Investing to Profit From 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.
Finding companies which have delivered superior growth rates in the past is not enough when it comes to choosing the best stocks. Investing is about the future, so investors need to understand the drivers behind those growth rates in order to evaluate if they will be sustainable over the years. The network effect is one of the strongest sources of competitive advantages, and a big factor for many of the most successful companies of our time.
The Power of Networks
The network effect is a phenomenon whereby the value of a product or service is increased when more people use it. It can be a fantastic asset for the companies benefiting from it: more users make the service more valuable, which attracts more users and increases the value of the service, creating in this way a virtuous cycle of self sustainable growth.
A typical example of this phenomenon is social networks. Being on Facebook (NASDAQ: FB) becomes more interesting when more of your friends and family use it, so more users increase the value of the service. Facebook has become so big that even those who don´t really enjoy the service feel the need to be on it, even if just to stay informed and connected.
Maybe you think Facebook is mostly a waste of time, but it’s still quite useful if you want to see pictures of a friend´s recently born baby, or send a congratulations message to someone on his birthday. Because – almost – everybody is on Facebook, you need to have an account.
In fact, Facebook has become so popular that it’s now some kind of “people directory”: when you want to get in touch with someone you don´t know a Facebook message is probably the preferred method, especially among young people.
When it comes to professional uses of social networks, LinkedIn (NYSE: LNKD) is the place to be. Even if you are not looking for a job, a presence in LinkedIn is almost required for most professionals and companies who want to have a relevant online presence. LinkedIn is another excellent example of the network effect: professionals want to use it because other professionals, potential business partners or employers are using it too.
There are important differences between both companies when it comes to monetization strategies, LinkedIn has found an excellent method via hiring solutions, premium services, and advertising, while Facebook is still trying to find a more effective way to make money from its more than 1 billion users. However, the two of them are immersed in the favorable dynamics of the network effect, so unless they make a big mistake - like ruining the service with too much advertising, they are very well positioned for growth in the years ahead.
Big Tech and the Networks War
Microsoft (NASDAQ: MSFT) is another company which has benefited from the network effect through decades. People don´t just choose Windows and Office because of their stand alone merits, you want your software and documents to be compatible with the technology used by friends and colleagues. Windows benefits from the network effect in an indirect way too: the fact that it’s widely used guarantees that most kinds of software and applications will be made so that they are compatible with the operating system.
The network effect has been one of the biggest advantages behind Microsoft´s success, and that´s why Apple (NASDAQ: AAPL) has worked hard over the last years to make sure that Mac computers are compatible with Windows and Office to a high degree. Many customers have long believed that Macs were superior to Windows operated PCs, but being isolated in terms of compatibility can be big drawback. The fact that Macs are gaining market share over PCs cannot be credited to increased compatibility alone, but this has clearly been a positive factor.
In fact, Apple benefits enormously from the network effect, both in a direct and indirect way. Services like iMessage, Facetime, and Game Center become more valuable as more people use them. Also, the popularity of IOS attracts more developers, which brings more applications to the ecosystem and increases its attractiveness. Just like the war for desktop is a war of networks, the competition for mobile computing is driven by the same factor.
Google (NASDAQ: GOOG) has been very smart in that sense. The company allows phone manufacturers to use its Android operating system for free, and that makes it a very convenient alternative for many smartphone producers, since they get access to the most popular mobile operating system at no cost. Users know that they will find all the relevant applications in an Android smartphone, so the popularity of the operating system becomes self sustainable thanks to the interaction between users and developers.
Google is no stranger to the dynamics of the network effect. The company understands that more users for its services; Search, Gmail, Chrome, etc. mean better information for Google, and this information becomes very useful to increase the quality those services. The more we use Google, the better Google gets, and that´s a great way to continue improving and growing over time.
Bottom Line
The network effect is a very powerful source of competitive advantages, especially in the tech sector. Many of the most successful companies of our times have been able to capitalize this factor in a big way, so investors should place close attention to the network effect when it comes to selecting the best investment alternatives for long term growth.
acardenal owns shares of Apple and Google. The Motley Fool owns shares of Apple, Facebook, Google, LinkedIn, and Microsoft and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Apple, Facebook, Google, and LinkedIn. 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.If you have questions about this post or the Fool’s blog network, click here for information.
