Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 312

Network effects: when big gets very big very quickly

One of our primary investing fascinations at Lakehouse Capital is around networks. Think marketplaces, exchanges, payment networks, social networks, or any other form of business exhibiting network effects.

The big idea with network effects is that the product gets better with each additional node in the network. For example, being the first person you knew who had a telephone would not have been much good except for bragging rights, but the usefulness of having a phone exploded as they became fixtures in offices, homes, and then pockets. Or we could be talking about a two-sided network like PayPal: the more users who pay with PayPal, the greater the usefulness for the merchant, and the more merchants who accept PayPal the greater the utility for the user.

Network effects are not exactly a new concept and we’re hardly the first to appreciate their virtue and value. However, many Australian investors underestimate just how quickly value can be created by some businesses with a network effect at their core. Indeed, while seven of the world’s 10 most-valuable listed companies as of 31 March 2019 were powered by network effects, only one of the 10 most valuable listed companies in Australia is truly network-driven.

When networks get big fast

Many businesses powered by network effects can scale quickly and capital-efficiently, enabling a significant amount of value creation in short order. Remember the seven of the world’s 10 most-valuable listed companies are powered by networks? They’re an average age of only 27 years compared to the average age of 154 years for the non-networked giants. eBay reportedly was profitable from the first month it started charging for listings while Facebook was only 12-years-old when it first outearned the then-100-year-old Commonwealth Bank of Australia.

Why are networked businesses able to scale to such heights at such a speed? The rise of the internet, digital commerce and connected mobile devices has enabled a hyperscale that previously did not exist as new networks can reach larger audiences with greater efficiency than ever before.

Another reason that networks create value at rates that can sneak up on investors is that the lifetime value of each user added to the network increases as the network scales. For example, the value of the 2019 new user cohort at PayPal in per-user terms is likely far higher than it was just a few years ago because PayPal is now accepted by many more merchants, which enables new users the ability to transact in more places and increase their value.

Another surprise to investors is that networks are often able to scale with very high incremental margins thanks to relatively fixed overheads. The one-two punch of operating leverage and increasing incremental returns on investment is a powerful combination that can set such networks up for a long series of surprises relative to expectations. Again, PayPal, which is widely followed and presumably well understood, has beaten consensus expectations for normalised net income in 14 out of the 15 quarters since the company was spun off from eBay.

Scaling networks also have increasing optionality. For example, a network with a large and growing user base is well positioned to leverage its size and engagement to take new shots on goal. Prime examples include the likes of Tencent’s WeChat Pay, Apple Music, Uber Eats, third-party logistics at Amazon, and data packages from securities exchanges, among many others.

Such call options are hard to price and predict, but they can often prove lucrative in their own right with the added benefit of increasing engagement across the network. For that matter, networks that are leaders in their space, have attractive unit economics, and are growing users and usage at healthy rates find themselves getting ‘lucky’ by virtue of that strong position and significant user loyalty.

When networks are built to last

The above all sounds great, however, not all networks are created equally. Most fail to reach critical mass. Wikipedia lists 39 defunct social networking sites and that tally neglects the countless sites that failed to gain enough notoriety for their failure to be catalogued.

The ones that do reach a self-sustaining level are not necessarily huge winners either. You would have done incredibly well as an angel investor in Twitter, for example, but public market investors have fared poorly as the shares are down 7.5% over the past five years. Meanwhile, its chief rival, Facebook, has roughly 16 times as many daily active users across its platforms and a market capitalisation that is more than 19 times the size.

Why is Facebook’s larger set of networks more valuable on a per-user basis? To users, larger networks make for more connections, which make for greater utility and engagement. For advertisers, a larger audience delivers a wider range of inventory while a more engaged audience makes for sharper analytics and savvier ad targeting.

But wait. Couldn’t Facebook be the next MySpace? Maybe. Then again, MySpace reportedly only had around 76 million monthly active users at its cultural zenith, which is only about 1/31 the size of the core base of Facebook ‘blue’ monthly users. If anything, Facebook’s relative position is vastly understated on a user basis because of the network dynamics. Working off Metcalfe’s Law, the number of potential connections within Facebook today is something like 980 times that of the number available on MySpace at its peak. Little wonder then, for all the talk of deleting Facebook, its monthly active user base has increased by 8% over the past year.

