How to Invest in Digital Advertising

Think of all the free stuff we have access to. If someone from the 19th century showed up today, they'd marvel at the tools we can use at no cost: broadcast TV, radio, internet search, email, mapping and directions. This list goes on -- it's truly amazing.

How can we afford all of this?

There's an old saying in advertising: "If you're not paying for it, YOU are the product." And therein lies the rub. All of those things are free because you are served advertisements.

It's a big business. No...a HUGE business. Increasingly, that business is moving from the old formats of TV commercials and newspapers to digital advertising. It's a once-in-a-generation shift that could generate wealth for growth investors...if you know where to invest.

Image source: Getty Images.

In the sections that follow, we'll review the advertising industry, how it's changing, who the big players are, and where you can invest to profit.

Advertising 101

Newspapers were one of the earliest mediums for advertising, but people still had to pay for their daily reading. Because of that, let's use broadcast TV as our exemplar for the mechanics of advertising, specifically focusing on one of the most popular shows of the last quarter century, Friends.

The formula for the business model is actually quite simple:

• Create a show that's enormously popular with a specific demographic. For Friends, it was young to middle-aged adults, particularly those living near urban areas.
• Find companies that want access to that audience. Sell them space to place an advertisement.

That's it.

While the details might make it seem more complicated, these are the two steps to the advertising business model. When Friends aired its series finale, there were so many people watching that NBC earned $2.8 million (in today's dollars) for each 30-second ad. That's how valuable all of those eyeballs were.

Changing landscape in advertising toward digital

But that model wasn't perfect. Let's say Procter & Gamble wanted to place an ad for Pampers diapers. That makes sense, given that young to middle-aged adults are usually starting their families -- and diapers become a major expense.

Not everyone watching that finale, though, had diaper-aged kids. In fact, let's assume that only 20% of the 52.5 million viewers who tuned in to the episode cared about diapers. That's still more than 10 million people that you're reaching with one ad -- which isn't bad. Procter & Gamble, however, was still paying a steep price for the 40 million-plus viewers who wouldn't even consider buying diapers.

With the dawn of the internet, things started to change.

For one, advertisers now have a much better idea how many people their ads are reaching. With broadcast TV, for instance, there's no way to know for sure how many people are watching. That 52.5 million figure came from an estimate by industry experts who had placed program-tracking devices in a much smaller number of households.

Second and more importantly, two different people visiting the exact same website can now see different ads being displayed. A person who has a history of searching for dinner recipes might see a food-based ad. Another who likes buying sports gear might see an apparel ad. Just like that, ads can be personalized.

It has been a game changer.

How important is digital advertising?

Let's break advertising mediums into two broad categories:

• Nondigital ads: Ads that are on broadcast TV, on the radio, in newspapers and magazines, and on outdoor billboards.
• Digital ads: Ads you see anywhere on a screen with the exception of broadcast TV.

Here's what the shift in advertising dollars has looked like...and how industry experts expect it to continue playing out.

Data source: eMarketer. Data for 2019 through 2023 based on industry forecasts.

While nondigital ads aren't going to disappear overnight, their importance is waning. Depending on which source you use (the above uses eMarketer's data), digital advertising has just eclipsed nondigital globally for the first time ever.

What are the different types of digital ads?

The first digital ads were pretty basic. Referred to as "banner ads," they were simply ads that appeared at the top of a web page you were visiting. Since then, digital ads have become far more diverse. In general, digital ads can be broken down into four broad categories:

1. Display: These ads show up on the sites that you visit. They are often interspersed (on the top, side, and/or bottom of a web page) throughout the screen you are viewing.
2. Video: Technically, this is a version of the display ad, but instead of just text and an image, it is a video. These types of ads are becoming much more popular on streaming services like YouTube and other connected TV platforms.
3. Social media: When you scroll through Facebook, Twitter, or Pinterest, you see ads that look like posts from your friends and colleagues. These are social media ads.
4. Paid search: When you type a term into Google and hit Enter, the results returned are not always there because they are the most relevant. Sometimes they are there because a company has paid to have its ad displayed at the top of the page.

While this list isn't exhaustive, it covers the vast majority of ads that are available through digital means.

How are digital ads placed?

Let's go back to our Friends example for a minute. Months before the final episode was aired, NBC had its employees filling all of the ad slots that would be available. Each slot was carefully selected and priced. Those ads were collected beforehand and were ready to go live long before the final episode aired on TV.

That's an arduous and laborious process that is increasingly being replaced by something called "programmatic advertising." This aims to make the process of getting the right ads in front of the right eyes a much less painful and time-intensive process.

Basically, it looks like this:

• Companies enter what type of person they want their ad to play for. This includes things like age, interests, and location.
• The programmatic advertising platform (more on the big players below) identifies when an ad can be displayed in front of this type of person.
• The platform offers up a price for the ad to be displayed and instantly selects a "winner."

The entire process relies upon machine learning and artificial intelligence. As more and more data is collected on what people are looking for on the internet, the ads displayed become better fit to specific viewers.

As you can see below, programmatic advertising has become an enormously popular choice.

Data source: PubMatic. All figures rounded to nearest billion.

The same dynamics are at play here: Nonprogrammatic advertising isn't dying out. But over time, it is significantly waning in importance. Today, more than two-thirds of digital advertising dollars are paying for programmatic means for placing ads.

Where do digital ads appear?

As with programmatic advertising, the other big shift that has occurred over the past five years has been a shift toward ads displayed on mobile devices. Before Apple came out with its iPhone, it was very difficult to display ads on a cell phone screen. But with the advent of larger and more functional screens, mobile devices have become the preferred venues for ad delivery.

