You’ve certainly heard of the Magnificent Seven and Big Tech. You’re probably tired by now of seeing news about AI and the cloud. These technology businesses are all around us, building highly valuable platforms that have captured the imagination of a generation of investors.
But therein lies a word that deserves more attention: platforms. What exactly is a platform business?
You could google it as an archaic approach, or you could pick your AI assistant of choice and ask it what a platform is, while using this as an opportunity to remember that even Google (a business that became a verb) isn’t immune to disruption. If there’s one thing platform businesses are good at, it’s disrupting things.
The AI assistant will likely give you an answer about platforms that includes the usual concepts such as network effects, scalability and multisided markets. Simply, a platform business creates value by sitting between two or more groups of people (for example, buyers and sellers, or content creators and content consumers). The platform becomes exponentially more valuable as more users join on both sides of the market. There are plenty of examples out there, including the likes of Uber and Airbnb, or even Apple’s App Store.
It’s all very interesting and well worth digging into in detail as you research the market, but how do the economics really work and why should you care as an investor?
The former takes longer to answer than the latter. That’s because the “why bother?” question can be answered by charting the US equity market against the market just about anywhere else. The best way to remove the distortion of emerging vs developed markets is to compare the US market with Europe, where innovative technology stocks are about as rare as an affordable meal on the French Riviera.
If you had invested similar amounts in the S&P 500 and STOXX Europe 600 in 2007 before Wall Street blew up the global economy, you would be more than three times better off in the US right now.
To see the impact of the technology sector, we should ideally use the Nasdaq-100 — which performed almost seven times better than Europe over that period. That’s the kind of stuff that creates generational wealth.
We know hindsight is perfect and we especially know that past performance isn’t a guarantee of future returns. Still, it feels like ignoring platform businesses would be foolish. Even if you aren’t prepared to pay high valuation multiples for them, there’s a good chance a platform business could disrupt the “cheap” stocks that you hold — a reminder that often things are cheap for a reason.
Even in sectors that seem boring and old-fashioned, the impact of platforms is being felt, with deep investment in AI and data. The way that companies go to market is changing. Everything is changing
And even in sectors that seem boring and old-fashioned, the impact of platforms is being felt, with deep investment in AI and data. The way that companies go to market is changing. Everything is changing.
Guess what? If you have only a passing interest in the markets and you hold a Top 40 ETF, or if your pension is heavily exposed to the JSE Top 40 (which it probably is), then platform businesses are part of your portfolio. In aggregate, Naspers and Prosus (our best local example of a platform business model) contribute about 19% of a Top 40 ETF. The global nature of our local index means that these “exotic” international business concepts are far closer to home than you think.
Great, so platforms matter — but how do their economics work?In understanding the economics of a platform business, we need to focus on a particular letter of the alphabet: J. You see, the J-curve is what dictates so much about valuations and capital allocation in the technology sector.
The beauty of the term “J-curve” is that it does what it says on the tin. You simply need to keep the image of that letter J in your mind, with an initial curve downwards and then a vertical climb. This is exactly how platform economics work, as it’s very costly to build the technology and establish a user base (this is the initial downward curve that represents cash burn).
But if they survive the initial dive, then the future can be vertical for these companies in terms of revenue, profits and cash flow. It’s not uncommon to see a platform business double its profits (or better) every year, as incremental revenue tends to have a high contribution margin once a platform has been built.
Put simply, it doesn’t cost Netflix much per additional user on the platform. The 300-millionth user is paying the same amount a month as the first user. But the cost to serve each user plummets as the number of users increases, as Netflix has to spend vast amounts on content regardless of how many users it has (otherwise it won’t have any users at all). This means profitability gathers pace as more users sign up.
This leads to other terms that regularly come up when discussing platforms businesses: winner-takes-most and even winner-takes-all economics. This situation describes a sector in which the market leaders make an absolute fortune and the long tail of competitors struggle for survival, drowning in the ugly part of the J-curve. The music industry is a perfect example of this — just consider what Taylor Swift earns vs local bands.
Practically any platform business you look at is somewhere on the J-curve journey. Some business models are much further along the curve than others, such as social media players that were in their loss-making phase a decade ago. AI start-ups are deep in the trenches of the J, burning cash and attracting investments from the companies that were in a similar position in the previous era of technology growth: social media and software-as-a-service. Today’s winners are incubating tomorrow’s winners, which is exactly why platform businesses shouldn’t be ignored.
Additional food for thought: are modern accounting rules actually capturing the value of platform businesses correctly? Most of the spend on people and software development tends to either be expensed immediately or written off over a short period, unlike in traditional business models that build substantial fixed assets and then depreciate them over many years. This creates a far nastier income statement in the technology sector than in traditional sectors, possibly to the detriment of investors who struggle to see the actual value being created along the way.
What does this mean for investors? The risks and opportunities of the J-curve form the foundation of the entire venture capital industry. Venture capitalists take bets on many different companies as they enter the initial curve. Predicting which ones will emerge into the vertical section is extremely difficult, hence the need to spread the risk by having a portfolio of many start-ups rather than concentrated positions in only a few. By the time companies come to the public market, they are typically on the cusp of emerging from the nasty section of the J-curve — the area where the last thing you want to be doing is “building in public”, as the losses can be so severe.
The public markets are a great source of growth capital for that final push through the cash-burn phase. Of course, they are also a helpful source of exit capital for the venture capitalists who rode through the worst of the J-curve and are ready to move on. And, sometimes, they are a place where management teams behave like venture capitalists, allocating capital to high-risk early-stage initiatives that have a long road to travel.
This is where the Naspers-Prosus stable was a few years ago, except they were taking the risky bets at a time when valuations were elevated across the sector. The nature of a J-curve is that the serious profits will only be made at a distant point in the future, hence the valuation is derived primarily from belief rather than demonstrable cash flows. This makes these valuations particularly vulnerable to hype and sentiment, creating a dangerous situation for capital allocators who pile into the market when valuations are too high.
As you read the current updates from Naspers-Prosus, keep the J-curve in mind. The narrative has shifted to one of profitability and more careful capital allocation, rather than throwing money at the wall and seeing where it sticks. This is the approach of the new management team and it seems to be the right one.
Though the approach during the pandemic was too fast and loose for my liking, it’s also true that the portfolio currently being optimised wouldn’t exist if it wasn’t for the rapid capital deployment strategy that was followed a few years ago.
I’m just glad I timed my entry into Naspers-Prosus in such a way that I’m participating in the part of the J-curve that I like: the vertical climb. The optimal entry point is when the market has lost patience with the story and pushed the share price lower, despite mounting evidence that the worst of the J-curve is over.
The darkest hour is just before dawn when it comes to platform businesses. By focusing only on trailing multiples and the prior year’s numbers, investors stare straight into the darkness instead of looking up towards the light.
Believing in the future is both brave and necessary for those who want to experience the rewards of the J-curve.
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