to predict future growth from more effective ad targeting.
Monetization can also cut the other way. During the Dot-com bubble, many companies were able to make money from selling banner ads since their cost per impression looked very cheap compared to other forms of advertising. Eventually advertisers figured out that they weren’t getting very good value on banner ads and the overpricing of banner ads disappeared. I do not believe that this will happen to banner ads again as marketers can measure their ROI.
Online growth in general
I believe that there are two other factors that will lead to increased online advertising:
- People spending more time on the Internet as it becomes more useful. Some of the new uses of the Internet may be completely unexpected. Would you have predicted that everyday people will spend hours on an Internet website creeping their friend’s pictures and Facebook walls instead of hanging out with them in real life? One of the trends over time has been the decline of newspaper and phone directory stocks (e.g. Idearc/Supermedia and Dex One went bankrupt) as the usage of these products decline. Online advertising will grow slightly as people spend more time on the Internet. Some of this will be at the expense of traditional media and traditional advertising.
- A growth in online shopping. It makes sense to buy software online. Yet some software is still cheaper in bricks and mortar stores than online (e.g. Ufile), presumably because the physical stores negotiated a deal to keep the online pricing artificially higher due to the volume that bricks and mortar stores can generate. I do not see this business model lasting. Over time, more shopping will be done online. Prices will come down as retailers find economies of scale, selection will be wider, and people will become more comfortable/familiar with buying products online. I believe that online advertising will ramp alongside the growth of eCommerce.
The investment challenge
While online shopping and online advertising are very obvious secular bull markets, this does not mean that related stocks will go up.
- Competition risk. Companies can lose their dominant positions in only a few years. The technology sector is littered with corpses. I believe that this tail risk should be reflected in the valuations of these companies.
- How do you model growth? Looking back at history, technology leaders tend to grow very rapidly until they begin to hit a saturation point. e.g. When you have almost the entire market, you cannot grow from gaining market share. I believe that investors will have to make an educated guess about when growth slows down. I believe that eventually almost all software (e.g. video games) and computer parts will be purchased online. Right now we are not at that point as companies like Gamestop (GME) are still alive in their current incarnation.
- “Dot-Bomb 2.0“. I see the recent IPOs of social media and Web 2.0 companies as a mini-repeat of the Dot-Com bubble. Many of these stocks are heavily shorted (e.g. at least one has a 90%+ interest on the borrow) and I tend to agree with short sellers. Many of these companies are ridiculously overpriced much like the original Dot-Com bubble.
- Unintelligent capital allocation. As with any other industry, some companies waste shareholder money on bad or overpriced acquisitions. You could make an argument against many tech companies (including Google) for this.
Right now, my opinion is that many of the valuations out there don’t make sense. Facebook has a good business and they are profitable. But its valuation is way too high. Google has an amazing business but its largest acquisitions are questionable (why would you buy Motorola over Google shares?). However, I believe that the strength of Google’s core business far outweighs their poor capital allocation.
There are second-rate search engines out there such as Yahoo (powered by Bing) and Bing/Microsoft. They may be overpaying for search traffic from toolbars. Bing’s product placements hurt the brand and are probably a waste of money… see this Youtube video and look at the number of dislikes. Bing’s plagiarism of Google’s search results suggests that R&D is poorly managed and that this division has lost its way. The copycat results guarantee that Bing will be a poor imitation of Google at best.
*Disclosure: I do not currently own or short any of these stocks. I have owned Google and Microsoft in the past. (The Microsoft position had nothing to do with how good or awful Bing is.) I am not short (or long) Facebook.