5 Essential Network Effects To Invest In The Digital Economy

Summary

• Warren Buffett suggests that economic moats are more durable than competitive advantages.
• Network effects, arguably the most powerful kind of economic moat, occur when a product becomes more valuable as more users join.
• As the world shifts to digital, identifying companies with the right kind of network effects have become more relevant now than ever before.
• In the age of software, market share growth can compound for those with the right types of dynamics at play in their business model.
• Let's review five types of network effects with examples of companies that could easily justify a spot in your portfolio.
• I do much more than just articles at App Economy Portfolio: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

In The Little Book That Builds Wealth, Pat Dorsey explains:

unless a company has some kind of economic moat, predicting how much shareholder value it will create in the future is pretty much a crapshoot, regardless of what the historical track record looks like. Looking at the numbers is a start, but it's only a start. Thinking carefully about the strength of the company's competitive advantage, and how it will (or won't) be able to keep the competition at bay, is a critical next step."

The term economic moat was popularized by Warren Buffett and refers to the ability of a business to maintain an edge over its competitors. A moat is a structural and sustainable competitive advantage that can drive long-term earnings and market share, which in turn is likely to be reflected in the price of the stock.

There are five main economic moats:

• Low-cost production.
• High switching costs.
• Network effects.
• Intangible assets.
• Efficient scale.

Because of their compounding nature, network effects are often recognized as the most powerful economic moat. They are defined as the "phenomenon whereby increased numbers of people or participants improve the value of a good or service." Network effects are present for many businesses of the digital economy. In consumer technology, they are most commonly sought as a path for sustainable growth. Social media or e-commerce platforms are often recognized as businesses greatly benefiting from such moats. In many ways, strong network effects can reinforce other moats such as brand and scalability.

But not all network effects are born equal. They can take many shapes and forms. For marketplaces, the key is for offer and demand to increase in tandem. For platforms, the key is for users to remain engaged in the ecosystem. Network effects can expand an addressable market over time, but some businesses may reach saturation and see a lower value from additional users once they reach a certain point. The commoditized nature of a business can also lead to a misguiding perception that the growth is exponential, right when it's on the verge of running out of steam.

Today, I want to review in more detail five types of network effects that can be identified in the companies of the digital economy and why they should have a place in your portfolio, in one form or another.

Let's review.

Source: App Economy Insights

The Different Types of Network Effects

There is a wide range of literature about the various types of network effects and how we can break them down. Among those that have done a tremendous job in the matter, I want to highlight the work of seed-stage venture firm NFX, that regularly has excellent posts on how to differentiate network effects and their nature. Andreessen Horowitz is another fantastic source of deep dives into what makes a network effect sustainable or not.

Source

NYU professor Arun Sundararajan has classified network effects into broad categories such as:

• Direct (Same-Side): Increases in usage lead to direct increases in value (e.g. the original telephone).
• Indirect (Cross-Side): Increases in usage encourage consumption of complementary goods, which increases the value of the original product (e.g. the entire Apple (AAPL) ecosystem).
• Two-Sided : Increases in usage by one set of users increase the value to a different set of complementary users, and vice versa (e.g. any marketplace with buyers and sellers).
• Local: Increases in usage by a small subset of users increase the value for a connected user (e.g. messaging apps your coworkers, friends and family are on).
• Standards: The use of one technology product encourages the use of compatible products (e.g. Visa (V) and Mastercard (MA)).

This led me to identify five sub-categories of network effects to apply specifically to the rise of the digital economy and how some products that may appear similar at first may be benefiting from very different types of network effects behind their success.

Let's dig deeper.

1) Direct Network Effects

Direct network effects are the easiest to identify. You can think of any product you are using that improves if people around you join in. You immediately benefit from an increase in usage from other members. Your personal identity and reputation are usually at stake and you can derive more value as you engage with the product and see more of your own network join the platform.

The properties of a direct network effect are usually personal. These businesses often serve as an extension of your existing relationships in real life. Social media platforms and messaging apps are the core of this category. They serve different purposes, but end up benefiting from the very same moat. More users beget more users, because of the personal nature of these platforms. Each user has an interest in seeing more people join to derive more value for themselves.

