Network Effect & How it Factors into the Economic Moat of a Company
I would like to talk about the network effect which is another way an economic moat can be created.
I would like to really stress the benefits of the network effect because it is often overlooked and is a key factor in the economic moat of a company.
When a business has the built in ability to both grow and improve as it gains more customers it is said to benefit from the network effect. It has reached critical mass and is now “snowballing” as in the snowball effect.
The snowball effect is a metaphor for showing how the bigger a company gets and the better it does, the bigger it can get and the faster it can grow. Think of rolling a snowball down a hill and as it goes it picks up more snow and as it increases speed it grow even bigger, even faster.
In these cases the more people who use a certain business the bigger its market share gets, but more importantly the more exclusive it’s hold on that share becomes.
This is simply because having more users translates into a more valuable product or service for all and inherently leads to a never ending cycle of continuous growth.
The network effect is an extremely powerful type of competitive advantage and its most often found in businesses based on sharing information, or connecting users together.
You don’t see it much in businesses that deal in physical goods.
Examples of this can be seen in companies such as eBay, Visa and Facebook.
The more people who use these particular services the better the experience becomes.
Which leads to more people using the services… and on and on.
The network effect gives a company a lot of advantages over its competitors.
Looking at Facebook for example, Facebook becomes more and more profitable when more people use it.
You know that Facebook has access to a database of billions of people around the world?
So this means they can easily make billions of dollars just by utilizing their customer base. They can serve advertisements, and for example if they have 1 billion users and make an average of just $10 per user then they are generating 10 billion in revenue. Not bad.
What’s more, you see, the network effect makes it hard for other companies to compete with Facebook because if they want to enter a competition, they must spend a lot more money on advertising and a lot more effort on reaching more people and showing their products.
In the case of Facebook they can reach billions of people without any hassles.
While for example when Google launched their Google+ service they could never reach this critical mass. And therefore with not being able to get the amount of users needed to become profitable and leverage the network effect, they never managed to make it. I just heard that they are now closing down Google+ and I can tell you, the reason is because they did not manage to get the network effect they needed to compete in that space.
If you can see who has the network effect already working for them, well…
You can guess who will win in this game.
This competitive advantage can be difficult to dislodge once it gains momentum and so it offers a potentially enormous economic moat.
That is, to the lucky company or two that managed to establish the first successful networks in a particular industry. Yet also look for new up and comers. Remember that Google was not the first search engine on the block. And often some companies offer services which are simply better than the pioneers of a market and they can be real home runs if you can spot them as they come up.
The network effect specifically is a fantastic way to ensure that the company will grow and thrive into the future. It also already snowballing or is just about to.
So make sure that you look for companies with a strong network effect when looking to invest for the long term in a company.
They are always winners in their industry long term, provided they can maintain their network effect.