Investing With Network Neutrality
/Market structure is one of the most important parts of understanding a company’s competitive position. And sometimes market structure is influenced by government policy. Network Neutrality (NN) is one policy that has had a major impact on every Internet company—and every company that has a website.
I first wrote about Network Neutrality 12 years ago as part of my Master’s program in economics.[1] At the time, I expected the topic to only be relevant for a few years, but I have been surprised. Although the topic came back again this year after the FCC voted to restore NN standards, it has actually remained relevant since I first wrote about it, and should continue to be relevant for many more years.[2] Understanding how this system works can be helpful for looking at how different companies compete.
A Quick Review
The simple summary of NN rules is that all Internet data should be treated equally. An Internet Service Provider (ISP or Network Provider), such as Comcast or Verizon, cannot decide that some websites are more important than others, and cannot dictate how their customers use the Internet by blocking or slowing connections to specific services. Effectively, it treats the Internet as a platform for businesses (or individuals) to create whatever they want online without an ISP choosing which websites are more successful than others.
NN rules are much older than you might imagine—they are a direct descendent of the “common carrier” rules that were created for railroads about 150 years ago. Similar rules have been applied to electric utilities and telephone networks. This extended naturally to the Internet, where the Telecommunications Act of 1996 enabled the FCC to regulate Internet connections. The FCC chose to enforce NN rules.
What these markets have in common is that they have businesses controlling access to the entire network, whether that be a railroad shipping cargo or an ISP connecting to the Internet. In many cases, there is (or was) only one real option. For the Internet specifically, we end up with a two-sided market, with individual users on one side and websites or services on the other. We also end up with a network effect, where the value of the network increases with more content and more users.
With NN in place, ISPs are limited on what they can do with their networks. They can provide the connection to the network, but they can’t extract any extra value from it. This leaves a wide open field for content providers to make the network more valuable, attracting more users.
What This Means for Investors
As investors, we don’t really care to argue about what should happen with NN. That’s for the FCC, or congress, or the courts to decide.[3] What matters is the effects on the markets that we care about and how this can help us understand similar markets.
The beneficiaries have become some of the largest companies in the world: Amazon, Google, Netflix, Facebook, and others. Without NN, these companies may have been required to sell a piece to the ISPs in exchange for access to the network (or some other form of extra payment). And they may not have been as successful. On the other hand, a total repeal of NN would make the winners even more powerful—they can afford extra fees that smaller businesses would be unable to pay.
If I put this in the terms of where to make bets, it’s another division between hardware and software. In this case, the hardware side is the ISPs that own the connections to the network, and the software side is the Internet companies. My view on this difference is that the software side is almost always a better bet. I would buy the websites, not the wires.
The irony of an open Internet is that some of these websites have become their own networks that collect their own fees. There are businesses that only have an Amazon store, where Amazon can capture some of the benefit. There are content creators that only exist on YouTube, where YouTube (and Google/Alphabet) can capture some of the benefit. Places like Amazon and YouTube have become platform businesses that connect two sides of a market. They control what happens within their own networks, and they can get an extra benefit from it.
The ISPs have been left behind. While they have diverse lines of business, they have not grown in the same way as the Internet companies. For comparison, the largest telecommunication company in the US is T-Mobile, with a market cap of about $200 billion. Verizon, Comcast, and AT&T are all around $150 billion market cap. Alphabet has about $100 billion of just cash in the bank!
The opportunities for these two types of businesses are incomparable. ISPs have generally been forbidden from creating the types of services that Internet companies provide. My view is that they probably wouldn’t have done it anyway. Aside from what is allowed, “better service” is not an attractive strategy when it’s not necessary (consumers often have no choice for which ISP they use). And the culture and management required to build something new is very different from what is needed to extract value from a network that already exists.[4]
Value building should beat value extracting almost every time.[5] Network Neutrality concepts make it easier for investors to separate the two.
What Comes Next
This is obviously a limited look at NN, but there’s a bigger picture.
The Internet has been around long enough that Network Providers are unlikely to be seriously challenged (Google tried and failed), but they are also unlikely to capture new pieces of that market. The amount of investment required is too big to overcome. This model of thinking can apply to other established industries.
The “Internet” side of the Internet has reached similar maturity, but continues to be a wide open field for new business markets. Google’s position in search is fully established, but new areas of investment are constantly being discovered. The biggest one right now is in AI. And after that, there will be another. Wide open fields are everywhere, but they’re harder to predict than established industries.
The range between these two types of industries is generally not created by government policies. It is a natural feature of how much investment is required to compete (and who has the resources). And I believe that we can find good investments in all types of industries. We just need to know what we’re looking for.
Andrew Wagner
Chief Investment Officer
Wagner Road Capital Management
[1] It is a complicated topic, so I won’t repeat everything here, but the entire report is still available online.
[2] Major changes from a recent Supreme Court ruling could make the topic even more complicated.
[3] My take on this 12 years ago was that the courts would be deciding NN, but it turned out that the FCC is not always guaranteed to support NN rules. I was mostly right.
[4] It sounds like going in a circle, but both of these things can be true at the same time. A business can be forbidden from doing something that it wouldn’t be good at doing anyway.
[5] Great companies will be able to do both.
Marketing Disclosure
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