Outline:
- Wide economic moats have allowed tech firms powerful political prowess;
- Network effects are likely to entrench these businesses further;
- Regulators generally operate on the assumption that profits should not exceed the level a competitive market would allow.
Most mornings, I wake up, reach for my phone and immediately start scrolling. I flick through a stack of apps. Before I’ve started my day, I’ve used five services powered by technology. All within five seconds of waking up. And I know I’m not the only one.
Technology has become like plumbing. We barely notice it’s there, until it’s gone. And the parallels don’t stop there. One thing we’ve been thinking about at Spaceship is how the regulators are approaching big tech companies like Alphabet, Amazon and Facebook. As well as how that will affect our technology investments.
Facebook and Google are engrained in our lives, like electricity and clean water, and that has some regulators worried. Google’s dominance in search and Facebook’s in social media give them huge economic moats and political prowess.
If we look at the combined market capitalisation of the world’s largest technology companies - Alphabet, Amazon, Facebook, Apple and Microsoft - it’s around $US3.6 trillion, with Apple clocking in at $1 trillion in August.To put that $3.6 trillion into perspective, Australia’s gross domestic product, a measure of all goods and services produced in a year, was less than half of that in 2017. Just $US1.323 trillion.
Even when we combine Australia and Canada’s $US1.98 trillion, we don’t get there. Not even India, with 1.324 billion people–about one out of every seven people on earth–manages to eclipse big tech’s combined market cap. I find it pretty amazing that we have these businesses that can not be purchased by an entire country's output in a single year! Some regulators think that these companies are as powerful as companies like the East India Company and Standard Oil.
But the dichotomy between technology companies and established players is in the fact that technology inherently improves with scale. Or at least a lot of the largest ones do. Technology companies often have strong network effects, and the best ones become platforms.
I’ll try unpack that last sentence a little.
Network effects.
Network effects are one of the most important concepts to many tech businesses, especially software businesses. Understanding network effects not only helps build great products, but it helps us find great technology investments that we believe will build moats and protect themselves against competitors eating away their profit margins.
If you want to dive deeper, I recommend this SlideShare from Andreessen Horowitz.
As well as this interview with Anu Hariharan a Partner at Y Combinator.
At its simplest form, a network effect is when a product or service becomes more valuable to you as more people use it. Economists might call this 'network externalities' or 'demand-side economies of scale'. I think network effect is the best, so let’s stick with it.
For a simple example of network effect, think of Facebook. The value of the product to the user is pretty low if nobody else is using it, however as you add more people (friends) to the network of users, the value of Facebook as a product increases. It also makes it harder for the user to switch away from Facebook to another competitor, if their friends are not switching too.
We think your wealth can grow even more significantly if we invest it in companies that benefit from network effects. By creating barriers to exit for existing users and barriers to entry for new companies, network effect businesses’ moats get stronger with more users. And the inherent user experience for the end consumer improves, too.
This can lead to winner-take-all or winner-take-most markets.
Metcalfe’s Law says the value of a network is proportional to square of the number of connected users. Facebook is probably the best example of Metcalfe’s Law at the moment.
What this graph is showing is that as the number of peer-to-peer connections grow, you adding your friends, the revenue grows in a nonlinear fashion.
This can become even more extreme in cases like Apple, where the network becomes a platform. Again, let’s unpack that a little bit.
A platform is a network of users and developers. The platform with the most users, attracts the most developers, which attracts even more users, and so on. This creates a flywheel effect that increases the value for each group. Let’s look at the iPhone and the App Store.
The more people who own an iPhone, the more developers want to write apps for the platform, which attract more users, and so on. Not only does Apple make money from sales of the iPhone, they also take their cut from every sale on the App Store. And by owning where the majority of customers are, developers have no choice but to continue to develop iOS apps.
In the past, to own a market, you had to own distribution. It was expensive to get things into the hands of a consumer. Today, the Internet has effectively cut the distribution cost to zero, at least for software.
I recommend you dive deeper on this idea with Stratechery's Ben Thompson.
Now, the best businesses are built on the back of giving users the best possible experience. Take Google and Facebook. Google is able to sell highly effective advertising, which drives the majority of its profits, because they know exactly what you’re searching for.
Why do you use Google? Because it’s the best place to find what you need. The search results are the best. Facebook is the best place to connect with your friends and the News Feed is perfectly tuned for you, and that means Facebook is able to sell highly effective advertising at scale.
As a side note, Facebook may have created the best ad unit of all time with their newsfeed ad on mobile. It takes up your whole screen but you barely even notice it. Crazy…
Regulators
And these wonderful technology companies only get better at this as they acquire more users. But given the winner-take-all dynamic of most of these businesses, regulators are getting worried. They don’t want another Standard Oil.
We use these companies like we use utilities, all the time. They’re absolutely central to our lives. So, given their dominance, should we regulate them like utilities? The idea of regulating monopolies, which I’m not saying these businesses are, is that profits should not exceed what the level a competitive market would allow. Or in simple terms, Facebook shouldn’t be able to make more money than it would make with a lot of competitors.
This means that businesses must run efficiently and keep costs low. One way to achieve this may be to unbundle these technology companies. The question is, would users benefit from an unbundling? If we assume that their network effects are real, maybe not.
The key thing to think about is the incentive structures of these big tech businesses. They own the relationship with you, the end user, because their service is better than anywhere else. You’re not locked into any contract with Google, Facebook or Apple. You choose to continue to use them because they’re better. So they’re incentivised to continue to improve or lose their top spot to someone else.
It’s hard to argue that these big tech companies are abusing their power when you look at Amazon which is lowering prices to consumers as they scale, rather than raising them. Sure, Amazon could take the entire market and then raise prices. But I don’t think they will, they’re incentivized to keep the consumer happy, because no matter how big Amazon gets, there will be somewhere else to shop. Technology might feel like a utility but we shouldn’t treat it like one.
Historically, utilities don't innovate quickly, and old infrastructure is becoming problematic, see below.
Compare that to technology. Technology changes so quickly, what is at the top today, may be gone tomorrow. When Microsoft began its antitrust battle with the United States on May 18, 1998, Amazon was just a year out of its IPO. Google would be founded a few months later and Mark Zuckerberg was 14 years old. Whatever the regulators do, in the end, the incentives and feedback loops that come from the consumer will win.
At Spaceship, we think we should invest where the world is going, not where it’s been. That means investing globally, not just in Australian equities that only make up 2.7% of the world’s investments.
The moats that these top companies have built make them some of the most valuable companies in the world. We don’t see many Australian businesses that are operating at the scale of Google or Facebook, nor ones that have the powerful inbuilt network effects that great technology companies often have.
Building networks is hard, they often require businesses to hit a critical mass of users before network effects occur. The only way to achieve the scale of Amazon is to build great products for consumers to make sure they come back again, and again.
Often that means focusing on engagement and not just growth. Think about Facebook, they started at Harvard before moving out to other colleges, only when colleges were happy, did Zuckerberg expand further. Network effect businesses rely on creating great experiences for the end consumer.
Without that, the network never grows. After scaling up, that often means looking globally. That’s why at Spaceship, we think your wealth can grow even more significantly if we invest it in the world’s top companies.
By writing about our investments and how we are thinking about the market, we want to help make super accessible and approachable. We hope this post will help you understand a little bit more about technology companies and how they are affecting your investments.
