dotDigital and Alphabet (Google) Compared

The Investment Perspective – October 2020

Peter Flannery CFP AFA

 

 

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business” 

Peter Flannery

Let’s compare a small cap with a large growth business

I thought it might be useful to compare a small cap (a business with a market capitalisation of less than US$1 billion) and a large cap (a business with a market capitalisation greater than US$10 billion). 

Which of the two is the best investment?

In general terms, small caps are more vulnerable compared to larger businesses because they lack the scale, market dominance, competitive advantage and therefore the resilience when things get tough. 

Changing market conditions or company specific issues that suddenly erupt can be quite damaging and even dangerous for small caps, particularly those with high debt. 

Larger businesses are generally more resilient because they have greater resources and the scale to work their way through the difficult issue in order to get back on track.  That said, large businesses can still fail. 

Almost always, failure is caused by mismanagement which leads to an increased use of debt as the business attempts to navigate its way through cashflow issues. 

Usually businesses are given enough leeway by lenders to work their way through challenging events.   Occasionally lenders change their minds, become tired of the risk or indeed decide to take over the business themselves and demand repayment of the debt facility, which of course the company, large or small, in some situations is unable to repay.

Anyway, smaller businesses with minimal debt and a sound business model / developing competitive advantage, whilst not having the scale and resilience of a larger business, nonetheless has much greater potential for growth than a large cap.  Larger business, have already grown significantly from when they were small caps (making investors wealthy along the way). Remember though, we invest in the future (not the past).

 

Warren Buffett’s success and small caps

If we look closely at Warren Buffett’s success, he has achieved significantly greater success than almost every other investor. 

Peter Lynch is a famous investor out of the US, whose net worth is circa US$380 million.  Warren Buffett, by comparison, has a net worth of approximately US$80 billion. 

The reason I raise these two investors is because they both have invested at some point in their careers in small caps, which is what helped them to achieve significant profits over time.  Neither made money overnight.  Both accumulated real wealth over many years and small caps and mid caps were a critical factor in their early success. 

The point here is that small caps can offer the better opportunity for growth when compared to large caps.  Also, it takes time.

 

dotDigital and Alphabet

dotDigital (a small cap) and Alphabet (a large cap) both operate in the tech space. 

In general terms, those operating in this area may have lower costs and as a result, larger profit margins. 

This is appealing from an investor’s point of view because a fat profit margin means that they use capital more effectively.  This can indicate a superior business model and potentially sound management as well.  Longer term it can mean that we investors achieve a better ROI and make much more money.

At the risk of stating the obvious, tech companies will not necessarily be highly profitable just because they operate in that space.  It requires savvy management plus strong economics.  At the very least, a small competitive advantage in a strong niche that can see the businesses overall suite of economics continue to strengthen as the business grows. 

This is a different business when we compare it to any other business that fails to develop a competitive advantage and expand the range of business economics that support the long term growth in the business. 

dotDigital, in simple terms, has developed an e-mail database system that enables businesses (their clients) to communicate more effectively with their existing customers and potential new customers. 

The way it goes about this has proven to be cost effective and efficient.

They have created their own niche in amongst a number of competitors in the same space by being able to offer greater efficiency at a lower cost, along with ease of use. 

Alphabet, on the other hand is a much larger business.  It operates on a global scale and has already grown significantly over the last 15 years or so.  Alphabet enjoys one of the most powerful competitive advantages that exists anywhere. 

They control about 90% of search engine activity around the world.  This is important because it means, within reason they can effectively charge what they want and this boosts bottom line profit, making for fat profit margins. 

They continue to grow as they progressively expand their competitive advantage and have also, over many years developed an eco-system. 

Alphabet’s eco-system consists of the search engine, as well as the well-known YouTube, Gmail and the many other offerings that have been developed over many years. 

Eco-systems are a powerful economic for any business because it means that their customers will buy more than one product and they are therefore more profitable when compared to other businesses that only sell one product.  Further, the more products  / services a customer buys, the more ‘sticky’ they become.

dotDigital has created a competitive advantage in its niche, whereas Alphabet, by comparison, has developed its niche into a global competitive advantage. 

Alphabet have become large enough that they have been able to remove competition by way of better pricing or simply buying them out. 

dotDigital, on the other hand, is not so large that it can beat other competition on pricing because of its scale but actually does so anyway because it offers a more efficient system and is therefore more competitive. 

dotDigital does not have the global scale to out muscle the competition.  It continues to expand and grow because of its competitive advantage. 

Both Alphabet and dotDigital have customers that are sticky.

For example, YouTube is not the only video system in the world but is the most well-known and by some measures, the most used.  By various measures, there is a significant amount of searching now done across YouTube system. 

There is also information and documentaries available for those that are tired of mainstream TV.  The vast scale of video footage is massive and unmatched elsewhere.

Brand Strength is another key business economic.  Google enjoys probably one of the strongest brands in the world. 

We know this because when we talk about searching the internet, we talk about ‘Googling it’ rather than ‘search engine-ing it’. 

dotDigital by comparison is possibly well-known in its niche but outside of that is unknown.  Therefore, dotDigital’s brand strength is relatively low when compared to Google.  Google has become a household name, whereas dotDigital is not. 