• Personal social network: Facebook (FB) (2.7 billion monthly active users) and Instagram (more than 1 billion monthly active users) have become gigantic businesses by benefiting from direct network effects. Their scale is so gigantic that it can be hard to grasp. They are the proof that there is virtually no ceiling for the platforms that reach a critical mass and know how to keep their users engaged and interacting with one another.
• Professional social network: New tools use the same playbook in the professional world. These include social platforms like LinkedIn (acquired by Microsoft (MSFT) for $26 billion in 2016), but also Enterprise solutions focused on collaborative work such as Slack (WORK). In 2019, Slack said that among its paid customers, users spend more than 9 hours a day connected to its service, including spending around 90 minutes per day actively using the platform. As Slack users move from one company to another, they turn from users to ambassadors and bring in new people.
• Discovery: Users of Pinterest (PINS) help organize the platform and categorize its search function, as well as generate more content. The content itself improves as more users "pin" the content, enabling discovery for others.
• Messaging: Some of the most successful businesses of the 21st century have been focused on the most basic aspect of online interaction: messaging. Facebook acquired WhatsApp in 2014 for $19 billion. A company like Tencent (OTCPK:TCEHY) has built an empire around WeChat (Weixin in China). At its core, a messaging tool is just like the original telephone. The more people join, the more that product can serve its purpose and retain users. For many companies, messaging has become a gateway into other monetization avenues. The most commonly used messaging tools have become parts of much larger ecosystems that tend to be at the top of the food chain today and among the biggest in the world.

Platforms benefiting from direct network effect are often difficult to leave because of how intertwined they are with our personal lives. They are often used daily and are a fundamental part of our lives.

2) Marketplace Network Effects

Marketplace network effects come into play when a company derives its business from bringing together offer and demand, customers and suppliers, in some kind of marketplace.

• Horizontal: The rise of e-commerce has given birth to some of the most outstanding investment opportunities of the 21st century so far. Amazon (AMZN) is first to come to mind. Its aggressive strategy with Prime has led to years of profit-less growth, but have in turn built one of the largest e-commerce platform in the world. Amazon has now more than 150 million Prime members paying around $119 annually for free fast shipping and other perks (streaming of video, music, exclusive deals). The review system has enabled more traffic to the site, and eventually powered its recommendation system (same-side effect). Amazon's marketplace (third-party sellers) generated cross-side network effects. Both buyers and sellers attract one another.
• Vertical: If Amazon represents the ultimate horizontal marketplace (all-in-one), Etsy (ETSY) is the perfect example of a vertical marketplace (niche). At its core, Etsy is another 2-sided marketplace in the e-commerce category. But an important differentiation is how it carved its own niche in specific categories. The platform satisfies specific needs for specific customers. Getting married? Looking for a vintage musical instrument? Etsy is your go-to place. The indirect network effects are here to incentivize each side of the market to join and continue to use its services. More sellers result in more unique and attractive products on Etsy's marketplace, which in turn attracts more buyers. It's a perfect virtuous cycle, as demonstrated by the strong growth on both sides of the marketplace over the years. This dual network effect has ramifications on the brand power of the platform, generating both top of mind and unprompted awareness.
• Payments: Card payments are a textbook example of network effect. The growth in number of Visa or Mastercard cardholders make the brands more attractive to merchants. The growth of the number of merchants makes choosing the card more attractive to cardholders. The ubiquity of these payment networks has made it extremely challenging for existing or new entrants to compete. This gives these companies a structural and sustainable advantage.
• Matchmaking: Matchmaking is taking on a brand new meaning in the rise of the digital economy. Tinder, Plenty of Fish, Hinge, OkCupid, BLK and more properties of Match Group (MTCH) have become essential tools for people to look for romantic partners. Online dating renders itself quite naturally as a marketplace. After all, it's a network connecting people participating in a two-sided market where potential partners can "match" with each other. The one difference is that there is no currency or product exchanged. Helping search and self-promotion is the main monetization source. A fundamental step in the growth of a dating platform is for it to reach a critical size where the "supply" compels other individuals to join. Once a platform manages to build itself as the place where everyone is, the growth can compound. This is illustrated by the long-term performance of a company like Match Group, about 10 times bigger today than the company was on its IPO day in 2015. Craigslist, OpenTable (owned by Booking Holdings (BKNG)), Zillow (Z) are all other forms of matchmakers that have built humongous platforms over time, gaining in relevancy as each side of their platform gained more users.

