The ‘In’ crowd

Read this article to understand:

• The importance of creating and reinforcing network effects to entrench customers
• How “club” effects achieve this
• The difference between open and exclusive club effects

While some clubs are open to all, others are exclusive, with requirements based on money, social connections or one’s place in society, making membership unattainable for most. And while both kinds offer members the benefits of joining forces – from finding tennis partners to securing a permanent location for activities – exclusive clubs have the additional draw of status symbols. The fact that not just anyone can join greatly adds to their desirability by increasing the social standing of those who are accepted. The more exclusive the club, the greater the appeal.

What is interesting for investors is that some brands can use this to their advantage. In our Global Equity Endurance strategy, we seek to identify companies that benefit from “network effects”, which tend to enhance both their durability and growth profile: the stronger the network, the higher the value of the company’s products and services for each customer. Managed well, a network effect can create a powerful competitive moat and give a company strong pricing power (see Supercharge me: The power of network effects).

Clubs, or communities of customers, are networks whose strength goes beyond a group of disparate individuals buying the same brand. They entrench loyalty and raise switching costs. Firms that create clubs for their customers can take advantage of these network effects and thereby enjoy a durable competitive edge.

In the same way as sports clubs, some look to attract a broad base of customers to benefit from scale, while others rely on the appeal of exclusivity. In this article, we look at one example of each type, retailer Costco and sports car manufacturer Ferrari, and examine their inner workings.

Costco: Using club effects to drive economies of scale

Network effects entrench products and customers, as the value to customers grows exponentially with each new user joining the network. But to boost growth and build durability, companies need to build in features that strengthen and protect these effects.

One way to do this is to raise switching costs, for example through client benefits that create barriers to exit. The stronger the benefit, the higher the pain of leaving the network. This is sometimes referred to as the “Hotel California effect” (as the Eagles sang, “You can check out any time you like, but you can never leave”).¹

Take Costco as an example. Its business model is based on building client loyalty by offering high-quality products at lower prices than its competitors. One example is the hot dogs available in its food courts, which cost $1.50 – the same as they did in 1985.²

Costco achieves a network effect in the sense that, as more customers join, the company’s buying power increases, enabling it to buy products more cheaply. This is compounded by Costco’s decision to limit the number of products it offers.

And the company protects these effects by keeping profit margins low, thereby sharing its economies of scale with its customers. This creates a virtuous cycle whereby more network members and sales volume deliver greater value to the network’s members.

But Costco also strengthens its network by raising switching costs through a club effect: customers pay $60 a year for membership to benefit from the wholesale prices. Not only does this boost Costco’s profitability, it also locks members in, as, having paid up, they don’t want to lose their benefits. They also want to get the biggest “bang for their buck”, which is a big incentive for them to shop as much as possible at Costco, further driving the firm’s revenues. On average, customers spend around $100 at Costco every other week – or just over $3,000 a year.^3,4

Ferrari: A hyper-exclusive club

At the other end of the spectrum is a more exclusive kind of club: the network of Ferrari owners. Like all luxury brands, Ferrari’s appeal relies on the Veblen effect – named for the US economist Thorstein Veblen, this refers to a dynamic by which demand increases as the price goes up, ostensibly conflicting with the laws of demand as usually understood. Ferrari’s cars are desirable precisely because they are expensive and thereby function as a strong status symbol.⁵

The Veblen effect has been observed in demand for a range of luxury goods, from wines to watches to handbags. However, Ferrari is a special case in that it has created an exclusive network even within the community of customers able to afford its products. From the start, company founder Enzo Ferrari stated: “We will always produce one less car than the market demands.”

A key part of the firm’s strategy is to reinforce its aura of exclusivity by carefully selecting its clients, ensuring they share a passion for the brand and its heritage.⁶ It can take years to even get on a waiting list to buy a Ferrari, and waiting lists themselves can be over three years for some models.⁷ New customers are also encouraged to first buy entry models, with the more exclusive lines reserved for longstanding owners. For instance, in 2023, almost 74 per cent of new Ferraris were sold to existing owners.⁸

These rules shelter Ferrari from the vagaries of fashion trends and create extremely strong switching costs, as few customers would wish to give up access to such an exclusive, hard-won privilege. It also ensures all owners are ambassadors for the brand, since both the company and its clients have a shared interest in maintaining the cars’ appeal and value.⁹

The careful management of supply reinforces this effect because it allows Ferrari to keep control of prices. Every time the company makes a new car, it can push the price up, not only because it strengthens its aspirational appeal, but also because it benefits existing owners, whose own cars see their value maintained or increased in turn.

This creates an exclusive network. Whereas many network effects rely on exponential growth – such as that enabled by technologies like social media – this one is based on the “community” effect whereby clients collectively promote the network and derive value from the company’s success.¹⁰

This does mean Ferrari needs to maintain a balance between shareholder expectations and growth opportunities on the one hand, and low enough production to keep its aspirational status on the other. However, given the length of waiting lists, as well as demand in new markets such as electric vehicles (EVs) or SUVs, this balance between exclusivity and growth seems achievable.¹¹ For instance, Ferrari has committed to 40 per cent of its sales being made up of EVs and another 40 per cent of hybrids by 2030, leaving only 20 per cent to combustion-engine cars.¹² It is due to build its first fully electric car in 2025, but hybrids already made up 44 per cent of its sales in 2023 (see Figure 1).¹³

Investment implications

Thanks to network effects, the more successful a company is, the more successful its customers are, creating a virtuous and perpetuating cycle. Customers often become the most powerful advocates for a product or service, which makes disruption difficult.

But to boost growth and build durability, companies need to build in features that strengthen and protect these effects. As shown by our two examples above, features that increase switching costs – like a club effect – can be powerful in that regard. Investments in such companies can deliver consistent returns over the long term and in all market environments. That is why network effects are one of the key elements that underpin the approach of our Global Equity Endurance strategy, which aims to deliver a portfolio with less cyclicality and higher predictability, alongside downside protection (see Five principles for performance persistence).

Of course, some clubs eventually fail to attract new members and disappear, to be replaced by others with more appeal. Similarly, companies that rely on such network effects could fail to innovate or could one day lose the balance between growth and exclusivity, or between a small product range and significant customer benefits. Investors need to understand the degree to which a company exhibits these characteristics and can improve upon them to get a realistic picture of its long-term prospects.

But whether they are exclusive or open, firms whose business model is based on strong network effects should not be overlooked.