Wednesday, December 6, 2017

Investment Moat - The Network of Users

Investment Moat - The Network of Users

Many people say that the buy-and-hold strategy does not work in today's short life cycle business world. Yes, I agree that the world has advanced so much, largely driven by advancement and better use of technologies, to disrupt existing business model so old business get replaced more rapidly. However, I do not agree that buy-and-hold strategy does not work. All you need to do is to find the right company with long term growth prospect.

Of course in real world, it's easier say than done. Most investors (myself included) failed to hold on to high quality stock for long term. There are all sorts of reasons why we are scared of stock price consolidation and get out prematurely but I like to conclude that in most cases, it's our lacking of faith or trust in current high valuation of the company. So the key question to us can be concluded in one word: "faith". We are, however, not talking about religious believe. Instead of "faith" in the management, I rather put my faith in the right business model.

We all know that over time as revenue and profit grow, stock price will follow. To buy and hold for long term means that you have faith or strong believe in the company's marketshare, revenue or profit growth over long term better against their competitors. I believe that "Network Effect" is one of the best business models for long term investment.

Value of A Network = (Number of Users)2

Network Effect means that the more customers the company acquire, the more value it has. According to Metcalfe's law, the value of a telecommunications network is proportional to the square of the number of connected users of the system (n)2. For example, in a social media network, the value of the network will be roughly equal to the square of the number of users.  Social network like Facebook fits this scenario. Some of the key metrics to evaluate Facebook is the number of users growth and monthly active users. If the company is able to monetise from the network user base (as in Facebook) or the market has faith that company will be able to monetise from the network user base, the investment market will assign a bigger price tags to these stocks.  There are plenty of examples here: Facebook ($FB), Tencent ($TCEHY), Alibaba($BABA) and Amazon ($AMZN) to name a few successful one (in terms of earning and stock price). There are certain questionable ones such as Twitter ($TWTR) and Snap ($SNAP) both see slow down in user growth, monthly active user growth or not able to monetise from the network.

The key point about Network Effect is that the business model will growth exponentially over time (of successful operation with good progress). If a company is able to grow the number of users to a critical point, the operation can withstand a long time even with not so great management execution (over short period of time of course). Therefore it is one of the key themes I would like to invest in: the "Network of Users". I like to further emphasise that it is the "Network of Users" and not just "Users base". The business model is based on number of users connecting and interacting. So if a company's products are used by users in separation, it's just a linear growth of the value from user base but not an exponential growth. It is still good result but not as powerful as a business model that encourage users to interact with each other. Other not so good examples of simple user bases are Master Card ($MA), Visa ($V) and Paypal ($PYPL). These are good companies with growing user base. Their moat will grow as their number of users increase. However, these users do not interact with each other. Therefore it's not a business model "network of users". Please do get me wrong that I do like Master Card and Visa and I do hold them. However, as far as potential growth concern, I do not think that they will match stocks like Facebook and Tencent.

If you trust these companies benefiting from strong network effect, then in time of consolidation or sell off (such as from last week), you will have stronger confident in holding on to the stocks.