Companies that fail to maintain a marketplace network effect will usually fail to retain users in their ecosystem over time. They may have a poor product-market fit, where their low price was the only reason people joined originally. Trust and authenticity are also key aspects of a marketplace. Be it critical mass or reputation, once a marketplace-like business is growing at a healthy and consistent pace, chances are it will do so for a really long time. The virtuous cycle at play makes these businesses highly defensible.

3) Platform Network Effects

Platform network effects occur when a company can keep a user engaged in its product ecosystem. This is a category that Alex Moazed wrote about extensively in his book Modern Monopolies: What It Takes to Dominate the 21st Century Economy. He explains:

Software is a commodity. The real value is in the ecosystem.

• Content: Influencer marketing has become a huge economy of its own. The platforms that enable content creators to build an audience effectively can truly shine. In this context, video has been the strongest medium to acquire, retain and monetize users. Once a platform has the most engaged audience, influencers come in droves and the virtuous cycle kicks in. Here again, first movers have a tremendous advantage. In this category, YouTube (online video) and Twitch (live streaming) are absolute winners. They are owned by Google and Amazon, respectively.
• Enterprise: In the Enterprise SaaS category, Salesforce (CRM) is the ultimate example of a company that has been able to build a true partner ecosystem. Salesforce has created a platform where developers can build custom applications on top of it and created a central community where users can build and sell their apps. They made it easy to build your business around their software solution. A growing portfolio of partners with many products natively available on the platform gives the company a durable edge over its competition.
• Operating systems: The operating systems that have the most users will tend to attract more developers. They make the system even more appealing with additional applications that, in turn, attract more users. With a new generation of gaming consoles on the way, Sony (SNE) PlayStation or Microsoft Xbox are great examples of operating systems that thrive as more users join and more studios develop compelling games for the platforms. Other obvious examples in this category are Microsoft OS, iOS or Android. They are all reinforced by their growing base of developers and end-users.
• Developer ecosystem: As more companies embrace the PaaS model (Platform as a Service), another fundamental network effect comes into play. One that revolves around developers alone. A perfect example is the communication platform Twilio (TWLO). Developer ecosystems can exhibit similar characteristics as social networks. As more developers become active users and contributors, the platform becomes more valuable. Many developers are building tools on top of the Twilio platform, building new functional use-cases. Twilio has a "developer-first" approach that you can also find in a company like Fastly (FSLY).

Companies that manage to build an ecosystem in which new users and developers add more value can be an extremely powerful moat. It should be no surprise that this kind of moat has created some of the biggest companies in the world.

4) Data Network Effects

Data network effects occur when a business is gaining a structural advantage by gathering user data. This advantage can become very powerful when the data itself, in turn, becomes more valuable to users.

Source

• Big data: Search engines are at their core intermediaries in a market between users and advertisers. They collect an enormous amount of data about users and their preferences that can help improve the search engines and offer a better, more targeted service. The number of users of a search engine increases the amount of data, which in turn improves the search engine algorithm. The quality of the results of the search improves over time by the sheer number of searches and results being chosen by other users. With a larger network of advertisers, Google (GOOG) is able to offer sponsored links with a high degree of relevancy.
• APIs: We have entered the age of the API economy (Application Programming Interface). An API is a connection point. A way for a small program to build a communication bridge. It's a set of routines, protocols, and tools for building software applications. An API specifies how software components should interact. Many SaaS (Software as a Service) companies offer a set of APIs as part of their solutions to avoid the need to build it from scratch. As developers build new use-cases within a software, they make the platform stronger. Think of it as a workshop that has thousands of tools tailor-made for your exact needs. DocuSign (DOCU) shines by offering an open platform with a wide range of APIs that developers can use. Over time, as DocuSign gained in popularity, more use-cases have appeared in its API library, giving it a fantastic edge on the competition.
• Artificial Intelligence: By design, some software solutions are improving as more data pours in. Let's take the example of CrowdStrike (CRWD) and its Threat Graph, the company's AI brain behind its endpoint protection platform called Falcon. Whenever a CrowdStrike customer suffers a breach, the customer is alerted and the data about the breach is sent to The Threat Graph. The breach is immediately analyzed and an update is sent to all other customers, giving them immunity to further breaches of this type. This is a perfect example of the expansion of a customer base improving directly the intrinsic quality of a technology.
• Personal data: Beyond the Enterprise world, data network effects can also appear at the personal level. Look at a company like Peloton (PTON), collecting the data on the performance of more than 3 million subscribers. The more data they collect about you and other subscribers you may be competing with, the more likely they are to retain you in their ecosystem. The same could be said of a platform like Pinterest that improves its use-case every time you "pin" something new. Similarly, services like Spotify (SPOT) let you follow other members, create playlists and save songs you like for later. After several years of usage, the trove of data built in can become increasingly valuable for a subscriber. Even a commoditized service can benefit from a data network effect with the right ingredients implemented.

