The Yacht Club Effect

Whenever I'm in Baltimore, my colleagues and I inevitably wind up at The Yacht Club.

The Yacht Club is no yacht club. It's a dingy little bar across the street from the world-renowned Peabody Conservatory of Music. Once inside The Yacht Club, we drink cold beer, throw peanut shells on the floor (at management's request), glance at the ubiquitous televisions, talk shop, and just hang out.

Why The Yacht Club? Why not somewhere else? The answer is in the question: because The Yacht Club is where everybody goes. If you ever watched an episode of the hit TV show, "Cheers," you know what I'm talking about. The characters around the bar at Cheers went there because that's where everyone went.

Now imagine that the The Yacht Club was the only bar in Baltimore. Instead of everybody in the neighborhood going there, everybody in the city would go there. As a result, its value as a place to go would be greatly enhanced. If you were looking for a member of the Baltimore bar scene, there's only one place you'd need to go to find them.

I can imagine that there would be one corner of The Mega-Yacht Club occupied by all the financial types, then one for the real estate people, then another for the lawyers, another for doctors. Within those groups, there'd be subgroups, and The Yacht Club would be the one place to go if you wanted to meet all the apartment owners in the city, or all the trauma nurses, or all the cops, or whatever. Millions and perhaps billions of dollars of business would be conducted there, informally.

Or like eBay. eBay is the place everybody goes on the Internet to buy and sell stuff. At this point, so many people go there, and its massive marketplace has become so large... that it's become the only place to go. There are other online auction sites, but who cares about them? Why would a buyer go elsewhere, when there are so many more sellers competing for his business on eBay? And why would a seller go elsewhere, when there are so many more buyers on eBay?It could become like Lloyd's coffee shop, which developed over a couple hundred years into an insurance underwriting marketplace with $21.6 billion of capital... or the informal gatherings under a certain buttonwood tree, which became the $21 trillion marketplace known today as the New York Stock Exchange.

The power of eBay as a business is absolutely unmistakable. It's identical to the reason my colleagues and I go to The Yacht Club. Everybody wants to go there because it's the place where everybody goes. That's it. That's why it's a no-brainer to predict that eBay's amazing growth will continue.

There's a term to describe the special attribute of a place everybody wants to go because everybody goes there. It's called the network effect. The network effect is one of the most durable business strategies ever created for locking out competition, creating a wide economic moat around a business.

The network effect's ability to crush competition is all over eBay's financials. The company makes 80% gross margins, 24% net. Approximately 30 cents of every dollar of eBay revenue flows through as excess cash that's not needed to maintain or grow the business. If you wonder how anyone can pay 62 times earnings for this stock and feel okay about it, now you know. A 30% free cash flow yield that's unlikely to go away anytime soon is a good thing. It reminds me of what Charlie Munger says about Berkshire Hathaway... that it's "drowning in money... pounding out money."

Last year, I recommended that my readers buy shares of The Advisory Board Company. I said its subscriber-based business model gave it a network effect, just like eBay. Since we recommended Advisory Board, the stock has risen about 24%. It's trading at around 43 times earnings. While that sounds like an astronomical price, it's not. I believe the fair value of its future cash flows is more than $60 per share. That's based on rather conservative assumptions. It's quite possible the stock is really worth $65 or more.

Last month, I recommended another network effect company to readers ofExtreme Value. This time, it's a name like eBay, one you'll recognize immediately. The company has been around for more than 150 years, and when you think of its service, you think of this name before any other. The stock was up 5% this week, but it's still below my maximum suggested buy price.