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Since the previous decade’s stock market peak in 2007, a group of 30 listed companies delivered a cumulative shareholder return in euro of about 1200%. That twelvefold increase is an outperformance of almost 1100% compared to the MSCI World Index. This outsized return was realized despite the untimely starting point, just one year before the stock market crash of 2008. Over the past year they delivered an average return in euro of 27%, compared to the market’s 5% return. These ‘Super 30’ are large, well-known companies that share one particular characteristic: they all have strong network effects. A network effect is present when the value of a product or service becomes more valuable to an individual as the total number of its users increases.
Like it or not
If none of your friends are on Facebook, it wouldn’t be much fun. With 10 friends, things start to get interesting. With all of your acquaintances on Facebook, it becomes a must have, as portrayed in David Fincher’s critically acclaimed movie ‘The social network’. So the first companies on the super 30 list are companies that own some of the world’s leading social networks: Facebook, Tencent (owner of China’s leading social networks WeChat and QQ) and Microsoft (LinkedIn).
More is more
Amazon’s founder Jeff Bezos supposedly sketched the company’s powerful network effect on a napkin more than 15 years ago: more customer traffic on its online market place attracts more sellers, more sellers lead to better selection, better selection improves the customer experience and better customer experience, again, boosts traffic. This growth enables cost savings that can be reinvested in lower prices – and later in faster delivery and content -, which further improve the customer experience. Amazon currently accounts for almost half of all US ecommerce sales, according to eMarketer. So next on the super 30 list are companies that own some of the world’s leading online market places: Amazon, Alibaba (China’s leading marketplaces Taobao and Tmall), MercadoLibre (Latin America’s leading online market place), Google (world leading online advertising platform DoubleClick), Apple (app store) and Rightmove (UK’s no. 1 property portal).
Netflix’s stock price more than doubled over the past year as its memberships count grew by 26 million to 125 million. Its soaring member base enables Netflix to ramp up massive investments in content to the tune of USD 8 billion in 2018. The streaming service will have 700 original TV shows on air and release 80 original movies this year. More subscribers enable larger content investments attracting more subscribers. Meanwhile, Facebook and Google, who mainly rely on free or user generated content, earn about half of digital advertising spent worldwide. If content is king, then free content is god? Online gaming and e-sports have strengthened the network effects of gaming producers, such as Activision Blizzard and Electronic Arts.
Before going into the rest of the super 30, let’s have a quick look at some of their financial characteristics. A good business has three key attributes: high profitability, strong growth and a winning business model. A winning business model can come in a variety of ways, but without a competitive advantage the high profitability will be competed away. We know the super 30 are protected by powerful network effects. Try building the next Facebook. But how do they score in terms of historic profitability and growth? Their return on equity averages almost 30%, close to triple the market’s profitability. Over 2007-2017, their compounded growth in earnings per share averaged 25% per year, about four times the market’s growth rate. Over that period, the super 30 delivered an average shareholder return of 27% per year, more than three times that of the market. If you are a long-term investor, the rate of return on capital that the company generates, and its ability to reinvest at that rate of return in the future, is the main driver of your return, not the change in the valuation premium you buy or sell the company on.
The right valuation premium
The super 30 are currently valued at an expected 2018 price-to-earnings ratio of 37 times. That ratio drops to 26 times, excluding Amazon, Netflix and MercadoLibre, which are re-investing all of their cash back into growth. That still is a large premium to the MSCI World Index’s price-toearnings ratio of 16 times. However, the price-to-earnings ratio does not take into account balance sheet strength or the level of investments needed for growth. The super 30 score very well on both fronts: they have almost no debt on their balance sheet and they don’t need to invest a lot to grow their earnings, because their return on invested capital is so high. A valuation metric that better accounts for these characteristics is the free cash flow to enterprise value yield, which for the super 30 is on average 3.7%, much closer to the market’s average.
