The network effect and how to navigate it as an investor

The term ‘network effect’ gets thrown around loosely when describing fast growing businesses. But as Erwin Tan from Lakehouse explains, there is an important difference between a true network effect and a company that is just growing quickly. He shares examples of few stocks with genuine network effects to illustrate the difference. 
Erwin Tan

Lakehouse Capital

As investors at Lakehouse Capital, we understand the benefits of taking a long-term approach rather than falling into the trap of short-termism and trying to time markets. Our long-term investment horizon is one of the key foundations of our investment philosophy. 

Sentiment can buffet markets in the short-term, invariably feeling different or worse than previous bouts of volatility. The reality is markets often face short-term headwinds and equally often recover quickly -For example, who would have predicted markets to rally from March 2020 in the face of a global pandemic and go on to set new all-time highs in many sectors?

At Lakehouse we have a very disciplined process that focuses on identifying world class growth companies with strong fundamentals. We do this by looking for business models with enduring attributes, regardless of the short-term market and economic cycles. 

We refer to these models as ‘Fascinations', which we have grouped under three key areas: 

  1. Intellectual Property (IP): Companies with strong IP and brand
  2. Networks: Companies with strong network effects 
  3. Loyalty: Companies that demonstrate strong customer loyalty. 
Often companies we invest in will fit one or more of the business models.

When markets are volatile, we all need to remind ourselves of why we invest and in terms of uncertainty actually lean more heavily into the time-proven factors that deliver long-term outperformance. In essence, investors should seek to take advantage of volatility, rather than be a victim or be taken along for the ride. Provided the fundamentals of a company remain strong, such sell-offs often present an opportunity for those with a longer-term view to add to, or build, positions at lower valuations.

Network effects: what they are, and what they are not

A simple definition of a network effect would be that a product or service gains additional value with each additional user. 

It’s a good representation of the proverbial chicken or egg problem, making them hard to create but, in turn, also hard to dislodge. We think that companies that exhibit a network effect can create enduring and/or reinforcing advantages over the long term, fending off competition and prolonging periods of high returns on capital.

The most successful companies in the internet era have possessed strong network characteristics. In fact, a study by NFX in 2018 showed that approximately 70% of value created in strong technology companies is due to network effects. For the Lakehouse Networks Fascination, we primarily look at exchanges, social networks, marketplaces and payment networks.

Finding a company that exhibits strong, and growing, network effects is rare but the concept of ‘networks’ gets thrown around loosely. Our view is that virality and network effects are too often conflated by investors, especially when a network increases its value and reaches a tipping point to attract many more users. 

The main difference between virality and network effects is growth and defensibility. 

Virality is more of a growth tool wherein users can attract other users, like word of mouth or referrals, whereas network effects provide ongoing increasing value that strengthens a company’s customer retention position. Both can work together and a good example for this would be TikTok, a product that has viral growth and network effects.

A few examples of networks we are invested in

A good example of a company in the Lakehouse Global Growth Fund that exhibits strong network effects is Visa. The scale of Visa’s payment network is unrivalled: it connects 3.8 billion consumer cards with roughly 100 million merchants around the world. The more consumers that transact using a Visa card, the more valuable it is for merchants to accept. In the same way, the more merchants that accept Visa cards, the more valuable it is for consumers to have one.

Visa is one of only a few payment networks that have scaled globally, is more than 60 years old and is still one of the most dominant businesses globally today. This is possible because the company is an open platform that creates a shared incentive for companies that issue cards and companies that accept payments. 

The company processes 173 billion transactions annually which is worth approximately US$11 trillion. The company has an opportunity to displace US$18 trillion in consumer cash and cheque payments by consumers around the world and has recently expanded into other payment flows outside of consumer payments, which is roughly a US$185 trillion opportunity.

More recently, there have been some concerns about the company such as the potential disruption from crypto and buy-now-pay-later (BNPL) companies, plus a very public dispute with Amazon in the UK. 

In the company’s latest quarterly results in January 2022, Visa shared that it has more BNPL fintechs issuing Visa credentials and has partnered with 65 crypto platforms and exchanges.

The company has emphasised that these closed-loop networks are harder to scale and that they would eventually partner with Visa to gain access to the 100 million merchants on the Visa platform. Meanwhile, Amazon reported that it is in the process of negotiating a potential solution with Visa.

