3rd Quarter 2016

October 15, 2016

Dear Client:

Continuous Learning

As our company name Noesis indicates, learning is key to our business process and crucial in providing quality financial services to our clients.  Our analysts, portfolio managers and advisors regularly attend industry and investment conferences to discover new developments and ideas and update our knowledge. We most recently attended a technology investment conference in September. Shihfang, our research analyst who has a master’s degree in management of information systems, had a chance to listen to 30 presentations over the span of two days. The main purpose for the trip was to confirm that our current investment in the information technology sector is on the right track for the long run.

As expected, Cloud, Mobile, Big Data, Deep Learning, Artificial Intelligence, Analytics, and Integrated Solutions were terms mentioned constantly during most of the presentations. These themes are quite in sync with our investment recommendation on Google (now called Alphabet). Other than having the dominant position among online search services, Google is also one of the top cloud service providers in the world. Its Android mobile operating system has been installed on billions of phones and tablets.  Its artificial intelligence and deep learning project, AlphaGo, is a computer program that has defeated the world’s top “Go” player in four out of five games last year. Go is a Chinese abstract strategy board game for two players with the goal to surround more territory than the opponent. AlphaGo uses knowledge and techniques learned by an artificial neural network, which is actually trained from games played by both human and computers.

We think it would be helpful to use Google as an example to illustrate our philosophy, decision making process, and efforts on monitoring investment ideas over the years. Furthermore, we want to share our thoughts on the latest trends in the technology industry and our disciplined approach on evaluation.

The Ground Work

Google opened its operations in 1996 while the two founders, Larry Page and Sergey Brin, were graduate students at Stanford. Starting in 1998, Google Search attracted a multitude of users and “Google” became a verb for describing online search activities. Google went public in 2004 and its revenue was growing at 50% per year when we decided to take a serious look in 2007. Google’s services were free so it was not clear how Google made its money. Since the dot-com bubble in 2001 was not a distant memory in 2007, a lot of investors did not consider Google as a solid and sustainable investment idea.

The first task for our research was to understand the business model and Google’s products and services. Two of the important technologies that propel the Google search engine are the PageRank algorithm and the AdSense platform. PageRank helps the Google search engine produce results with high accuracy according to the webpage’s popularity and relevance. PageRank is crucial to Google’s winning over Microsoft and Yahoo’s search engines due to its better search results. AdSense provides an easy and fair market for advertisers and website owners to exchange their demand and supply for online advertising. Google receives payments from advertisers when a person clicks on the sponsored link generated by the search engine or a link displayed on a webpage.

After understanding the tools that made the most revenue for Google, our analysts expanded their research on the “long-tail” segment of the internet ecosystem which encompasses small business population and studied the favoritism created by the Web 2.0. It turns out the “long-tail” population is the biggest clientele for most internet companies nowadays due to its size and longevity. By identifying this opportunity, it was obvious that we had found a long-term investment idea in Google. So we decided to invest more in Google during the financial crisis in 2008 because we knew the “long-tail” would be the first group to recover; the worse the economy becomes, the more Google search engine can help to generate convertible traffic (search lead to purchase) to advertisers’ websites since customers were more pressed to find the best deals.

We learned from the technology conference that small businesses benefit the most from the Cloud trend. Google and other Cloud providers are making these small businesses run more efficiently. Entrepreneurs now have scalable turnkey solutions, so they can then focus on their core strategies and products. When growth comes, they do not have the headaches usually brought on by staff and infrastructure expansion. The more they rely on companies like Google to provide business functions such as email, storage and computing power, the higher switching cost will be and the stickier the relationship becomes.

Simply having excellent products and services is no guarantee of success. A good management team with long-term vision and flexibility to make strategic changes at key crossroads is the defining factor for sustainable business growth. So the next run of efforts was spent on researching Google’s founders and management team. We started with the founder’s letter in order to understand the philosophy and vision of Google’s future. We listened to their conference calls, major product announcements and interviews.  We carefully examined their words and actions. We even became Google’s customer and had first-hand experience with its services.  That was why we did not panic when the market reacted negatively to its CEO change (back to one of the founders) in 2011. We believed the new CEO will bring in a new run of innovation and transformation that Google needed at that time. We agreed with the founders that Google has to be run by visionaries in order to keep the entrepreneurial spirit alive when the company becomes larger in size. Operating talent can be hired but not the spirit and the vision of the founding members. We are also happy to see that the company has promoted talent from within to run the day-to-day operations, and recruited a reputable Wall Street veteran to be its CFO to communicate more effectively with the investors.

