The S&P 500 Index returned 0.58% and the S&P Global Broad Market Index returned -1.03% in the quarter ended September 30, 2021.1
From an overall market return perspective, the third quarter proved uneventful. However, under the surface, we saw a continuation of the substantial year-to-date outperformance of cyclical sectors such as financials and real estate.2 We also saw a number of great businesses with what we believe to be better pricing power, less cyclicality, more conservative balance sheets, and more attractive long-term growth opportunities dramatically underperform not only these cyclicals but the S&P 500 and S&P Global Broad Market indices as well. Where appropriate given client-specific tax considerations, we’ve tried to take advantage of this divergence by opportunistically trimming or exiting some of our more cyclical businesses such as the dominant U.S. banks and brokerages and adding to existing or new positions in some of our favorite less-cyclical, faster-growing global champions, many of whose stock prices have recently underperformed. In the remainder of this letter, we’ll highlight the new investments we’ve made in Amazon, CoStar Group, S&P Global, and Apple and discuss why we find the long-term prospects of these businesses to be so attractive.
Amazon is far and away the largest e-commerce company in the United States with 40% market share (the next largest is Wal-Mart with 7% share).3 Possibly even more importantly, Amazon Web Services (AWS) is the largest cloud service provider in the world with 33% market share (the next largest is Microsoft with 19% share).4 Both of these businesses are dominant networks with high switching costs in industries that we believe can continue to grow much faster than GDP for many years to come.
In the case of e-commerce, Amazon benefits from physical network effects as a result of its unrivaled distribution network of warehouse, transportation, and other delivery infrastructure and from two-sided network effects as a result of its unrivaled marketplace connecting consumers with both third-party sellers (which now represent 56% of total product sales on Amazon)5 and advertisers (a small but rapidly growing part of Amazon’s e-commerce business). Additionally, Amazon benefits from high switching costs due to 1) Amazon Prime, which gives consumers access to unlimited and faster free shipping on millions of items as well as to services such as Prime Video and Prime Music, and 2) its device/media ecosystem where consumers build out content that is hard to transfer to other services, such as Kindle, Kindle Fire, Amazon Fire TV, Prime Video, and Audible. Furthermore, e-commerce still only accounts for 19.6% of U.S. retail sales6 (and similar percentages in Europe and the UK, where Amazon is also dominant),7 which we believe will enable Amazon’s ecommerce platform to grow at higher-than-GDP rates for many years to come. Finally, India, where Amazon and Flipkart are the two dominant e-commerce platforms with roughly 31 to 32 percent market share, 8 has incredibly exciting long-term growth prospects. With low GDP per capita ($1,900 versus the U.S. at $63,544),9 low e-commerce penetration (4.7% in 2019),10 fast growth (projected 27% compounded annual growth),11 and, fairly soon, the largest population in the world (1.4 billion and growing),12 we believe Amazon India can rapidly and profitably grow for decades.
In the case of cloud services, which allow companies to outsource their key information technology needs such as computing, storage, networking, database, and analytics, Amazon’s AWS benefits from physical network effects as a result of its unrivaled global network of data centers including over 80 availability zones across 25 regions, over 100 direct connect locations, and over 200 edge locations.13 These network effects are so strong and the investment required to build the network is so massive that Google Cloud Services, the third biggest cloud services provider in the world with annualized revenues as of Q2 2021 of $18.4 billion, is still experiencing annualized operating losses of $2.4 billion!14 AWS also benefits from protocol network effects. Because of the complexity of cloud environments such as AWS, it can take years for a software engineer to become an expert in just one of them. When combined with the fact that the market for software engineers is both liquid (i.e. many software engineers change jobs frequently) and global, it’s no surprise that the global cloud services market has coalesced around only a few industry standards or “protocols.” Furthermore, AWS benefits from an app-store-like network that connects AWS customers with third party software providers who have created applications for use on AWS. As if three types of network effects weren’t enough, AWS also possesses extremely high switching costs since it is incredibly costly (both in time and money) and risky to migrate core IT infrastructure from one cloud service provider to another. Lastly, AWS operates in an industry with attractive long-term growth tailwinds. Cloud services accounted for only 9.1% of global enterprise IT spending in 2020,15 which we think will enable AWS to grow significantly faster than GDP for many years to come.