Being in the middle is great
Visa and Mastercard are so entrenched in the payment system that even a well-funded potential disruptor like Apple chooses to rely on their infrastructure for its ApplePay service. PayPal was originally set up to circumvent interchange fees charged on payment transactions, but now partners with Visa and Mastercard.
Amadeus connects hundreds of airlines with thousands of travel agencies. Contrary to its fragmented nature offline, the online travel agency market is much more concentrated. Online travel agencies benefit from strong network effects, such as Booking Holdings, which has around 400,000 hotel properties on its website. The dominance of online travel agencies is driving independent hotel owners into the franchise networks of the largest hotel groups, such as Intercontinental Hotels Group and Marriott, which have more negotiating power with the online travel agencies and much more direct bookings by loyalty members.
Networks are hard to create, but Intuit is likely to succeed with its launch of Turbotax Live, a software platform where US consumers can connect with tax professionals to help them file their taxes.
The expert’s helping hand
Many surgeons are building their careers on proficiency with Intuitive Surgical’s robotics systems for assisting minimally invasive surgery. Its installed base of about 4000 robotic systems creates an ever-growing clinical database. To amass such a body of data, new competitors have to convince enough hospitals to purchase or trial their robotic systems for an extensive period, train surgeons and recruit patients.
Adobe and Dassault Systèmes are supported by millions of users that learned to be skilled in their software programs, often from an early age, which creates a network of employees and employers that prefer to use their products.
Credit rating agencies like S&P Global and Moody’s are a good example of the chicken and egg problem faced by competitors of network effect companies: corporate bond issuers only want to pay for ratings from credit rating agencies that bond investors will rely upon, but new credit rating agencies can’t gain credibility, until they are hired by corporate management teams.
Stock market indices with “benchmark” status also benefit from powerful network effects. It is no coincidence that MSCI and S&P Dow Jones – owned by S&P Global – account for about half of the index market as measured by ETF assets under management.
Insurance broker Marsh & McLennan is an intermediary between many companies and insurers. And it needs little explanation that financial exchanges, like London Stock Exchange and B3 (Brazil’s stock exchange), are at the heart, network-based businesses.
Even banks can have network effects: Bank Central Asia’s low funding costs can be partly attributed to the fact that most Indonesian small and mid-sized enterprises (SME’s) have a BCA account, because they can make free payments to other SME’s who also have a BCA account.
With power comes responsibility
Environmental, social and governance concerns for the super 30 centre around data privacy, dominant market positions and taxes. Data privacy recently was in the spotlight in the wake of revelations of Facebook’s massive data leak to Cambridge Analytica. In Europe the General Data Protection Regulation is coming into effect on the 25th of May 2018. China is taking a different approach: in 2020 it plans to launch a Social Credit System that uses big data to rate the trustworthiness of its citizens. Network effects can create and sustain dominant market positions, raising the rightful question of abuse of power and appropriate regulation. Answers are complex and not within the scope of this article, but to sum it up our global sustainable funds are invested in an important number of the super 30, because we believe that they generally offer great customer value propositions, while few networks are natural monopolies that are insulated from competitive threats. For instance, Amazon was ranked no. 1 in the American Customer Satisfaction Index for the last 8th years in a row. We are enthusiastic users of Netflix, which we see as having strong untapped pricing power. We view the payment networks as quite lean and efficient, while it is the banks that take the biggest share of payment fees. While Marsh & McLennan is operating in a fragmented market, Intuit is even competing with free software.
Picking the right horses matters
In his paper ‘Do stocks outperform treasury bills?’, published in 2017, Professor Hendrik Bessembinder of Arizona State University concludes that the entire gain in the U.S. stock market since 1926 is attributable to the best-performing four percent of listed stocks. Even more remarkable, less than one third of one percent of all companies accounted for half of all the wealth generated for investors. Over the past two decades companies with strong network effects have undoubtedly been part of the few star stock market performers.