Investing in the Power of Networks
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Competitive strengths are not easy to create or sustain. When a company is obtaining juicy profit margins competitive pressures usually increase and the business needs to have sufficient competitive advantages to sustain earnings and growth rates. In some particular cases, however, the network effect can be a powerful tool that keeps competition at bay and benefits shareholders in the long term.
The network effect occurs when the value of a product or service increases with increases in the number of users. More users mean more value which at the same time attracts more users. This dynamic constitutes a virtuous cycle that can benefit the company and provide a fabulous competitive advantage versus other companies trying to capture a portion of the business.
eBay (NASDAQ: EBAY) is a clear example of such a phenomenon, as more buyers use the platform, sellers have more incentives to choose Ebay because that´s where the purchasers are, and it makes it easier to sell a product quickly at the desired price. Buyers also choose the platform that has more sellers in their search for variety and competitive prices. Buyers attract sellers, and sellers attract more buyers.
Social networks are another line of business in which the network effect can have a huge impact. LinkedIn (NYSE: LNKD) provides a service that increases in value when the social network grows via more individuals and companies using the site. People feel more attracted to LinkedIn if they believe it provides better opportunities for professional contacts and job searches. Companies looking for potential employees obviously prefer successful and growing sites like LinkedIn.
Microsoft (NASDAQ: MSFT) benefited enormously from the network effect through the decades. Everybody wants to use software that is well understood and compatible with the technology used by most people. As Office and other products from Microsoft became the industry standard, most users had almost no choice but to choose the same software in order to work smoothly with other people or companies. In fact, the network effect worked so well for Microsoft that the company had to face serious problems because of its monopolistic position.
But the network effect is not the exclusive domain of technology companies, credit and debit card companies are another industry that exemplifies the network effect very clearly. Visa (NYSE: V) has the leadership position in that industry, and as more customers choose Visa, merchants feel more inclined to accept it. Shoppers obviously value the fact that Visa is widely accepted by sellers.
Something very similar happens with Google (NASDAQ: GOOG) and its operating system for mobile devices, Android. Apps developers focus their efforts on those platforms that have more users, and users prefer platforms that include more and better apps. Android has an enormous popularity and that increases its attractiveness for apps developers and customers at the same time.
Competitive advantages are one of the most important factors for success in the long term growth of a business. Companies which are able to create and develop a network effect can be very attractive investments for long term investors looking for businesses with strong fundamentals.
Motley Fool newsletter services recommend eBay, Google, LinkedIn, Microsoft and Visa. The Motley Fool owns shares of Google, LinkedIn and Microsoft. acardenal owns shares of Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
