But there's another even more active electronic exchange that most consumers participate in daily -- digital advertising.
On almost every Web page you browse, a flurry of banners and videos tell you about something you might want to buy or use. Sometimes the ads seem eerily personal. When you visit the Web site, you'll see a different ad than will your next-door neighbor visiting the same Web site at the same moment. So who decides that you should see an ad for an iPad, and your neighbor should see one for a local shoe store?
Behind those decisions is a vast army of computer algorithms all over the world competing on elaborate electronic exchanges for the opportunity to catch your attention. This system dwarfs Nasdaq by transaction volume and frequency, and the ecosystem of players competing on millisecond time scales for a piece of the pie rivals the financial markets in complexity.
The first set of players is the inventory owners like Facebook (FB) or TheStreet (TST). These are the web spaces that generate large amounts of traffic and look to sell advertising space. They are the Internet equivalents of busy street corners and popular TV channels.
The next level is the ad exchange -- a technology platform that connects inventory owners and buyers. Two of the more popular exchanges are Right Media, owned by Yahoo! (YHOO), and DoubleClick, owned by Google (GOOGL). These platform facilitate advertising transactions in much the same way that Nasdaq facilitates equity transactions.
Participating in an ad exchange is a high-stakes matter that requires a fair amount of sophistication, and many companies and ad agencies choose to hire third parties to buy ad impressions on their behalf. These firms' edge is in proprietary algorithms that buy optimally targeted impressions for the lowest price possible, much like HFT firms try to scalp pennies off stock prices. This next level of high tech ad bidders is the one we'll focus on here.
Let's use Rocket Fuel (FUEL) as an example.
Rocket Fuel, which trades around $18 and is down 71% for the year to date, says it has developed an artificial intelligence-driven optimization engine that leverages big data to make ad decisions based on consumer online activity, market events, bid history, brand interactions, and first-party data. It uses this platform to programmatically buy ad inventory on behalf of customers, and it derives most of its revenue from this middle-man activity.
There are a number of significant risks inherent to FUEL's business model that should make investors cautious.
Tech and infrastructure arms race: The company's selling point is the same as that of its competitors. Namely, that it has a sophisticated software and hardware infrastructure that makes buying decisions smarter than everyone else's. The obvious danger here is that, in order to maintain this claim and keep customers coming back, the company has to devote substantial resources to constantly making its algorithms smarter, faster and more robust. As was observed with HFT firms, this is likely to lead to a rapid growth in technology costs that kill margins.
Lack of customer commitments: Because of the extremely fluid nature of the ad exchange process, inherent to FUEL's business model is a lack of customer loyalty. The only real selling point is performance and price and, as soon as either becomes compromised compared to the competition, ad agencies have no reason not to move their business elsewhere. This feeds the tech arms race of the first point, and puts further downward pressure on profit margins.
Rapidly changing online advertising landscape: If you compared the same Web site from 2010, 2012 and 2014, you would notice a very different look and feel in each case, and different kinds of advertising. The market is underground a rapid shift from traditional display advertising (banners of various sizes) to video and interactive. Shifting company technology and expertise is difficult, and failure to adapt to new trends poses an ever-present existential risk.
Social and legislative privacy trends: There is growing backlash against what is perceived as intrusive data-gathering by advertisers. Some privacy legislation has already been pushed through in Europe, and it's possible similar measures may move forward in the U.S. Even without legislation, if social or tech trends (like Google's push for cookie-free browsing) gain traction, FUEL's business model will be severely compromised.
In addition to FUEL's specific risks, which are also shared by other companies in the same space, there are good reasons to be cautious about the industry as a whole.
Margins have been steadily declining even as revenue grow, and most of the companies have been unable to turn a profit. R&D and infrastructure costs are bound to increase further as competition remains intense, and it's hard to see how the environment could improve without significant consolidation.
Some of these firms may become viable acquisition targets for large ad agencies or exchanges looking to cut down third-party costs, but it's unclear which of the competition will prevail and when.
Given the trends in the space, we expect smaller players to succumb to competitive pressures and the industry to consolidate significantly. The consolidation will likely come by way of larger vertically integrated digital advertisers buying out niche companies with the most effective proprietary algorithms.
As standalone companies, FUEL and its competitors face too many risks. They will become attractive investments only when they are able to solidify their customer relationships, reduce the cost of competing by integrating vertically, and demonstrate several years of robustness to changing environments.
Until then, investors looking for exposure to the booming digital advertising business but not willing to pick buyout targets should stick to the inventory owners -- the likes of Google, Yahoo!, Twitter (TWTR) and Facebook. These companies and smaller publishers realize the full benefits of growing online marketing budgets, but don't face the various uncertainties that FUEL's highly competitive immature niche does.
At the time of publication, the author held no positions in any of the stocks mentioned, although positions may change at any time.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.