In many ways, a data network effect is more defensible than a Brand because it's harder to replicate. The first mover can greatly benefit since the data accumulation can maintain and grow an edge over competition. The main risk is often linked to larger companies that may be offering the same product or service as part of a horizontal strategy. For example, Google is rendering Yelp (YELP) somewhat useless. With aggressive bundling efforts, Apple Music and Amazon Music will discourage many to opt for a Spotify premium account. The retention strength of a platform like Peloton applies to any other service in the fitness category, challenging the sustainability of the competitive advantage.

5) Social Network Effects

An important distinction to make here is that the "social" nature of this category has nothing to do with social media. Here, we are talking about human nature and how it can be a natural source of growth once the right assortment of favorable factors kick in.

Social network effects are in many ways the strongest kind of network effects. They are built from the initial strong appeal of a product or service, and create a compounding effect to the existing success story once they kick in.

• Belief: The larger a group of human beings embrace an idea, the stronger that idea can become. Religions, cults, conspiracy theories, fiat currencies, and the value attributed to gold are all examples of how powerful belief can be as a network effect. The rise of Bitcoin (BTC-USD) and other cryptocurrencies obviously fall in this category.
• Standard: Many developers choose to implement Stripe because it is the easiest payment gateway. Even though competition may eventually catch up and offer the same simplicity, the reputation of a product as being a superior one can lead to a rapid rise and concentration of demand. This has also happened recently with the trading platform Robinhood, despite the fact that other online brokers have cut their trading fees to zero to match the company's aggressive approach. If your peers are using a specific product recognized as a "standard," you are far more inclined to make it your predilection.
• Language: When a product or service becomes ubiquitous enough, it can become part of our language, which has obvious long-term ramifications. A recent case-in-point is Zoom Video (ZM). The video messaging app has become a verb as a result of its increased usage in the midst of the global pandemic. This can lead to a mainstream usage that is unheard of for a product that was originally an Enterprise Software solution.
• Bandwagon: When a product or service becomes popular enough, its sheer popularity can make it a coveted product by nature. Apple has been extremely successful at creating buzz and demand when it launches new products. This creates long lines in front of stores across the world, which, in turn, creates more anticipation and curiosity for said products. This is a powerful virtuous cycle.

Platforms that become so ubiquitous that they become an official standard, part of our language, or simply reach a cult following have possibly the strongest kind of network effect at play. They become stronger every time they gain a new believer, which in turn rewards the existing community of believers. Technology disruption is likely the most prominent risk for businesses that manage to enter this category. After all, Xerox (XRX) is a verb, but that doesn't make it a good investment today.

Wrapping Up

Not all network effects are born equal. But even those that may appear the weakest at first can turn out to be the strongest ones.

Several companies discussed today are already among the largest in the world. And they already were many years ago. After all, a company like Facebook was valued at $41 billion when the movie The Social Network was released in theaters in 2010. The company is 18 times bigger today.

Many investors will consider these businesses too big, and they will consider them as being already "played out." By doing so, they are overlooking the underlying strength of their network effects.

It's one thing to understand and appreciate the economic moats of a business. But it's another to buy shares of said business and hold them for many years to let the story play out.

One thing is certain. Those who have capitalized on the companies that demonstrate network effects in their portfolio have done extremely well in the 21st century so far. And I bet that they will continue to do so looking forward.

• What companies in your portfolio exhibit network effects?
• What companies would you add to this list?

Let me know in the comments!

Analyst’s Disclosure: I am/we are long AAPL, AMZN, BTC-USD, CRM, CRWD, DOCU, ETSY, FB, FSLY, GOOG, MTCH, PINS, TCEHY, TWLO, V, WORK, Z. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.