Should you invest in E-commerce businesses?

Before we begin, I’d like to first define what is an “Online Marketplace” – An online marketplace is basically a place where various independent sellers and buyers get together. Buyers can search for the items listed by sellers through a website or a mobile phone application.

And if you’ve ever used Taobao, Shopee or Amazon, (think of that 9.9 Sale everyone was talking about!) you will have a basic understanding of how an online marketplace business works.

As such, the job of such a business is to manage the marketplace.

Now, what does it mean to “manage the marketplace“?

Here are some examples:

• Ensuring that there is a good variety of products offered
• An efficient search algorithm to give buyers what they want and show useful product recommendations 
• Prevention of bad behaviour (scamming, failure to deliver, poor quality goods). Sellers are punished through store removal or banning user accounts
• Encouragement of good behaviour (good reviews, high sales), where sellers are promoted through better listing benefits, such as being a featured seller

In return, marketplace owners profit by charging a “take-rate” from sellers.

A take-rate is known as a “tax”, “fee” or “commission”. In short, this is how they monetise their platform.

This is key because more and more people are forced to accept that making their purchases online is the new normal, particularly during this Covid period.

Because of that, I believe that the most-used consumer marketplace will become extremely profitable because they are receiving a huge amount of sales, since it provides tremendous convenience to the buyers.

Why?

• An online marketplace does the policing for the consumers; it punishes bad users and promotes good users within the platform.
• It provides price transparency, creating value for both buyers and sellers who are competing to provide that value. Sellers are forced to become better and consumers get good value.
• It is convenient because of the quick delivery time and the wide variety of products.
• It provides security because the marketplace tends to act as an “escrow”. This is where payment is not made to the sellers unless the buyers receive the goods.

With such advantages over physical retail stores, e-commerce has been growing rapidly across the globe. Just like Amazon, Alibaba was one of the first few e-commerce businesses. Some other consumer marketplace business are: Google Play Store, Apple App store, Booking.com, Airbnb, eBay, Etsy, and Flipkart.

These businesses do a good job in providing great user experiences to justify their take-rates.

And so, online marketplaces today hold a disproportionate amount of untapped power because it provides they provide much-needed distribution channels for many brands. During the worst lockdown periods of Covid, e-commerce platforms became a life boat for most offline retailers. They finally jumped on board after resisting it for years.

Because of that, I don’t believe that the market is saturated yet, given that there are more people who are warming up to e-commerce, including the elderly. With more people using it, the habit of online shopping will become commonplace. 

So Why Should I Invest In An Online Marketplace?

Most businesses are linear. To deliver X amount of products, you need Y amount of costs.

However, for an online marketplace, it is an entirely different model. These models are surprisingly exponential!

Let me explain how it works:

As an online marketplace proves itself to become the only choice in the eyes of the consumer, it benefits from multiple “growth levers”, which are ways to grow their revenue.

Borrowing this idea from Alex Caption of Cat Rock Capital, here is the growth lever formula:

Revenue potential = population size x penetration rate x order frequency x average order value x average take-rate 

Here are a few examples:

In scenario B, when a consumer orders 5 times from the platform instead of 4 times, the overall revenue earned by the marketplace is increased by 25% from scenario A.

In scenario C, when I tweaked it on a few variables such as penetration rates, average order value, the overall revenue earned by the marketplace is increased by 68% from scenario A.

This shows that online marketplaces are a highly scalable business model. Just a small increment in any of the conditions will lead to an exponential increase in the revenue potential. To top it off, it is a business model that is easy to enter into a new category (e.g. cars) once it has dominated its current categories.

With each customer feeling more confident of the marketplace, he/she is also likely to purchase items of higher prices.

Which Growth Lever to Pursue?

An intelligent marketplace operator should never be in a hurry to generate profits. Rather, it should ensure that the sellers are able to earn a comfortable profit margin on their products after paying the take-rate to the marketplace.

This promotes trust. Instead of increasing the take-rate, an operator should start by increasing the volume of transactions. It’s a win-win proposition as this encourages more suppliers to hop on to their platform.

BONUS: Software Companies Versus E-Commerce, Which Is Better?

While software companies are often admired as the best business model in the world, I realised that online marketplaces do have certain software characteristics in its business model.

Both businesses are spending on sales and marketing to gain scale very quickly. They do that because they know the pay-back is quick and it is extremely advantageous to be the market leader.

For example, if a marketplace is bigger than its nearby competitors, it is able to charge a higher take-rate without losing buyers or sellers. This is because both the amount of sales it can generate for its sellers, as well as the value and variety of products it can give to its buyers, will make them continue using the marketplace instead of switching to its competitor.

Additionally, while it is true that e-commerce platforms are unable to lock in their customers contractually, they continue to do it by altering consumer behaviours.

Platforms like Shopee are creating e-wallets and Shopee coins which create stickiness.

For example, why would I shop at other platforms when I have accumulated 1,000 Shopee coins that will allow me to offset my purchase price?

Over time, users do not like to deal with multiple platforms. They will discard the rest and stick with one. Scale reinforces the value of the platform because with more reviews, the marketplace is more trusted. And with more trust, there will be more reviews.

Conclusion

Apart from investing in software, a big chunk of my net worth is involved in online marketplace business models. I firmly believe these are extremely scalable and repeatable business models.

As they dominate in certain categories such as electronics or fashion, they are able to continue dominating subsequent categories such as home furniture, car purchases or even home purchases.

To serve an additional customer, it does not require any incremental costs, although there are huge incremental profits. As they scale, they becomes harder to compete with them because buyers and sellers would typically flock to high volume marketplaces for liquidity* reasons.

(*Liquidity means that a merchant is able to sell his/her products quickly and a buyer is able to find what he/she wants to buy quickly too. )

“In the long run, the vast majority of gains in the stock market seemingly come from picking the right businesses.”

I hope my article has benefitted you. If it has, please pay it forward by sharing it with more people!

In my next article, I will compare the business models like JD.com, Sea, Meituan Dianping and Delivery Hero! Want to be the first to be notified? Join my mailing list here!