Remember the network effect when evaluating tech stocks

Nick Griffin is a founding partner with Munro Partners

According to Nick Griffin the network effect is underestimated by most investors when looking at stocks like Amazon, Facebook and Google. It goes far beyond the physical network effect developed by retail and food chains.

Nick Griffin tells James Brandis that the tech giants won't be knocked off their perches any time soon and in many cases, like Paypal, there will be only one.

Nick you only set up shop last year. What was behind the decision to set up Munro Partners?

We as a team had worked for 10 years in international equities based out of Melbourne with our previous employer. Over that time we'd run an international equity fund but that fund was some international and some Australia if that makes sense and some Australia and some Asia. We really wanted to produce a pure international only product that was concentrated so 30 to 50 positions that was growth. Basically no Australian stocks.

From that point of view we felt there was a hole in the market for that product. We felt that we were good at that. We had a good 10 year track record of investing in growth stocks and identifying them early. Once we decided to do that we decided to model it on some of the better, more successful, independent funds management businesses in Edinburgh, Scotland. They run really long enduring partnership structures that basically run products like this that have been successful for many years with American investors and we hoped to achieve the same with Australian investors.

Are they doing something different there with the partnerships than we're doing here. What's the benefit?

Look I think the interesting thing about Edinburgh is it has 100 year funds management industry experience. Edinburgh runs more money than Australia quite frankly. It runs more than a trillion dollars out of a city that's not much bigger than Geelong. They do that because they have great culture around how they look very long term. They have great culture in the way they invest and they have great culture in the partnership structure. I suppose the beauty of the partnership structure is we wanted to be 100% independent.

We wanted everybody who works at the firm to have an interest in the firm. But ultimately if they leave the firm then they give their interest back. It works no different to a law partnership or an accounting partnership. We felt that's the best way to align the staff in the firm to get the best results and ultimately it's the best way for the firm to endure over a period of time. I continue to attract talent and regenerate talent because ultimately we are in the talent business in funds management.

Are the partners all fully invested in your global growth fund?

Yes. We have a policy that the founding partners in particular have to be invested in the fund and have no investments elsewhere. All of my personal investment money in the equity market is inside this fund. I have property investments but I don't have any outside equity investments apart from that and that's the same for all the partners.

Tell us a little bit about the fund. It's an absolute return fund so what sort of techniques are you using for that? Is it more than just sort selling and options?

Yes, that's a good question. The big differences I suppose with what we're doing here in Australia versus what some of the products we look at in Edinburgh do, is this is an absolute return fund specifically designed for retail investors. It's not a long only fund designed for institutional investors. What we mean by that is ultimately we're targeting a return for the year that's roughly 10% prime. We have a mandate that gives us a lot of flexibility in achieving that so we can be long investments. We can also have some short investments. We can hold cash and we can hedge the currency for instance, which is also another capital protection tool, and we can use some insurance, some options to protect the downside against unforeseen events.

All of that means that we are a better risk adjusted chance of getting our 10% target than a standard long only fund would be that has to go up and down with the market over time and obviously would be unhedge the currency, so affected by currency moves. Ultimately the reason why we do it that way is because we think that's what our clients want. That's what I want with my money. I just told you that all my money's in the market. I'm not really in the funds area. I'm not really interested in a relative return. I'm interested in an absolute return and that's what we target.

Tell us about the makeup of the portfolio. It's pretty heavy on tech stocks isn't it?

Yeah, so the other key differentiator for us in the marketplace is that we're growth and we don't think there's actually many people doing international growth investing in Australia at the moment. It's something that some American investors are good at and as I mentioned some of the guys in Edinburgh are good at it. But the key is that we're focusing on growth stocks. We're trying to find companies that win no matter what.

The beauty of equity investing is we think it's a market of stocks, not a stock market. Ultimately there are always going to be stocks that win over time. Great examples over the last 10 years would be things like Google or Facebook but in the past there were other things like GE. Ultimately there are stocks that will win no matter what over a period of time and it's mainly because something structural is occurring or it's mainly because there is a shift in the marketplace.

Our job is to find those stocks and to find them at the right price and invest in them. From that point of view, yes we do end up with a bit of a tech weighting at the moment because there's a lot of change occurring there but it doesn't have to be tech. But at the moment yes, we're 45% tech and that also draws us obviously to the U.S. where they're probably the best innovators in tech so we're more than 50% invested in the United States at the moment.

