Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 266

Apple at US$1 trillion: tech titans give runaway returns to scale

There is a well understood principle in investment known as the law of large numbers. Essentially, it says that the larger a company is, the harder it is to increase revenue growth rate, since most people already have the product or service. It’s why revenue growth for big banks and retailers like Coles is almost always below 10%. Of course, this is after having got large in the first place, which is another story (about economies of scale, about which we all know).

But back to the main point. In the past few years, something very unusual has been happening to some of the biggest companies in the world, like Google (Alphabet), Amazon, Microsoft, Tencent and Alibaba. The revenue growth for these companies isn’t tapering off, it is actually accelerating. Meaning that growth this year is higher than growth last year.

It’s known as ‘runaway returns to scale’. The formal definition of this is based around the concept that when output increases by more than the proportional change in inputs, there are increasing returns to scale.

Is this happening, and if so, how?

One thing that has definitely emerged in the past 20 years is the network effect. This states that arithmetical growth in users leads to geometric growth in value of the network, since each incremental user increases the number of transactions by more than just the one incremental user.

It’s true that one telephone and one person cannot transact with anyone. Even two people can only do one transaction (assuming for a moment, one transaction per connection). But ten people can do 45 transactions.

There is a formula for this: n(n - 1) ÷ 2. In this case, if n is the number of users, then:

10 x (10-1) ÷ 2 = 45 connections

This is the network effect in simple terms.

So it is that growth rates for some of the largest companies in the world, as measured by revenue, are increasing, in part because of the network effect, as shown below:

The chart above shows revenue growth in aggregate for six of the world’s largest companies: Amazon, Google, Facebook, Tencent, Microsoft, Alibaba. It shows revenue growth accelerating in the past few years, not slowing down as could be expected from the law of large numbers. So perhaps these are examples of runaway returns to scale? (There is some further explanation needed for Microsoft and Apple, which will we get to.)

The connection between these companies is their use of software to connect users arithmetically, in the process increasing transactions, and the value of their networks, geometrically. Alibaba and Tencent connect more people in China than any other network, so have the largest dollar value of transactions. Same with Amazon in the US. For clarity, we have broken out the revenue growth of the individual companies in question.

Microsoft works slightly differently, but is still showing big returns to scale. The company’s major products, enterprise software and Windows, are the largest corporate operating system in the world. The company is shifting from the provision of these products within individual companies to providing them as a service in its datacentres, effectively moving every on-premise data centre to Microsoft’s own datacentres, and providing the product (IT) as a service. We are not certain whether this is part of a network effect or simply a one-time business migration. The acquisition of LinkedIn a few years ago suggests that Microsoft is trying to turn itself into a network company. But in any case, it is showing runaway returns to scale as it moves whole industries to the datacentre.

As a separate case, we should consider Apple. It hasn’t primarily been a network company. It sells phones, which are hardware, and are interoperable with all other brands of phones, and most all other networks, so while it is a beneficiary of the network effect, it is not driven by it. Its product set is expanding, in turn attempting to lock users to its ecosystem to ensure seamless operability, which is driving sales, though previous quarters’ growth don’t point to runaway returns. And its expansion into networked services like the app store, music, entertainment etc. can be classed as a network, (though it has been the company’s choice to pursue this more slowly because of privacy issues) but it is much smaller though faster-growing than the hardware business.

Just how big are the big six? They are now bigger in revenue than the ASX top 50, once the currency conversion is considered. And growing faster.

Does size bring problems?

What happens when companies become so large that they create problems for lesser competitors? Eventually, they get broken up, like AT&T or Standard Oil, into a group of smaller businesses. And of course, as Thomas Piketty noted in his excellent book Capital in the Twenty-First Century, every so often a major global calamity comes along, like say a World War or even two), at which point everything is blown up, quite literally, and everyone starts again from a more or less zero base.

The first is preferable to the second. And it should be noted, in the case of the Standard Oil break-up, the sum of the parts wound up being much greater than the whole.

 

Alex Pollak is Chief Executive, CIO and Founder of, and Anshu Sharma is Portfolio Manager at, Loftus Peak. This article is general information and does not consider the circumstances of any individual.

RELATED ARTICLES

Why the tech giants still impress

Why the four tech giants are not expensive

The connectivity revolution is only just beginning

banner

Most viewed in recent weeks

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates

Retirement

Stop treating the family home as a retirement sacred cow

The way home ownership relates to retirement income is rated a 'D', as in Distortion, Decumulation and Denial. For many, their home is their largest asset but it's least likely to be used for retirement income.

Property

Hey boomer, first home buyers and all the fuss

What is APRA worried about? Most mortgagees can easily absorb increases in interest rates without posing a systemic threat to the banking system. Housing lending is a relatively risk-free activity for banks.

Property

Residential Property Survey Q3 2021

Housing market sentiment has eased from record highs and confidence has ticked down as house price rises slow. Construction costs overtook lack of development sites as the biggest impediment for new housing.

Investment strategies

Personal finance is 80% personal and 20% finance

Understanding your own biases and behaviours is even more important than learning about markets. Overcome four major cognitive biases that may be sabotaging your investing and recognise them in others.

Where do stockmarket returns come from over time?

Cash flow statements differ from income statements and balance sheets, and every company must balance payments to investors versus investing into the business. Cash flows drive the value of the business.

Fixed interest

How to invest in the ‘reopening of Australia’ in bonds

As Sydney and Melbourne emerge from lockdown, there are some reopening trades in the Australian credit market which 'sophisticated' investors should consider as part of their fixed income portfolios.

Shares

10 trends reshaping the future of emerging markets

Demand for air travel, China’s growing middle-class population, Brazil’s digital payments take-up, Indian IPOs, and increased urbanisation are just some of the trends being seen in emerging economies.

Sponsors

Alliances

© 2021 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 ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). 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.

Website Development by Master Publisher.