Network Effects

Network Effects (also known as 'network externality') describe a phenomenon where a product or service becomes more valuable as more people use it. Think of the very first telephone – it was a useless box. But with every new person who bought one, the value of that original telephone grew, because there were more people to call. This self-reinforcing loop is the magic of network effects. For an investor, understanding this concept is like being given a map to find buried treasure. Companies that successfully cultivate network effects can build a powerful economic moat around their business, creating a fortress that is incredibly difficult for competitors to attack. This is because the leader becomes a magnet for new users, pulling further and further ahead in a virtuous cycle, while latecomers struggle to even get started.

The core idea is simple: More is merrier. A social media platform with only your cousin on it isn't very fun. But when all your friends, colleagues, and favorite brands join, it becomes an indispensable part of your social life. The product itself hasn't changed, but its value to you has skyrocketed. This explosive growth in value can be illustrated by Metcalfe's Law. While it sounds technical, the concept is straightforward: the value of a network is proportional to the square of the number of its users. If a network has 2 users, there's 1 connection. If it has 10 users, there are 45 connections. This exponential growth in connections (and thus, value) shows why companies with network effects can become so dominant so quickly. Once a network reaches a critical mass of users, it can hit a tipping point, leading to runaway growth that leaves rivals in the dust.

Network effects aren't all the same. They generally fall into two major categories.

This is the most straightforward type. Each new user directly increases the value of the network for all other existing users. The benefit comes from interacting with other users of the same group.

• Examples:
• Social Media (Facebook, LinkedIn): The primary value is connecting and communicating with other users. More users mean more potential connections.
• Messaging Apps (WhatsApp, Telegram): You can only message people who are also on the app. The more friends who join, the more useful the app becomes.
• Video Games (Fortnite, World of Warcraft): The experience is enriched by having a large pool of other players to compete with or cooperate with.

This type is a bit more complex and is often found in a platform business model. It involves two or more different user groups, where the growth of one group increases the value for the other group(s). This is also called a “two-sided network.”

• Examples:
• Operating Systems (Microsoft Windows, Apple iOS): A growing user base attracts software developers to build more applications. The wider variety of applications, in turn, attracts even more users to the operating system.
• Credit Cards (Visa, American Express): The more merchants that accept a card, the more useful it is for cardholders. The more cardholders a company has, the more merchants are willing to accept the card to gain access to those customers.
• Ride-Sharing Apps (Uber, Lyft): An increase in riders attracts more drivers seeking fares. More drivers on the road reduce wait times, which in turn attracts more riders.

For disciples of value investing, finding a business with strong and durable network effects is like striking gold. The legendary investor Warren Buffett has long prized companies with a wide competitive advantage, and network effects create one of the widest moats possible.

Once a network is established, it becomes a natural monopoly or oligopoly. Why would you join a new social network with 1,000 users when all your friends are on one with 2 billion? The leader's product doesn't even need to be the best; its value comes from the network itself. This creates a winner-takes-most or winner-takes-all market, resulting in immense pricing power and fantastic profits for the dominant company.

Network effects create powerful customer lock-in. These are known as switching costs. Leaving a network is not just about adopting a new technology; it's about leaving a community, losing data, or forfeiting access.

• If you leave WhatsApp for a rival, you can no longer talk to the friends and family who remain.
• If you switch from an iPhone to an Android, you lose all the apps you paid for on the App Store.
• If an e-commerce seller leaves Amazon, they lose access to the world's largest pool of online shoppers and the trust associated with the platform.

As an investor, you must be a detective. The term “network effects” is often thrown around by starry-eyed CEOs, but you need to verify if the claim is real.

• Ask the Right Questions: Does the product truly become more valuable with more users, or does it just get bigger? A restaurant chain gets bigger with more locations, but the 100th restaurant doesn't make the first one taste better. That's a brand or scale advantage, not a network effect.
• Analyze Engagement: Look for user growth, but more importantly, look for user engagement. A growing but inactive network is a mirage. Are users deeply embedded in the ecosystem?
• Assess the Pain of Leaving: How high are the switching costs? Try a thought experiment: how much of a hassle would it be for you to quit using Google Search, Microsoft Office, or Amazon Prime? The greater the imagined pain, the stronger the moat.

A Word of Caution: Be wary of weak or fleeting networks. A trendy new social app might enjoy a temporary network effect, but if it's based on a fad, it can collapse as quickly as it rose. The most durable networks are those that become integrated into a user's daily life or a business's core operations.