CoStar Group is a data aggregation and analytics firm with a dominant position in commercial real estate information services. CoStar Group benefits from what we call a data network effect, which we define as a situation where companies in an industry all contribute their data to one centralized compiler who then provides industry-wide statistics and analytical tools that help each company reduce their risk and increase their return relative to a situation where everyone hoards their data. This arrangement solves a classic prisoner’s dilemma problem and works as long as the trusted third-party, which essentially gains a monopoly, doesn’t abuse its position. In the commercial real estate industry, CoStar Group is the trusted third-party monopoly data provider. CoStar Group collects its data on commercial real estate properties from conversations with brokers, from on-site inspection and aerial surveillance of properties, and from real estate transaction data on the multifamily platforms it owns such as LoopNet and Apartments.com. Then, commercial real estate buyers, sellers, brokers, and researchers subscribe to this aggregated, mission critical data so as to optimize their pricing, inventory and staffing levels, and investments in research, development, and capital expenditures. Since the network effects inherent in this business make CoStar Group’s database nearly impossible to replicate, and the cost is a small percentage of company budgets, the company can almost imperceptibly pass on price increases year after year which drop to the bottom line and allow it to boast high profit margins. Due to its pricing power, its international growth, and its market share gains in multifamily buyer-seller marketplaces, we believe CoStar Group is likely to sustainably grow both pricing and volume faster than the commercial real estate industry, which has itself grown as fast as GDP over the long term.
Furthermore, we believe CoStar Group’s profits and cash flows should prove to be much less cyclical than the commercial real estate industry as a whole. In contrast to CBRE, another business in commercial real estate that we like and own, where a significant percentage of its revenue is dependent upon the number and size of real estate transactions that take place in a given year, CoStar Group’s access or no access subscription-based revenue model combined with the mission-critical nature of its property and transaction data make its cash flows fairly cycle-independent, though even CoStar Group could be impacted by bubbles with large numbers of new entrants or extended busts with persistently declining industry participation (no business is completely immune to cycles!). We think CoStar Group’s strong business performance in COVID-disrupted 2020, during which revenue grew 19% and gross profit grew 22%,16 emphatically demonstrates this business stability.
In S&P Global’s biggest business, it sells credit ratings to corporations, governments, and banks so that these entities can raise debt from the capital markets. In our view, it’s useful to think of S&P’s credit rating system and the analytical methodology that underlies it as a language that buyers, sellers, and other industry participants use to communicate about the bonds they research and trade. Languages are complex and require a significant amount of time and energy to learn, so most global information marketplaces tend to coalesce around one or two standards or “protocols.” In the case of the bond market, S&P and its main competitor, Moody’s, have long dominated the global credit ratings market with far larger protocol networks and far more data than any of their competitors. Additionally, the scope of their networks is unmatched. They provide corporate, government, and structured product credit data going back, in some cases, over a hundred years, and they provide analytical support and software that increase the use-cases for the data. Moreover, most corporations and governments, along with most large endowments, pension plans, and sovereign wealth funds, are run by employees instead of owners, further solidifying S&P’s competitive position because employees are incentivized to make the “safe” choice (in this case, by hiring an industry leader like S&P for their credit rating needs instead of an upstart). Finally, the company’s protocol and data network effects have been reinforced by regulation. For much of S&P’s history, the U.S. government and its various regulatory bodies made S&P and a few other specially-designated rating agencies so important to banks’ bond purchases that it made their ratings almost mandatory for most corporations and governments. As a result of these network effects, principal-agent incentives, and regulatory advantages, S&P is able to generate incredibly attractive financial returns by charging corporations approximately 7 basis points17 to rate their bonds while creating much larger economic value by saving these corporations as much as 30 to 50 basis points in annual borrowing costs.18 Finally, S&P ratings operates in an attractive industry that possesses favorable long-term growth prospects. Debt issuance has historically grown at least as fast as GDP, and capital market bond issuance has grown even faster as it has taken share from banking loans. Over the long term, we believe this GDP-or-better growth is likely to continue.
S&P Global’s next biggest business is index construction and analytics. In other words, S&P publishes indices, such as its flagship S&P 500 Index, that are used by investors and allocators in stock, bond, derivative, and commodity markets to communicate about investment performance. Similar to the credit ratings industry, the leaders in indexing benefit from protocol network effects, data network effects, and principal-agent incentives. As a result, one or two standards dominate the indexing market for each country or investment category. In the case of S&P Global, its S&P and Dow indices are the dominant indices that global industry participants use when communicating about United States stock and derivative performance. Additionally, some of its international indices also have meaningful market share. S&P Global also maintains strong indexing market share in a number of commodity markets through its Platts division. Finally, the index provider business benefits from the growth of capital markets, which we believe will continue to grow faster than GDP over time, as well as from secular trends within capital markets such as indexing and the “slicing-and-dicing” of portfolios based on ESG characteristics.
In addition to its credit rating and indexing businesses, S&P Global also own financial market data providers such as Capital IQ and SNL, which benefit from switching costs. Since these products are commonly integrated into spreadsheets and other customer workflow, customers are resistant to changing providers, though they may be induced to switch by a sufficiently compelling pricing offer from a competitor such as Bloomberg, FactSet, and Refinitiv.
Finally, S&P Global is expected to close its proposed merger with IHS Markit in Q4 2021. This acquisition will further bolster S&P’s financial markets data and index offerings as well as expand S&P Global’s information services portfolio by adding strong offerings in industries such as energy and transportation.
