By Margin of Safety Equity Research
For those who follow the value investing principles of Warren Buffet, you have probably come across one of his more enduring quotes: “In business, I look for economic castles protected by unbreachable ‘moats’.” In Buffet’s world, a company is a castle and the size of its moat is the strongest indication to him as to how it will fare against its competition; the larger the moat, the more impervious the company is to a competitive breach of its market share. With the increasing interdependence of technologies and the emergence of e-commerce on the Internet, more powerful moats are now being created through what has been termed the “network effect.”
By definition, the network effect is an economic condition created by a company that produces a particular product or service in which its perceived value increases the more it is adopted by other users. And, as long as the perceived value exceeds the price paid for the product or service, more people will want to own/use it. The network effect differs markedly from achieving economies of scale which is supply-side driven and is limited by production capacity. Instead, it is demand-side driven and limited only when critical mass is achieved.
The simplest and most illustrative example of the network effect is also where its impact on business was first fully realized – the telephone. To the first person that ever owned a telephone, it didn’t hold very much value, but as more people began using it, its value increased exponentially to that person, as well as every other person who owned a phone. The value wasn’t so much in the telephone itself; rather it was in the service that connected all of the users. The rapid growth of users created a network effect that prevented entry into the market by other telephone service providers, thus creating one of the biggest monopolies in history – AT&T (T).
Today the network effect occurs more frequently in the realm of the Internet-based businesses and interdependent technologies that can capitalize on the bandwagon mentality of today’s consumers. The meteoric rise of social network sites such as Facebook and Twitter are iconic examples of the power of the Internet in unleashing the network effect. And, all of us who use a PC have been drawn into the network effect of Microsoft (MSFT) due to the interdependency of the computer, the Windows operating system and all of the software applications written for Windows. Currently, these companies have no peer in their respective domains. Some of today’s most successful companies are dominating their markets due to their network effect.
EBay (EBAY)
One of the earliest Internet-based companies to climb to dominance using the network effect was eBay, the online auction site. While there have been other online auction sites, eBay’s model attracted more sellers than the others. As a result it had the largest selection of products, which attract a larger buying audience. This created a positive feedback loop which continued to attract more sellers and buyers. By the time other Internet powerhouses, such as Yahoo and Amazon entered the market, eBay’s network effect had all but locked them out.
While eBay may have been one of the first to capitalize on the network effect, it may also be one of the first to suffer from a “reverse” network effect in which the perceived value begins to fall below the price paid. One of the many criticisms of eBay is that it has become very convoluted and has attracted too many opportunists which have drastically decreased its value. In recent years, eBay has been losing as many users as it has gained.
United Health Group (UNH)
UNH, one of the largest health care insurance providers with over 70 million insured individuals, is an example of a company that created a network effect by first building scale. Through multiple acquisitions since its inception back in 1977, UNH captured a dominant market share which eventually became self-perpetuating. Because it has the largest network of medical providers, it attracts a larger share of health care customers. Its oversized customer base has become a barrier to new entrants into the market. It behemoth size ($95 billion in revenue), would normally preclude any company from sustaining a 10% growth rate, but UNH has been able to do so because of its network effect with no signs yet of it becoming overly congested.
Yelp
It was only a matter of time before the big old Yellow Pages books became obsolete. The Web, with all of the search capabilities is virtual Yellow Pages in and of itself. We have seen the emergence of several e-Yellow Pages alternatives, but none have reached the level of users than that of Yelp. In this digitally connected world, people want to know what other people think of the store or business being considered. When they search online for a restaurant or business, they are more likely to click on the site that offers the most reviews. Yelp aggressively solicits reviews from thousands of users across the whole business spectrum. For Yelp, the larger number of reviews is a competitive edge that poses big barrier to other market entrants. With each additional review added to a Yelp advertiser, its value increases. It’s the reason Yelp is about to go public with a $100 million offering and there is no one even close.
Investing in the Network Effect
If we can learn anything from Warren Buffet it’s his penchant for buying companies with a wide economic moat that are able to generate consistently high returns on invested capital. A recent study by Morningstar found that of 160 companies it deemed to have a wide moat, the characteristic that generated the highest returns on invested capital is the network effect. Unlike other characteristics leading to an economic moat (such as high switching costs or economies of scale), the network effect, with its self-perpetuating cycle of growth, enables a strong company to get even stronger over time.
The takeaway is that, if you find a company with a network effect, the company has a greater chance of yielding above-average returns on invested capital and should go on your watch list. However, before you buy a stock based upon its network effect alone, it’s important to realize that companies that are positioned to ride their network effects to huge success are few and far between, which is why Google, Microsoft and Facebook only come along once every few years. But, that shouldn’t stop you from trying to find them and subjecting them to as rigorous analysis.
