Like most investors, I prefer a structured approach to guide my investment selection process. In that regards, Morningstar’s grouping of economic moats into five categories (intangible assets, cost advantage, switching costs, network effect, efficient scale) has been extremely useful to me, in determining the source of competitive advantages for the potential wide-moat compounders I have shortlisted.
Hence, when it came to my attention that a Morningstar June 2012 research paper titled ‘Moats: Sources and Outcome’ showed that network effect firms had the highest variability of ROA, ROE, and operating margin, it set me thinking on how to assess the strength of network effects.
To quote from Morningstar: ‘The network effect occurs when the value of a particular good or service increases for both new and existing users as more people use that good or service, often creating a virtuous circle that allows the strong to get stronger.’
What is the nature of goods and services?
Auction sites have stronger network effects than its matchmaking and brokering peers. This is because physical items can only be put up for auction in a single location, while there is no restriction on online listings.
The network effect is so strong that eBay (NASDAQ:EBAY) has remained dominant in the U.S. but has failed to expand successfully in Japan and China, losing out to their respective incumbents, Yahoo Japan and Alibaba. Another example is the fine auction market which has been essentially a duopoly between Sotheby's (NYSE:BID) and Christie’s for the longest time.
Comparatively, jobseekers and employers have incentives to post their resumes and job advertisements respectively at multiple job sites to enhance their chances of success. The same logic applies for online dating sites, where people will register themselves with as many dating services providers possible to find Mr or Mrs Right.
Is the economic pie shared fairly?
Nintendo (NTDOY) was the market leader in console games in the early 1990s, benefiting from network effects. Although Nintendo isn’t a matchmaker, all parties in the gaming value chain will ideally be winners, assuming only a single console system existed ('network effects').
Game producers won’t have to develop games for multiple platforms, resulting in added costs to meet the requirements of different systems. Similarly, consumers will only need to buy a single console to play all the games they liked. In contrast, console-exclusive games meant that some consumers had to buy multiple consoles.
However, the above will only hold true, if the outsized economic profits of a dominant console company was shared equitably among all participants in the network. That wasn’t the case.
Game producers were limited to making five titles a year and had to give up a big chunk of the profit to Nintendo. In addition to the 20% license fee, game producers had to outsource cartridge manufacturing for an upfront fee.
Retailers had to pay Nintendo for the consoles upon delivery, unlike with most suppliers which they will enjoy negative working capital by virtue of generous credit terms and slotting fees. In addition, Nintendo largely dictated retail price and in-store displays. More importantly, Nintendo controlled supply closely, leading to stockouts which frustrated consumers.
As a result, consumers, game producers and retailers wished for a competing player which came in the form of Sega.
Think about the rise of Android to battle iOS. Similar dynamics were at play. iOS’ high standards of qualifying apps led to some app developers turning to Android, an open source platform.
Also, if Sotheby’s and eBay raised their fees/commissions to ridiculous amounts, it might indirectly lead to the rise of competing networks.
Are buyers and sellers likely to go direct?
Two factors will deter network participants from bypassing the matchmaker/broker and go direct.
Firstly, how fragmented is the user base on both sides of the transaction? In other words, is it easier for a buyer to find a seller or vice-versa? It is easier to find buyers for your collectible sports cards on eBay; and a rare art piece will fetch its maximum value on Sotheby’s, rather than via privately-negotiated transactions.
Secondly, how important is trust in the whole mix? Some dating services providers will interview their members and do background checks. This helps to assure its members that the potential Mr or Mrs Right is less likely to falsify his or her credentials. Similarly, the reputation of century-old firms Sotheby’s and Christie’s gives buyers the confidence that the probability of paying millions for a fake art piece is significantly lowered.
Interestingly, the same Morningstar study also indicated that the network effect is the most common moat among wide-moat firms i.e. 24% of Morningstar’s wide-moat firms’ source of competitive advantages was derived from network effects.
With asset-light online matchmaking business models becoming more common and popular, I expect more network effect companies to appear in the shortlist of value investors. However, that also means that investors need to be more cautious in assessing this particular moat type, as there is a huge variability in the strength of the various network effect firms.