Network effects, especially indirect network effects, are usually associated with so-called two-sided markets or platforms.2 Although the formal study of these platforms dates back to the early 2000s, they, too, have been around for a long time. Understanding the characteristics of these platforms also helps us address questions about the FAANG companies and their competitive practices.
Two-sided markets bring together different types of customers and allow them to interact through an intermediary or a platform. The decisions of one type affect the decisions of the other type, usually through an externality, which could be related to usage or membership. One side of the market may care about usage, while the other side may care more about membership in the platform.
For instance, an online restaurant reservation platform has two types of customers: restaurants and diners. Restaurants care about usage. The more diners use the platform, the more valuable it is for the restaurant to make dining slots available through the platform. Diners care about membership. The more restaurants on the platform, the more valuable it is for diners to use the platform. The platform facilitates interactions between diners and restaurants such that the transaction costs of bypassing the platform are generally large enough that neither diners nor restaurants have an incentive to do so. The platform captures the benefit of bringing diners and restaurants together.
Two-sided platforms tend to have very different pricing structures for each side of the market. The lower price, which is often zero and can even be negative, will tend to be for the side more sensitive to changes in prices.
In the credit card industry, for instance, consumers are more price sensitive than merchants. The reason: consumers can generally choose their payment method in every transaction, but merchants have to commit in advance to be part of the network. As a result, consumers tend to pay low prices (annual fees)—or pay nothing—to be part of the network, while merchants tend to pay high prices (per-transaction fees as well as membership fees). In the case of users with a rewards card who do not incur financing charges, they actually get paid to be part of the network.
Similarly, search engine or social media users will usually pay nothing to use those networks (and load them up with personal pictures!), while advertisers provide much of the revenue for these platforms.
Thus, neither low prices nor high prices are evidence of monopoly power. In a two-sided market, pricing below (or above) marginal cost for one side of the market can be the steady state profit-maximizing strategy.
In sum, network effects and two-sided platforms are not particularly new or limited to tech companies. While they may have contributed to the success of the FAANG stocks, we believe they cannot be the sole explanation for that success.
Furthermore, to the extent that network effects imply a natural monopoly, innovation along with market contestability have consistently pushed prices down, expanded product choices, and broken up natural monopolies. Think of railroads in the early 20th century and the competition they faced from emerging technologies in the form of trucks, cars, and airplanes. As long as markets remain open for entry and innovation, this should continue to be the case, especially now that switching costs may not require building new large physical infrastructures.
Finally, because of their extraordinary performance over the past decade, most FAANG stocks are now among the largest stocks in the US market.3 Should we expect that strong performance to continue? While it is possible that those companies can exceed market expectations and deliver extraordinary returns over the next few years, we believe those returns would be unexpected and not in line with the long-term historical performance of mega cap stocks. Indeed, a recent Dimensional analysis shows that, from 1927 to 2019, the 10 largest US stocks barely outperformed the market on average in the three years after first joining the list of top 10 companies and underperformed in the five and 10 years after.4 And, because it remains impossible to consistently pick the handful of winners, we believe that a broadly diversified portfolio focused systematically on stocks with higher expected returns provides the best chance of investment success.