ALPHABET’S FUTURE GROWTH SCOTTISH MORTGAGE INVESTMENT TRUST Tom Slater, Investment Manager. Fourth Quarter 2018 – Alphabet’s Future Growth Baillie Gifford IMPORTANT INFORMATION AND RISK FACTORS The views expressed in this article are those of Tom Market values for securities which have become difficult Slater and should not be considered as advice or to trade may not be readily available and there can be no a recommendation to buy, sell or hold a particular assurance that any value assigned to such securities will investment. They reflect personal opinion and should not accurately reflect the price the trust might receive upon be taken as statements of fact nor should any reliance be their sale. The trust can make use of derivatives which may placed on them when making investment decisions. impact on its performance. 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The images used in this document are for illustrative Please remember that changing stock market conditions purposes only. and currency exchange rates will affect the value of your investment in the fund and any income from it. Scottish Mortgage Annual Past Performance To 30 September each year Scottish Mortgage invests in overseas securities. Changes in the rates of exchange may also cause the value of your 2014 2015 2016 2017 2018 investment (and any income it may pay) to go down or up. 27.6% 4.2% 37.0% 30.4% 29.0% The trust’s risk could be increased by its investment in unlisted investments. These assets may be more difficult to Source: Morningstar, share price, total return. buy or sell, so changes in their prices may be greater. Past performance is not a guide to future returns. The trust invests in emerging markets where difficulties in dealing, settlement and custody could arise, resulting in a negative impact on the value of your investment. The trust can borrow money to make further investments (sometimes known as “gearing” or “leverage”). The risk is that when this money is repaid by the trust, the value of the investments may not be enough to cover the borrowing and interest costs, and the trust will make a loss. If the trust’s investments fall in value, any invested borrowings will increase the amount of this loss. Alphabet Sculpture Blocks. © Brent Waltermire / Alamy Stock Photo. Alphabet Future Growth 36587 1218.indd Ref: 36587 IND AR 0512 Fourth Quarter 2018 ALPHABET’S FUTURE GROWTH BY TOM SLATER This year marks a decade since we first invested in Google for Scottish Mortgage Investment Trust clients. Its market capitalisation was around $200 billion at the time. Today, it has a new name and is of course worth much more. 3 – Alphabet’s Future Growth ...Alphabet has scaled its Precedent suggests that making significant returns from a market revenues significantly faster capitalisation of $750 billion is improbable. Research on complex than its headcount. adaptive systems by Geoffrey West and his colleagues at the Santa Fe Institute suggests that as an organisation increases in size its output grows more slowly than it does. Support for this contention can be We know this intuitively as ‘growth of seen in the low headcount and physical bureaucracy’ or, more articulately, the infrastructure relative to revenue that 2016 shareholder letter from Amazon’s these businesses exhibit. Over the CEO Jeff Bezos suggesting that past 10 years, Alphabet has scaled its “Day 2 is death”. Similarly, complex revenues significantly faster than its systems analysis puts forward the headcount. This is a strong argument concept of organisation metabolism: for its ability to break through the in plain English, the idea that the empirical difficulties of growing output of an organisation is a function decisively beyond its current market of the energy that goes into it. As it capitalisation, however it is important scales, you have to put more energy in to consider what will be the drivers of for each unit of output – just as is true growth from this point. of biological organisms. The potential upside for Scottish Could it be that some of the large Mortgage’s investment in Alphabet platform businesses defy this has two parts. efficiency decline because they aren’t — First, the core business is more the only ones putting energy into their nascent than $90 billion of annual platforms? The way they facilitate advertising revenue suggests. interactions between members of their Conventional models of the ecosystems perhaps makes them less market opportunity in advertising like traditional corporations and more are rooted in the past and fail to akin to cities, whose output grows capture the recursive impact of more quickly as they scale. Alphabet and Facebook: these companies and their products are redefining the opportunity set. To value Alphabet in terms of current advertising spend would be akin to valuing Uber or Lyft based on the current taxi industry. — Second, the technology that powers search is at the heart of many other technological developments, opening up new markets for Alphabet to monetise 4 in ways other than advertising. Fourth Quarter 2018 but those adverts also become more helpful to us. More broadly, as search results improve, the definition of PART 1: THERE IS advertising expands. In reality an advert is a proxy – users don’t want to see it and advertisers don’t want MUCH FURTHER TO to pay for it. Rather, both are seeking a transaction and as personalisation improves Google will be closer to GO IN ADVERTISING facilitating this. The movement of economic activity online is a powerful force for Alphabet, but counterintuitively, it may be offline where Alphabet’s Online advertising is exploiting a of search as becoming everyone’s actions have the greatest impact. It is new opportunity. Digital advertising personal assistant? Consider the rapidly improving its measurement of grew from $118 billion in 2013 to product evolution from suggested activity in the ‘real’ world, including $206 billion in 2017. Yet, ‘blue links’ of 10 years ago to the Store Visits programme, an astonishingly (to me at least), other Google Home which responds to attempt to match users viewing an forms of media combined grew voice queries. This demonstrates the online advert to a completed in-store over the same period by $23 billion, changing consumer conception of transaction. This now has thousands rather than being displaced by online search. Internally, Google engineers of customers and 5 billion store advertising. If you believe this is a look at ‘headroom’, defined as the visits were tracked across 2016. new market then it makes sense to list of searches where results are Demonstrating the link between search think in terms of consumer use cases. poor. That list is growing rather than activity and offline purchases provides What does search do well and what shrinking because users’ expectations a powerful signal of the value of does it do poorly? are rising faster than search search advertising and should increase improvements. Users often refine their the price that offline businesses are As internet connectivity grows, search queries and, whilst they are prepared to pay for search keywords. more people are searching and are prepared to do that today, it does send doing so with greater frequency. This a fairly direct message that the service The use cases for search are volume growth creates untapped is not doing a good enough job. This growing. The quality of the product opportunities. The impetus from will change, but the future expansion is improving. The quality of the mobile remains huge yet there is much in use cases for search is evident. advertisements is improving. room for improvement in the mobile Advertising customers are driven by experience. As a greater volume and One response to this is greater return on investment and if you keep proportion of search is done on mobile personalisation. Often search doesn’t delivering this at greater scale, they devices, the expected improvement in take advantage of the many things will keep spending – indeed Google’s speed and quality of the mobile web it knows about you when delivering unspoken operating model revolves will be a significant positive. Alphabet results. This is beginning to change, around the aim of driving 20% growth is not merely a passive beneficiary, as initially with geographic location, but in the core business, decade after initiatives such as Accelerated Mobile with assets like Gmail and calendar decade. There is, therefore, no need to Pages – an open-source website (as well as your entire search history) frame the opportunity in terms of the publishing technology designed to at its disposal, Alphabet should current advertising market – Alphabet improve web content – are driving continue to improve our experience. is changing the game. these improvements. As the product gets better we will use it more. This not only creates more Search is not just accelerating, but opportunities to serve us adverts also changing, and becoming more 5 complex. What if one conceives – Alphabet’s Future Growth PART 2: NEW SOURCES OF REVENUE Put simply, the technology that powers search is opening up new markets that can be monetised through means other than advertising.