At first, industry experts were skeptical. People are far more likely to view and appreciate an ad displayed on a larger desktop device. That might be true, but mobile phones are far more ubiquitous globally. While North Americans and Europeans may be the only ones able to afford large desktop computers en masse, just about anyone can get a smartphone these days.

That has accelerated the shift toward mobile ads. By 2022, it is expected that 77.5% of all digital ad spending will be on mobile advertising.

Is digital advertising effective?

But are we putting the cart before the horse? On a theoretical level, digital advertising makes more sense. As a company, it makes much more sense to only pay for ads that are ending up in front of the eyes that I care about.

Perhaps in practice, however, we're missing something. In his 2019 book Alchemy, advertising guru Rory Sutherland argues that we're forgetting about the power of signalling. In it, he argues that the real value in advertising is in sending a signal that one's goods are worth it.

Think about it: If Procter & Gamble can pay for a $2.8 million, 30-second ad, it must do a lot of business. Doing a lot of business means that lots of your family and friends also use the company's Pampers diapers. And if so many trustworthy people use them, they must be safe and affordable.

Sutherland doesn't argue that we consciously jump through those mental hoops every time we see an ad. It happens on a subconscious level.

If Sutherland's idea is true, digital ads will be far less effective. Consider: If I know it was far cheaper for me to see the ad placed in front of me, I might think this brand of diapers is coming from someone starting a diaper company out of their garage. I'm not apt to attend to such an ad, so I look for other places to inform my decisions.

All along, I've been using Procter & Gamble as an example for a reason. A few years back, the company very intentionally cut back on its targeted digital advertising. The results: It increased its reach!

From an Adweek article at the time:

P&G's $200 million digital cut [was] reinvested into areas with "media reach" including television, audio and e-commerce...[T]he cuts helped P&G eliminate 20 percent of its ineffective marketing and increase reach by 10 percent.

This may have just been the tip of the iceberg. Recently, Facebook revealed that it had misreported the effectiveness of its video ads by enormous margins. A new lawsuit states that ad viewing time was inflated by 150% to 900%. If true, this means that companies were spending a lot of money with Facebook and getting very little -- in terms of reaching their target audiences -- in return.

Does all of this mean that digital advertising is doomed? I doubt it. The internet is here to stay, and it's impossible to imagine a world in which advertisers don't find a way to take advantage of the fact that -- because of mobile devices -- the internet is just a few inches away from people's eyeballs.

But it does mean that investors need to wade into the industry with reasonable expectations. This is a brand new way of doing business. As with any new format, it will be fraught with plenty of kinks and bad practices. The industry will adjust over time, but it will be important for investors to monitor these changes as they happen.

Who are the biggest players in digital advertising?

Having spent time investigating the dynamics of this industry, let's now take a look at its biggest players. Below is a list of the 10 largest companies involved in digital advertising (by digital advertising revenue, as of September 2018) and the role that each plays in the industry.

Data source: eMarketer.

Six digital advertising stocks to consider buying

Just because a company is a big player in the digital advertising space doesn't make it a good investment.

In the end, the strength of an investment is only as great as the moat -- or sustainable competitive advantage -- that protects that investment. In other words, if a company doesn't have something special that can bat away the competition, it isn't worth your investment dollars.

The half dozen stocks I'm suggesting below all have one or two moats in common.

• Network effects: These companies benefit from a phenomenon whereby each additional user of its service makes the overall service more valuable.
• Low-cost production: The thing being produced is data. The more data a company can get without having to spend tons of money on it, the better. That data leads to ads that are better targeted at the intended audience.

So without further ado, here are the six stocks to consider buying, with a brief explanation of each one's moat.

As you can see, the dynamics with these investments have a lot in common. Facebook, Pinterest, Amazon, and Roku all collect data at very low cost. And the forces bringing in all that data are network effects. There's no point to joining Pinterest or Facebook if none of your friends are using the service. And Roku and Amazon draw in third-party providers based on the popularity of their platforms.

Alphabet is a little different in that it doesn't necessarily benefit from network effects. If you decide to start using Chrome or YouTube tomorrow, that doesn't really improve my experience of those services. But the company itself is so dominant that it collects unprecedented amounts of data. Its eight tools with more than 1 billion users -- Google Docs, Google Photos, Google Play Store, Chrome, Android, Search, Maps, and YouTube -- are enormously popular.

Which brings us to The Trade Desk. The company is a specialist in programmatic advertising. Remember the Facebook issue we talked about earlier -- in which the company had inflated its numbers? Well, that can be a serious problem for people looking to place ads. They need someone they can trust.

The Trade Desk is offering the platform of trust for programmatic advertising. It can match up advertising inventory (spots on the internet where ads can be placed) with those looking to place ads.

That's not that different from what Facebook or Google does, but there's a key difference: The Trade Desk is agnostic. In other words, it's not selling its own inventory. When Facebook places an ad for you, it's on Facebook's own website. The same is true for the bulk of Google's ads.

Because it is agnostic, advertising agencies are flocking to The Trade Desk's platform. Advertisers generally trust the data they get back, as The Trade Desk has little to no incentive to inflate the numbers. Technically, it is starting to benefit from low-cost production as it collects more and more data about users.

But in the end, The Trade Desk's execution is unmatched. The company is focusing on getting big clients to place ads, and it is pleasing those clients to no end because of the transparency they get in terms of how effective those ads are. When an agency can use a single platform to meet all these needs, the real moat comes from high switching costs: It would be a pain to use any other provider.

A final word about digital advertising

Digital advertising is an undeniable, once-in-a-generation shift. As this piece has tried to drive home, there's no guarantee as to how this will all play out. Companies will continue to test and experiment with digital advertising to make sure it's more effective than its print- and radio-based predecessors.

But over time, I believe the six companies mentioned above are well positioned to benefit from these long-term trends. They are all worthy of your own due diligence.