Alan told us in his overview that you're very keen on Amazon, Facebook, and Google as investments. Amazon and Google, they're both around $900 a share at the moment. Do you think they're the new Berkshire Hathaway?

Obviously completely different. The actual share prices is irrelevant I suppose. They've been through some splits already, these stocks. Berkshire Hathaway hasn't been through a split that I'm aware of. But ultimately Berkshire Hathaway is a fund. It's more the market capitalization that we would look at and if you look at Amazon, it's over $400 billion dollars now and if you look at Google, it's over $500 billion dollars. We can pretty easily get the numbers to get these things above a trillion dollars. It's not a difficult assumption to get them there and potentially beyond, so yes, we are big fans of these stocks. We felt that from when they were as small as $100 or $200 billion dollars. Our thinking on these stocks hasn't changed for a long period of time.

Do you think anybody will come along and disrupt those industries as they've obliviously disrupted and taken over?

I'm not saying that we don't think that would happen but right now we can't see it and we have a very hard time seeing it. I think the important thing that a lot of Australian investors in particular don't understand, but the Americans get this and they've got it for a long time is the digital businesses benefit from network effects. Physical businesses don't benefit as much if that makes sense. There is a distinct difference between a digital business and a physical business. The best example here is Google Search.

When Google Search first started it's a digital business so it's essentially an aggregator of directories so it's the yellow pages for the world if that makes sense. That's what Google Search is. You pay to get your products up there and you search for them. It's the yellow pages, not just for Melbourne or Sydney or Brisbane, it's the yellow pages for the world. Now what's interesting about that is when Google first started there was probably 11 search engines as you remember. I'm sure we can name a few. Ask Jeeves, Alta Vista, Yahoo. But over the time what happens is people generate towards one.

As that one gets ahead of the pack everything has to be on Google because everyone's looking at Google so everything has to be on Google so everyone's looking at Google if that makes sense. There's a virtuous effect to the point now where Google is effectively the only search engine in the world. There are two and three but Google's worth five hundred billion dollars as I said and the number two search engine in the world is Yahoo and that was recently sold for just five billion dollars. That's essentially a 99% difference in value between the two search engines in the world. Between number one and number two.

Now you don't see that in any other industry. A physical industry you walk into Coles, if you're not happy with the product you go next door to Woolworth's. You could easily open a search engine right next door to Google but you won't have a business model because the digital effects have created this network effect to create this stickiness that can't be broken. It's very hard for us to see how that gets broken from here.

Is Google's value in its share of the advertising market or is it bigger than that?

That's it. Ultimately by creating this search engine that is now the largest search engine in the world and we can say the same for Facebook, but Google has gone from 2000 having 0% of the advertising market to 2017 having nearly 20% of the global advertising market. From that point of view, you've got one company that ultimately has managed to go from 0 to 20% in the space of 17 years. That's that network effect at play. What that means is that everybody else has essentially lost that 20%. That only occurs as I said in digital businesses.

It's very hard to think of a physical business that could actually get 20% share in something as big as the global advertising market in that amount of time. Interestingly if you look Facebook. Facebook is up to 5% of the global advertising market yet the business was only created in 2005. To see something happen that rapidly, that quickly is a testament to why digital businesses are different to physical businesses. We've believed that for a very long time and that makes it very difficult to disrupt them.

Facebook seems like a minnow when you put it next to Google but it's got such a powerful advertising model as well. Is that about to take off in the same way that Google has in their 20% growth?

Yeah, I think I would just merely put it as Facebook has got two advantages over Google at the moment. One, it's bigger in mobile, which is what most people are looking at more so than desk top. Two, it lends itself better to video advertising rather than directory or display advertising if that makes sense. Obviously Google does do video advertising through YouTube but Facebook's much more relevant in video advertising as is Instagram and others.

From that point of view, the video advertising means you can go for that bigger share, which is the TV share and TV roughly is 40 to 45% of the global advertising market. So you're not going for that print directory share, you're going for that TV share. Which means that Facebook at 5%, yes ultimately we can easily see it getting to 10% of the global advertising market. If you actually look at the growth rates of Facebook and Google today they're both taking roughly the same amount in terms of growth. That means Facebook's growing twice as fast.