As a result of the industry and competitive dynamics of its various business lines, we believe S&P Global is likely to grow volume and pricing at attractive rates for years to come. Furthermore, and remarkably, S&P Global’s businesses require very little incremental capital to add another user, leading to incredibly high incremental and overall returns on capital. We believe these characteristics increase the earnings multiple investors should be willing to pay for the company.
Apple is partly a luxury goods company and partly a software company.
First, Apple has created a global network of consumers who strongly associate its brands with wealth, social status, innovation, and creativity. This is called a belief network effect. And just like in the cases of other network-driven businesses, the value of the network scales exponentially relative to the size of the network, leading to winner-take-most outcomes. But in the case of luxury goods brand networks, this winner-take-most dynamic doesn’t show up in the number of units sold by the company. Rather, it shows up in the dollar value captured by the brand. You can see this effect most clearly by looking at lists of the most expensive items ever sold in a given luxury category. Automobiles are a great example of this. Ferraris account for 59% of the dollar value share of the top 100 most expensive automobiles ever sold, 75% of the dollar value share of the top 10 most expensive cars sold, and a whopping 83% of the dollar value share of the top 5 most expensive cars sold.19 In other words, the more clearly the purchase relates to social status signaling as opposed to driving utility, the more clearly Ferrari dominates the value capture. And this general pattern plays out in most other luxury categories, with Hermes dominating luxury handbag value capture, Patek Phillipe dominating luxury watch value capture, and Nike and its Jordan brand dominating luxury sneaker value capture. In Apple’s case, it’s even more dominant in mobile phones than Ferrari is in automobiles with 95% of the value capture in the top 10 most expensive mobile phones ever sold and 100% of the value capture in the top 5 most expensive mobile phones ever sold.20 Moreover, in Q1 2021, Apple captured 42% of global smartphone revenue even though it only accounted for 16.8% of global units shipped.21
What makes Apple different than many luxury goods companies is that it also benefits from network effects and high switching costs as a result of the software part of its business. Apple’s most powerful network effect from a software perspective is its app store, which connects consumers with application software providers. Because consumers derive exponentially increasing value from app stores with more app choices and application software providers derive exponentially increasing value from app stores with more consumers, the global mobile operating system market has developed such that just two players control over 99% of it, with Android at 73% market share and Apple at 26% market share.22 Furthermore, Apple increases switching costs through its device and media ecosystem where consumers build out content that is hard to transfer to other services and where tight integration of devices such as the iPhone, Apple Watch, iPad, iMac, MacBook, and AirPods increases convenience and utility, especially on shared family accounts.
As a result of its dominance of the luxury mobile phone category as well as the network effects and switching costs of its software, we believe Apple will continue to grow its already premium pricing in the years to come. In fact, if Apple wants to remain a reliable status symbol, it must increase its prices as global wealth increases or else its products will become too easy to obtain, thereby diluting the company’s value proposition. Finally, we think Apple’s future volume growth opportunities are abundant. As billions more people get added to the middle class in the coming decade, we think they will also desire association with the Apple brand, further strengthening the company’s belief and two-sided network effects.
We hope you’ve found these descriptions of our new investments to be informative and compelling. If you would like to refer back to them at some point in the future (or to any of the other investment rationales we’ve written), they will be posted on our Global Champions page at https://ycginvestments.com/commentary/.
As always, if you have any questions about your accounts or what we’ve written in this letter, please reach out to us. Finally, thank you so much for your trust, know we’re invested right alongside you, and have a wonderful holiday season!
The YCG Team
Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security nor were they selected based on profitability. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not necessarily reflect current recommendations nor do they represent an account’s entire portfolio and, in the aggregate, may represent only a small percentage of an account’s portfolio holdings. A complete list of all securities recommended for the immediately preceding year is available upon request. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. S&P stands for Standard & Poor’s. All S&P data is provided “as is.” In no event, shall S&P, its affiliates or any S&P data provider have any liability of any kind in connection with the S&P data. MSCI stands for Morgan Stanley Capital International. All MSCI data is provided “as is.” In no event, shall MSCI, its affiliates or any MSCI data provider have any liability of any kind in connection with the MSCI data. Past performance is no guarantee of future results.
1 For information on the performance of our separate account composite strategies, please visit www.ycginvestments.com/performance. For information about your specific account performance, please contact us at (512) 505-2347 or email [email protected]. All returns are in USD unless otherwise stated.
16 See page 43 of CoStar Group’s 2020 10-K filing at https://www.sec.gov/ix?doc=/Archives/edgar/data/1057352/000105735221000032/csgp-20201231.htm.
18 In 2012, for the first time in its history, Heineken decided to get its debt rated. Based on Heineken’s post-mortem analysis, getting its debt rated saved the company 30 to 50 basis points of yearly interest cost. See http://treasurytoday.com/2013/02/do-companies-need-to-be-rated-to-issue-bonds.