Because dotDigital is a smaller business, it is in theory more risky when compared to Alphabet, which is massive by comparison. 

Alphabet, however, has become so large and dominant that the US Justice Department is now preparing an anti-trust case against Alphabet, which you will hear more about, possibly later this year or in 2021. 

dotDigital, by comparison, is a relative unknown and anti-trust action or anti-competitive action against dotDigital is highly unlikely in the foreseeable future. 

 

Which is the better investment?

Obviously, it is difficult to predict the future; however, in theory, dotDigital could grow at a faster pace when compared to Alphabet over the next 10 to 15 years. 

That is because dotDigital is much smaller and has much more head room to grow when compared to Alphabet, which is already a large business by any measure. 

This does not mean that Alphabet will not grow.  The underlying business of Alphabet is powerful, with plenty of muscle to continue to engineer more growth in the future.  Larger companies though struggle to grow at a fast pace when compared to smaller companies like dotDigital but nonetheless, over a period of time can still offer investors worthy growth. 

 

Investing Suitability

Alphabet is a business that most people could invest in without too much concern. 

It is a growing business and has global scale, along with strong economics which makes it a secure investment. 

dotDigital however, as a small cap is more suitable for advanced investors.  That is because in general terms, smaller businesses can demonstrate much greater volatility with regards to not only the trading price but also sales and profits. 

Whereas the trading for the likes of Alphabet in extreme conditions could swing by as much as 50% or 60% (rare), the trading price of a small company like dotDigital could decline by as much as 80% or 90%. 

I know this sounds massive but at the same time, if the trading price of dotDigital dropped, even by 20%, whilst it would depend the underlying business event at the time, the chances are that this would represent a buying opportunity. 

You can imagine then the buying opportunity if the trading price was to decline by 90%. 

 

Complementary or Targeted Investing?

For those that are perhaps less advanced investors, combining the likes of dotDigital and Alphabet together in a portfolio offers balance with those two businesses representing complimentary investing approaches. 

Alphabet, being a large resilient and growing business with opportunity for future growth and more consistent performance.  dodDigital is a much smaller business, much more volatile and possibly more vulnerable, but offering more likely a much greater opportunity for long-term growth, all things equal.

For investors that are more advanced, they may prefer to weight their investment in favour of the likes of dotDigital

More advanced investors are comfortable with any amount of volatility and indeed understand volatility as distinct from those perhaps less advanced investors, who simply tolerate volatility.  Two different approaches right there.

So, for those preferring greater stability, larger businesses like Alphabet would be favoured investments. 

For other investors that are perhaps more advanced and who may have a better understanding about volatility, not just in the trading price but also sales and profitability, they may prefer to target small caps as they aim to maximise growth longer term. 

 

Alphabet Financial Overview

Size:  Market Cap $1.0 trillion (large cap)

Valuation

  • P/E ratio: (trailing 12 m) 28.94 – somewhat high (but in acceptable growth business range 15 – 35)
  • P/E ratio: (forward 12 m) 33.24 – somewhat high (but in acceptable growth business range 15 – 35)
  • PEG ratio: 1.80 – somewhat high
  • Price to sales: 6.36 – high

Performance

  • Operating Margin: 19% – good but continuing to decline over the last 5 years
  • Net Margin: 20.7% – very good
  • Return on Assets: 13.5% – good
  • Return on Equity: 18.12% – very good

Financial Strength

  • Debt / equity: 0.08% – very strong
  • Interest Cover: 258.7 times, is the average from 2015 to 2019 – very strong

Income Statement: Click here to take a closer look.

Balance Sheet: Click here to take a closer look.

 Recent Results: full 12 months ending December 2019

  • Total revenue increased to US$161.87 billion up from US$136.82 billion in the previous corresponding period (pcp);
  • Earnings (profit) increased to US$34.34 billion up from US$30.74 billion pcp.
  • Free cash flow increased to US$30.97 billion up from US$22.83 billion pcp.
  • Click here to see Annual Report for further details.

dotDigital Financial Overview

Size:  Market Cap £421 million (small cap)

Valuation

  • P/E ratio (trailing 12 m): 33.28 – expensive but tolerable for a growing small business
  • P/E ratio (forward 12m): 35.90 – expensive but tolerable for a growing small business
  • Price to sales: 7.64 – very expensive

Performance

  • Operating Margin: 28.68% – good
  • Net Margin: 21.47% – very good
  • Return on Assets: 19.60% – good
  • Return on Equity: 26.60% – very good (especially with no debt)

Financial Strength

  • Debt / equity 0 – they are debt free
  • Interest Cover N/A – no long-term debt

Income Statement: Click here to take a closer look.

Balance Sheet: Click here to take a closer look.

Recent Results: full 12 months ending June 2019

  • Total revenue decreased to GBP42.522 million down from GBP43.094 million in the previous corresponding period (pcp);
  • Earnings (profit) decreased to GBP8.525 million down from GBP8.558 million pcp.
  • Free cash flow increased to GBP6.213 million up from GBP5.277 million pcp.
  • Click here to see Annual Report for further details.

 

 

 

“Success in investing doesn’t correlate with IQ … what you need is the temperament to control the urges that get other people into trouble in investing”.

Warren Buffett

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