Wow. Tell us a little about Amazon. We are all thinking about Amazon entering Australia at the moment in the retail sense. They're also taking over the world of cloud computing aren't they?

Yep. On the retail sense it's the same network effect but it's much harder to execute. The network effect on the retail side is you actually have to have physical businesses. You have to have physical distribution businesses. You have to be able to deliver a product within a delivery window, which they do 48 hours guaranteed. That's their goal. They've spent literally hundreds of billions of dollars on 160 distribution centers around the world, which means that their Prime service, which we don't have in Australia, but you do have in other parts of the world allows any product you order on Amazon to be delivered to your door for free within 48 hours.

By doing that they've created a massive share gain in eCommerce that others just cannot compete with. That's the moat in their business because no one else can get the product to you that quickly for free. By doing that they've created a stickiness on the retail side of it and ultimately the driver now has more and more drops as he goes and Amazon is now 40% of all eCommerce orders in the U.S. They've taken an amazing share in the same way but they've done it with physical dominance. While there's a lot more upside of the total adjustable market for Amazon on retail it costs a lot more than say Facebook who really doesn't have to spend much money at all because all the content is created for them by its users.

That's Amazon on the retail side. We're very excited about that. We think it's great business. If I told you about the total addressable market that Facebook has to go in, it's the global advertising market. It's 5%, it'll probably get to 10. They'll probably get beyond that. Google's, as I said, just below 20. It'll probably get to 20 and a bit beyond that. But ultimately though they’re not going to get to more than half of the global advertising market. We see that as very unlikely. Amazon at the moment is just 4% of U.S. retail and less than 2% of global retail.

You can pretty easily put together a scenario where they get to 10 to 20% of all retail in the world. That's a phenomenal opportunity if they continue to execute in the way they're executing today. Again, their competitors just can't compete because they're either mono product companies or they quite literally can't do the distribution. They have to rely on the postal service and the postal service can't hit the delivery window.

Just quickly on the competitors, they've obviously got retailers in Australia quaking in their boots but is there any industries likely to benefit from their arrival in Australia like logistics and couriers?

Yeah, I mean interestingly FedEx and UPS haven't done as well when Amazon came through the U.S. because Amazon did a lot of it itself and they used the U.S. Postal Service. I think Amazon's strength is their ability to put the distribution centers close to where the customer is and so they can just use the postal service. The postal services in Europe have done quite well with packages and some of them are listed. We have invested in them in the past.

Yes, there is a logistics angle there but it's interestingly not as obvious as you'd think because Amazon does a lot of it itself. Outside of that, from a REIT perspective, we've seen some REIT plays in the UK and the U.S. in particular who specialise in big boxes in the outskirts, which is previously the property that no one wanted and now they're the properties that everyone wants. That's just a fundamental way that the retail landscape is changing.

There are some side beneficiaries but the Australian retailers, they have time here. Amazon's not going to get here as quickly as everyone thinks. If they're building a billion dollar distribution center just outside of Melbourne we would have noticed by now quite frankly. I don't think they're coming as quickly as you think they are. And they won't come without their distribution center because that's their delivery benefit. That's their competitive edge. They don't just need to build one, they need to build a couple.

I thought they would just slide into all those empty masters buildings.

Yeah, there was chat around that but again, I mean you're hiring tens of thousands of people here to do this. You really need to understand the scale of how they enter a market. Like I say, we would have noticed by now if that had happened.

What's the Cloud computing angle? They seem to be the fastest and strongest and most reliable.

Yeah, so the Cloud computer angle is again very exciting and it's going back to the Google example so it's a network effect. Ultimately when you have a computer, a lot of people would use Drop Box or they would use One Drive or one of these Cloud storage models where you can access all your files from different computers so you don't save anything onto the hard drive. All Amazon web services is, is that for enterprise and it doesn't just do storage, it does compute. If you wanted to run a big process you wouldn't run it in your office, you would run it in their server base. It's essentially an outsource compute centre. That's what Cloud computing does. It's storage and compute.

From that point of view it's very attractive to customers because you don't need as much stuff on site. You don't need server loads, so if you're doing a certain amount of compute you need a certain server  load to do it but you might only use that one time a year and the other time it's running at only 20% capacity, whereas you can just put it out into Amazon and it comes up and back down the pipe. Cloud computing is about 10% of all computing today and 10% of all enterprise loads and that's growing from zero about five or six years ago and staggeringly Amazon is 80% of the market so of that 10% Amazon is 80% and the other 20% is Microsoft and Google.

