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EXCELLENCE IN INVESTMENT MANAGEMENT
THE NETWORK EFFECT
An Exceptional Competitive Advantage
At Madison one of the key corporate
qualities we seek when purchasing and
holding common stock is a sustainable
competitive advantage. This could be an
innovative product protected by ironclad
copyrights, the power of a well-loved
brand, or an established and expensive
infrastructure that keeps competition at bay.
We’ve found a less traditional competitive
edge in many modern firms and in
companies that we admire and hold. This
comes from what has become known as
the “network effect.” What is a network
effect? A network effect occurs when
the value of a product to one user is
dependent upon how many other users of
the product there are.
Think about something as common and
widely used as email. The first users of
email were scientists sharing time on a
large, expensive and solitary mainframe
computer. They used electronic mail to
leave notes to their fellows. But without
any connectivity, the notes were of
extremely limited use. They couldn’t send
messages to other computer scientists in
other locales, let alone best wishes to their
far-flung friends and family or order up
lunch at the local deli.
The first desktop computers were not
linked to each other either. Eventually
telephone modems were added to
computers which allowed users to
visit electronic bulletin boards to post
messages. But no person-to-person
communiques were available. Only when
computers began to be interconnected
via the World Wide Web did email begin
to take off. As more and more people
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purchased home computers with web
access (more users joining the network),
the more valuable email became.
In commercial applications, this effect
explains why there are usually only one or
two major competitors in industries where
businesses benefit from a network effect,
as the natural development is for the
strongest network(s) to squeeze out the
smaller networks. This “winner-take-all”
dynamic combined
with the fact that each additional user in
the network usually comes with a high level
of profitability means that as companies
grow their networks they are capable of
earning substantial levels of profitability.
Given the attractiveness of obtaining a
strong network effect from a business
model perspective, a natural question
is how this can be achieved. A crucial
aspect is being the first mover. Since the
key in creating a strong network effect is
reaching a critical mass of users such that
your network creates the most valuable
product, first movers have a head start in
reaching this point. However, this must
be achieved while ensuring your product
remains relevant and in tune with the
users’ needs.
The Value of Network Effects
Network effects matter because they
protect businesses by locking out
competition. A business model that
generates high profitability attracts the
attention of entrepreneurs and other
businesses that may want to try to replicate
the model and also enjoy high profits.
However, a strong network effect makes
it extremely difficult for competitors to
gain customers. Armed with the strongest
value proposition to offer both current and
potential customers, the company with a
strong network effect
is able to fend off competition and
maintain its high profitability for many
years, which is the key to creating longterm shareholder value.
Let’s take a look at some companies
which have exemplified different
forms of the network effect.
Visa — Visa’s network includes 1.9
billion credit cards and around 30
million merchants who accept them. As
more merchants accept Visa, the card
becomes more valuable to the cardholder;
additionally, the more cardholders there
are, the more a merchant is incentivized
to accept Visa. This snowballing effect
has allowed Visa to grow its network of
cardholders to become almost twice as
large and the number two competitor,
MasterCard, while allowing Visa to
historically produce high returns on capital
and admirable profits.
Microsoft — Benefitting for a first mover
advantage, Microsoft’s network of
Windows users exceeds 90% of desktop
computers globally. Since consumers
and businesses desire a common
operating platform to ensure familiarity
and compatibility, the more Windows
users there are the more valuable using
the platform is to everyone else. Similar
network effect dynamics are at play with
Microsoft’s Office product, which has also
grown to more than 90% market share.
Having strong network effects with its key
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products has historically driven Microsoft
to consistently high levels of profitability.
Copart — Copart operates an auction
primarily for salvaged vehicles (i.e. cars
that have been deemed a total loss for
insurance purposes). Copart’s network is
comprised of sellers (insurance companies)
of vehicles and buyers (vehicle dismantlers)
of vehicles. As more vehicle dismantlers
bid at Copart auctions the auctions
become more valuable for insurance
companies, and as more insurance
companies sell their vehicles via the
auction, the more attractive it is for vehicle
dismantlers to participate. Copart’s large
network of buyers and sellers have driven
the company’s market share up close to
40% and has allowed the company to
historically earn consistently high returns
on capital.
Conclusion
Fundamental to a strong network effect is
a product that increases in value as more
and more people consume the product.
A business with products or services that
fit this description effectively locks out
competitors from the market which helps
protect the business’s economic returns
and profitability for sustained periods of
time. From our investment standpoint
the implications of this are incredibly
important. Companies with sustainably
high returns which can compound their
values nicely over the long term are the
types of companies we can gain high
conviction in and are less likely to incur
permanent value impairment. These
attributes are perfectly in sync with our
philosophy of investing for the long term
in a concentrated set of companies with
superior risk profiles.
The securities identified above are for
illustrative purposes only and there is no
representation that any one or more are
held in any Madison Fund portfolio at any
given time. Nothing contained herein is
intended to be a recommendation to buy
or sell any security.
This piece must be accompanied or preceded by a current Madison Funds prospectus or summary prospectus. Please consider
the investment objectives, risks, charges and expenses of any Madison Fund carefully before investing. Call 1-800-877-6089 for an
additional copy of the prospectus or summary prospectus which contains this and other information and read it carefully before
investing. Madison Funds are distributed by MFD Distributor, LLC. December 23, 2013.