Consider for a moment the market darlings of the online realm – Webjet, Seek, Carsales, realestate.com.au, Wotif and even Fairfax’s Stayz website. It is remarkable to think that these companies have achieved considerable growth year on year, when effectively their core product is something that has no tangible value. In essence, these companies are lists: lists of flights, lists of jobs, lists of houses. How is it that these seemingly simple items – classifieds – can possess billions of dollars in value?

These companies have successfully developed and exploited what is referred to as the ‘network effect’ – an oft-mentioned concept by Montgomery Investment Management, but one that we haven’t really delved into despite its considerable ability to create long-term value for a company. So let me explain the network effect in the context of the above businesses.

Word of mouth

The network effect is the effect that one’s use of a good or service has on its value to other users. Lists tend to have a positive feedback loop – the more users a site attracts, the more others will want to use it. In the case of some of the above businesses, the more customers view the site, the more suppliers want to list their products. The more products listed by suppliers, the more customers view the site and so on.

Real value from the network effect comes when critical mass is achieved, which is when there are so many users of a service that the value of adopting the product outweighs the price of adoption. The websites effectively become natural monopolies with an exponential number of user connections. To illustrate, just consider how you would sell your car, or book accommodation for a holiday, or look up properties or a holiday house – the above websites have become THE places to list classifieds.

The network effect has a tendency to ‘lock-in’ users as switching costs increase overtime. This phenomenon is evident with Webjet’s repeated attempts to list hotel bookings on its core website. Webjet is the market leader when it comes to searching and booking flights online in Australia – it therefore seems like a logical business model to provide customers with online hotel rooms to complement flight bookings. The remarkable thing is that users have been very hesitant to adopt this behaviour.

Customer loyalty

Webjet was expecting that 70% of people would book hotels as a result of cross-purchases with flight bookings, while the remaining 30% would book hotels on a stand-alone basis. It turns out that the reverse of this is actually happening. Management have acknowledged that Wotif has cemented itself in the hotel bookings market, and Webjet is finding it increasingly difficult to shake people’s mindset that Wotif is the only place to go in order to book a room (as an aside, can you imagine how powerful Wotif and Webjet would be if they merged?).

Companies that can achieve network effect critical mass have the ability to generate significant, sustainable profitability and profit growth. As an example, REA Group –which among its services runs the website realestate.com.au – was many years ago seen as mature and yet it just announced profit growth of 24.5% for the 2013 half year. The company is a cash-generating machine, with one of the most amazing balance sheets you’ll ever see – cash comprises 76% of the company’s equity. In addition, the company has sustained a return on equity above 35% since 2008.

It is because of these stellar returns that companies will do whatever it takes to drive user growth in their early years, but they must be careful to not sacrifice brand value in the process. Once it becomes too costly for users to stop using their services, companies can then increase prices without fear of ceding market share. For instance, Carsales recently increased the fees for leads it provides to its automotive dealers. The price was increased from $35 to $40 per enquiry – that’s $5 of extra cash for every enquiry that will flow directly to the company’s bottom line.

Opportunities continue offshore

Ultimately, however, markets mature and in Australia that point is reached much faster than similar companies might experience in the US for example. Companies that become natural monopolies can find it difficult to sustain growth domestically, but the beauty of the network effect is that it endows a company with cash flow that can support offshore endeavours. Seek has a particular focus on overseas expansion given that its domestic website now accounts for 70% of ads, visits and total time in the online job advertisements market. Seek has recently agreed to increase its controlling stake in China’s second largest employment website to 79%.

Ultimately, just because these ‘listed’ companies are able to achieve positive network effects, doesn’t mean that valuation fundamentals should be ignored. Despite REA Group having stellar growth, a fortress-like balance sheet and amazing prospects, it is our opinion that its share price is still above its intrinsic value. We do believe however that these sites are terrific businesses and should be an essential addition on any investment watch list.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.