Politicians are trying to build walls around Alphabet (GOOGL) and Facebook (FB). Bless their hearts.
In April, the Wall Street Journal ran a big story about Europe, privacy and the coming crackdown. The plot twist was positively Shakespearean. More regulation is likely to benefit current leaders.
It’s a lesson in scale, network effects and unintended consequences.
The General Data Protection Regulation will go into effect throughout the European Union on May 25. After that date, businesses must get affirmative consent before collecting any personal data online.
This means every ad technology, online publisher, data broker and analytics firm that harvests personal data is going to need prior permission from consumers. That’s not going to be a tough ask for Alphabet and Facebook. Consumers understand, and have come to depend on YouTube, Gmail, Google Maps, Instagram, WhatsApp and Facebook. Plus, their friends are there.
For the hundreds of smaller firms with no name recognition, or large networks, it is going to be considerably more difficult.
That’s the opportunity for investors.
Regulators should have seen this coming. Last fall, Věra Jourová, the EU justice commissioner, travelled to Silicon Valley to meet with representatives from Alphabet and Facebook. She expected them to be nervous. Instead, “they were more relaxed, and I became more nervous,” she told the Wall Street Journal.
Alphabet and Facebook managers must have thought they won the lottery.
Erecting barriers to entry helps the companies already on the inside. It’s economics 101. Competitors are forced to grow larger, faster to climb the barriers. This usually involves more costs and a big change in business strategy. And if they get inside, it’s harder to make profits because of the increased costs.
Alphabet sells seven digital products with more than 1 billion users. Facebook has 2.13 billion monthly users and a slew of popular mobile apps. Spreading fixed costs across so many users is a powerful competitive advantage.
Smaller companies will not get that luxury. They also will not get the benefit of entrenched brands and the network effects. It is tough to leave Facebook or YouTube when that’s where your friends and family meet, and your favorite shows post content.
GDPR could be a death sentence for many smaller digital firms.
Companies that have always operated behind the scenes are being forced out into the open. Consumers will vote up or down, to trust them with personal data. Many at technology firms see the writing on the wall. They are already leaving Europe.
In 2017, eMarketer, a digital advertising research company, forecast global digital ad spend would climb 19.1% in 2017, to $228.4 billion. Alphabet and Facebook accounted for $151 billion in digital sales. Alibaba (BABA) and Baidu (BIDU) captured $35 billion.
GDPR, and the possibility the underlying policy will spread across the globe, means the remaining digital ad market share is up for grabs.
eMarketer believes the total market will reach $375 billion by 2021.
I have been an full-throated Alphabet and Facebook bull. I have urged my members to buy every meaningful decline because these are dominant companies. And frankly, the critics are wrong. The prospect for regulation is not a negative.
So many cutting edge technologies are converging. There is so much opportunity for invention. Yet, scale and network effects have never been more important.
Investors need to be focused on companies that have built scale, dominant networks and remain on the cutting edge of what is possible.
One of my long-term favorites is Microsoft (MSFT). The Redmond software giant is often overlooked because it is not as flashy as the FANG stocks. However, Office is the dominant corporate productivity platform. In business, Word, Excel and Powerpoint are ubiquitous.
Microsoft has cleverly leveraged that franchise into a robust cloud computing business.
Last week, the company reported first quarter cloud revenues surged 93%, versus a year ago. According to Synergy Research, its market share rallied 3%, to 13%. Although that is a long way behind Amazon Web Services, the industry leader at 34%, the trend is in the right direction.
Microsoft is growing market share in a segment Gartner (IT), a global IT research firm, expects to reach $411 billion by 2020.
The bottom line is that investors should not be afraid of owning big companies; they have all the advantages, and can accept higher regulatory costs at a much scale than their smaller rivals.
What’s more, by taking some calculated risks and using leverage, you can own highly liquid options on these big companies to multiply your profit potential. In my Markman’s Strategic Options trading service, I only recommend options on liquid, large cap equities. That’s one of the reasons my readers have averaged 99% yearly returns since 2012.
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Jon D. Markman