The Follow up and Monitoring

For most companies, growth is fueled by two methods: capital investment for organic growth or acquisitions for leap growth. Examining the past investment done by Google, we found investors were not happy with short-term capital investment but were patient with acquisitions. Google does not provide earning guidance so Wall Street analysts have to rely on their own research to provide estimates for investors. As expected, sometimes the results were below analysts’ consensus. In most occasions, these below consensus performances were a result of aggressive spending in the data centers and hiring, or slower growth of revenue due to changing algorithms to provide better search results and services. These types of short-term investments usually produced returns within three to four quarters. On Chart 1 (on the next page), we have highlighted several important events when markets reacted negatively to the news. Many of them had created buying opportunities for long-term investors. Impatient investors who had taken short-term trading strategies, such as “stop-loss” orders, lost out in the long-run. The reasons why we are confident in taking advantage of the market’s overreactions are because we understand the business, follow the product evolutions, and monitor the management team on every step.

Chart 1

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#Event DateEvent Name7 Days Worst ReactionNoesis Comments at that timeUpside from Event Date to 9/30/16
14/15/2010Q1 2010 Earnings Release-10.70%Modest growth in "Cost per click" is the price needed to pay to go into high growth areas, i.e. Mobile and International 170%
27/15/2010Q2 2010 Earnings Release-6.97%We don't mind the increased spending in Mobil, Display and App . Each could be $1B business225%
34/4/2011Larry Page took over as CEO-3.16%Page is a visionary. With him back to the CEO seat, Google is starting another innovation run173%
44/14/2011Q1 2011 Earnings Release-9.90%Be patient with the increased investment, the next leg of growth is coming178%
58/15/2011Acquisition of Motorola Mobility-11.90%It is important that Google secures important mobile patents. Risk is higher but necessary188%
61/19/2012Q4 2011 Earnings Release-11.70%Foreign exchange and product mix are the culprits but core business is strong151%
74/16/2014Q1 2014 Earnings Release-7.26%We would rather see Google investing in coming trends earlier than later. Not mind the heavy investment43%
84/21/2016Q1 2016 Earnings Release-9.61%Earning miss came from below-the-line items and important business metrics remain strong3%

At Noesis, we are not at ease when companies announce mergers or acquisitions unless they can generate long-term values. We carefully examine the intentions and financial consequences. Google has completed many acquisitions in the past and not all of them turned out to be good investments. Among the successful ones, YouTube and Android have opened two brand new ecosystems which are the key additions to Google’s growth potentials. We are pleased to see that the company has adopted a disciplined metric on evaluating projects and become more decisive in cutting moonshots.

Vision and Trends

One word you could not miss in the technology conference was Mobile. Mobile devices and technologies have changed our life in the years since smartphones were introduced. The Internet of Things push the boundaries of what devices and information can be connected and shared through the internet. The connected driverless cars take the auto industry into a totally different direction.  The collaboration workflow changes how people work together and redefines the meaning of office spaces. The Big Data provides real-time analytic information for business decisions. All of these are just the beginning of this mobile revolution.

Unlike during the dot-com bubble when a lot of dream ideas were relying on the realization of some future technologies, most of these new ideas are using existing capability of technology and infrastructure. These are mobile programs that integrate real life data with huge knowledge base and run on cheap and fast hardware. They are scalable and the scope of functionalities is only limited to human’s imagination.  Instead of chasing hot ideas, we use Google as the gateway to participate in these trends. It owns many key assets in the ecosystem and has a growing and sustainable business to support all these new investments. As we always remind ourselves to invest with margin of safety, a well-run business is our cushion to trust Google to invest for the future on our behalf.

As your investment advisor, our responsibility is to guide your investments with the best long-term ideas. But nothing is forever, we have to continuously learn about new trends, do fundamental research on industries and companies and have a vision of our own to spot opportunities and exit obsolete areas. Google was quite a controversial recommendation in 2007 due to its short history as a public company and the lack of understanding of its business strength. Then it turned out to be one of the best internet stories post the dot-com bubble. We will continue with our bottom-up fundamental research efforts, strictly follow our investment disciplines and have our minds and eyes wide open to find the next Google story.

One caveat: Google is an information technology company that operates in a cyclical environment and subject to macro economy and technology changes. We only invest for you when we consider the valuation is right and the risk is within your tolerance.

Sincerely,

Research Team