Interestingly Cloud computing is clearly going to grow to roughly 50% of the market, probably more and Amazon will hold, if that 80% share goes down to 65% over time or even 50% over time it's a huge growth opportunity for them. They are streaks ahead of the competitors here. Again, this is a cost model. This is a, "Who can provide the lowest cost," and really it is a game because it's a digital business. It's very much a winner takes all market. It's very unlikely there'll be more than a couple of players here.

And surely the other one would be Google.

Yeah, Google has got this wrong to a certain extent. They're coming for a second time now so they tried to get into the market and couldn't quite get there and now they're coming back. Again, it's a scale market as I said, so whoever is the biggest generally wins. Going back to the Google example, the difference between number one and number two is 99%. We see this in everything we look at by the way in any digital business. Whether it's carsales.com or realestate.com in Australia, or whether it's Right Move or Auto Trader in the U.K. or PayPal for instance. There's PayPal and there is no other one. From that point of view this is how network effects work. The same thing will happen in Cloud computing.

I guess your advice to anybody looking at tech stocks is to consider that network effect when evaluating the growth potential of the stock.

Correct. I think the mistake that everyone always makes is they don't think it's sustainable. What we've seen in the 10 years we've been doing this it's always number one gets stronger and number two disappears. You used to always say, rule of thumb, always invest in number one and number two. In tech, in digital businesses in particular you only even look at number one. Number two doesn't really have a business model.

Nick, I'd like to find out a little bit about the personal lives of our fund managers. Can you tell us where your investing career began?

I was a graduate trainee they called me, which sounded like I worked at McDonald's but the Commonwealth Bank of Australia employed me as a graduate trainee in their graduate trainee program on the funds management side in Sydney in 1995. That's because they were basically trying to build up the Commonwealth Bank like it was Banker's Trust and eventually that merged and became Colonial and that's where I started straight out of Melbourne University.

Did you spend some time in Scotland working there?

Yeah, the Scottish history. After I left Colonial - Commonwealth Bank I went to the UK and ended up getting a job as an oil and gas analyst with Deutsche Bank Global Oil and Gas. Covering everything from Exxon down to small service companies in the U.S. and eastern European refiners would you believe it. They were based in Edinburgh because they had a company called Wood Mackenzie and Wood Mackenzie was the world's largest oil and gas consultancy so I spent seven years in Edinburgh and then I came back to Australia and worked for our previous firm doing international equities here for 10 years. Some of the time that 10 years I spent back in Edinburgh as well where my wife is from.

That's lovely. I guess with all these tech and this focus on tech have you found a way to source information about stocks and the market in a tech way that's making your life easier than the old fashioned methods. I guess the newspapers are pretty much dead, but there's a lot of online information and newsletters. Are you finding that you're able to use things like social media or any other technical advantages to get that information?

Yeah, we do. One of the key things and don't think that we are all tech and I promise we do other stuff apart from tech, but we have learned over time, particularly running money out of Australia that you can access conference call transcripts for companies quite easily. You can access webcasts for companies. We use this machine called a TelePrescense, which is essentially a video conference on steroids built by Cisco to talk to companies when they come through Hong Kong and Singapore and also talk to them in the U.S. We can have conference calls direct with management in their own offices in Milwaukee for instance and we've done that quite a lot.

What's also interesting right now is we spend a long time with Google Search trends data and Amazon reviews data so what's interesting is if we're looking at a consumer product for instance - an interesting example is a company like Michael Kors that we've owned in the past - a fashion label. They do handbags for women. Clearly this is not an area of expertise for us. But we were able to get an edge on the stock by looking at the Google Search trend data and how that was growing over time by region as to where they put their stores.

Then we can also obviously access the review data on Amazon. We've invested in some video game companies quite heavily and we know from Amazon, we can track the best sellers through the Amazon site and Amazon is such a large part of viewers retail, it's actually a very good guide as to how the video games are selling over time. It is very helpful. We do try a lot of innovative tricks. Particularly on the customer perception side, which is a very important part of our process.

That’s fascinating Nick. It's almost too much to take in. Thanks for introducing us to Munro Partners and the tech stocks and of course the other things you do there as well.

Yeah, no thanks very much James. Thanks for your time.