We can’t know for sure when or how Facebook will be toppled, which is true of every other powerfully-networked business. Still, by seeking out leading, growing networks with attractive, improving unit economics, investors just might find themselves discovering a business that the market might be sorely underestimating.

 

Joe Magyer is the Chief Investment Officer of Lakehouse Capital, a sponsor of Cuffelinks. This article contains general investment advice only (under AFSL 400691) and has been prepared without taking account of the reader’s financial situation.

Lakehouse Capital is a growth-focused, high-conviction boutique seeking long-term, asymmetric opportunities. Lakehouse is the investment manager of two strategies: the Lakehouse Small Companies Fund and the Lakehouse Global Growth Fund. Amazon, Facebook, PayPal, and Tencent are holdings of the Lakehouse Global Growth Fund. Joe owns shares of Amazon, Facebook, and PayPal.

For more articles and papers by Lakehouse Capital, please click here.

 

RELATED ARTICLES

Why the tech giants still impress

Why the four tech giants are not expensive

The value of ‘value’ and Benjamin Graham’s three core beliefs

banner

Most viewed in recent weeks

Why we’re not buying the market yet

The Australian market bounced back last Friday (13th) and Monday (16th) tempting analysts to call the bottom of the coronavirus scare. This is too early as the impact on companies is not yet evident.

How $200 billion is magically created

Australia is in a relatively good position to borrow $200 billion, with the RBA using printed money to buy bonds in the market. The long-term consequences are better than the alternative.

Howard Marks on 'Which way now?'

Howard Marks is the largest investor in the world in distressed securities. What does he think after checking the virus positives and negatives, and how much has he changed his mind in only a few days?

Drawdown reductions needed for retirees - UPDATED POLICY

During the GFC, in the face of rapid falls in super balances, the minimum drawdowns required for pensions were reduced by 50% to help preserve overall retirement savings. It's time for a repeat.

What are the possible economic effects of COVID-19 on the world economy?

In a widely-quoted scenario using estimated attack and fatality rates of coronavirus, about 0.07% of the population of the US dies. That's about 230,000 people, which the market is not ready for.

Note to Australia: be more French in the COVID-19 war

Andrew Baker is well-known as a superannuation consultant. Now working in the UK, he was caught in France with his family and is in lockdown. He worries Australian policy was too slow.

Latest Updates

Economy

Bill Gates: How to make up for lost time on COVID-19

Bill Gates warned the world in 2015 that we were not ready for the next inevitable pandemic, and we ignored him. The Washington Post has provided free access to his updated views.

Hamish Douglass on COVID-19: the three keys to the outlook

Hamish Douglass outlines three important issues in the outbreak of the coronavirus, and describes some consequences which may change businesses and consumers forever. We may never be the same.

Economy

How $200 billion is magically created

Australia is in a relatively good position to borrow $200 billion, with the RBA using printed money to buy bonds in the market. The long-term consequences are better than the alternative.

Investment strategies

Howard Marks on 'Which way now?'

Howard Marks is the largest investor in the world in distressed securities. What does he think after checking the virus positives and negatives, and how much has he changed his mind in only a few days?

Latest from Morningstar

Four stages of a typical bear market - but is this typical?

Bear markets caused by recession fears follow a pattern, but we have never seen anything like coronavirus. If financial stimulus and medicine prove ineffective, all bets are off. 

Economy

COVID-19 executes to a different playbook

The turning point in this crisis will be when the number of new COVID-19 cases starts to decrease. Until then, can we mitigate the damage to businesses and the economy so that we can snap back?

Investment strategies

Why technology stocks are good for the future

Over the long term, the technology sector has a vital role to make the essential transition to a more sustainable global economy and a cleaner planet. We highlight a few names with strong prospects.

SMSF strategies

Avoid complacency with your SMSF's investment strategy

Many trustees of SMSFs have become complacent about vague Investment Strategies, but fund auditors and regulators are paying far more attention. Ensuring your fund complies requires some simple changes.

Sponsors

Alliances

© 2020 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use.
Any general advice or class service prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, has been prepared by without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.