Another company we are invested in is MarketAxess. MarketAxess is a US founded company that operates a leading fixed income electronic trading platform that works with a total of 1877 institutional investment firms and dealers worldwide. Unlike the equity markets, the large majority of fixed income is traded through telephone calls between brokers. 

The platform handles an average of US$35 billion daily trading volume, bringing better price discovery and liquidity to opaque markets like corporate and municipal bonds. In these opaque markets, the network effect is that the incremental user gravitates to the most liquid platform, creating a positive feedback loop. Liquidity attracts liquidity, and further liquidity improves cost efficiencies for both buyers and sellers.

Currently, Eurobonds and US high-grade corporate bonds, the company’s most advanced markets in terms of electronification, are around 45% and 35% electronically traded, respectively. The opportunity for the company is to drive the market to full electronification of trading and with it, the benefit of an increase in volume as the friction to participate in these markets disappear.

The recent concerns about the business have been competition and lower market volatility. In regard to competitive concerns, we believe in the long run, the fixed income trading platform that will win will be the one that is the largest because it provides the most liquidity and price transparency for users. However, in the short to medium term, the main challenge is to displace the use of telephones and get the industry standard to be the use of electronic platforms. In regard to the market volatility concerns, MarketAxess has used this time of low volatility to build out value-added services outside of transactional fees on trades. As central banks start to taper off bond purchases and we move to a more normalised trading environment, we expect volumes and market share to continue to increase, similar to what we’ve seen in the past.

While we do not claim that companies with strong Network effects are immune to market conditions, or indeed that all companies with this trait are equal, we do feel it is a key attribute that is a marker for businesses that have the potential to outperform over the longer term. 

Conclusion

Like all investors, we feel the pain of short-term volatility. However, by relying on a disciplined process we aim to quieten those emotional, prehistoric urges and instead seek to take advantage of our knowledge to buy companies temporarily unloved but that Fascinate us with their long-term potential. 

Follow me for first access to my insights 

I am a Senior Investment Analyst at Lakehouse Capital and Deputy Portfolio Manager for the Lakehouse Small Companies Fund. I specialise in Lakehouse's Networks fascinations & if you would like first access to my insights this year and how best to approach the network effect in your portfolio hit the follow button below. 


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Lakehouse Global Growth Fund
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Erwin holds shares in Visa and also holds units in the Lakehouse Global Growth Funds which holds shares in Visa and MarketAxess. Disclaimer: Equity Trustees Limited (‘Equity Trustees’) ABN 46 004 031 298 | AFSL 240975, is the Responsible Entity for the Lakehouse Global Growth Fund and the Lakehouse Small Companies Fund (‘the Funds’). Equity Trustees is a subsidiary of EQT Holdings Limited ABN 22 607 797 615, a publicly listed company on the Australian Securities Exchange (ASX: EQT). The Investment Manager for the Funds is Lakehouse Capital Pty Ltd (‘Lakehouse’) ABN 30 614 957 603 | AFSL 526842. This publication has been prepared by Lakehouse to provide you with general information only. In preparing this publication, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Lakehouse, Equity Trustees nor any of their related parties, their employees or directors, provide any warranty of accuracy or reliability in relation to such information or accept any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statements before making a decision about whether to invest in these products. The Target Market Determination for both funds is available at www.lakehousecapital.com.au It describes who each financial product is likely to be appropriate for (i.e. the target market), and any conditions around how the products can be distributed to investors. It also describes the events or circumstances where the Target Market Determination for the financial product may need to be reviewed. Lakehouse, its directors, clients, employees, and affiliates, may, and likely do, hold units or securities in entities that are discussed in this presentation and ensuing question and answer sessions. Livewire gives readers access to information and educational content provided by financial services professionals and companies (”Livewire Contributors”). Livewire does not operate under an Australian financial services licence and relies on the exemption available under section 911A(2)(eb) of the Corporations Act 2001 (Cth) in respect of any advice given. Any advice on this site is general in nature and does not take into consideration your objectives, financial situation or needs. Before making a decision please consider these and any relevant Product Disclosure Statement. Livewire has commercial relationships with some Livewire Contributors.

Erwin Tan
Senior Investment Analyst & Deputy Portfolio Manager
Lakehouse Capital

Erwin Tan is a Senior Investment Analyst at Lakehouse Capital and Deputy Portfolio Manager for the Lakehouse Small Companies Fund. Erwin is the strategy captain for our networks fascination. Previously, Erwin was a Research Analyst at PAC Partners...

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