Why do companies with a ‘Network Effect’ make for a good investment?

The network effect can be described as a phenomenon whereby a product or service gains additional value as more people use it. Ever since the Tech-Boom in the 90’s, investors have been looking for internet-based businesses that can scale at an exponential rate, while simultaneously creating more value for their existing users. Companies that can facilitate more interactions between suppliers and customers tend to have a tremendous advantage over their competitors.

Before deciding to invest in tech businesses, understanding how the ‘Network Effect’ works is vital in predicting the future growth potential of the company at hand.  In this article, I’ll be going over what makes for a good network effect and what to look out for before investing in internet-based businesses.

Barriers to entry

As the network effect of a company becomes stronger, the more defensible it is to existing competitors and potential new entrants. The mere fact that its existing operations become more valuable with every new user added results in the business beginning to pull away from its competition in terms of the number of connections facilitated by its network. Asa result of these companies aggregating more users, they become one-stop-shops for all existing customers available to that industry. This in turn creates a lock-in effect which results in higher user retention and profitability.

Another interesting point to consider about investing in companies with a strong network effect is, if competing businesses become bankrupt and cease operations, the existing clientele of the distressed business will migrate towards becoming clients of the surviving business and thus allow it to aggregate a greater market share. This is exactly what happened when Amazon tried to compete with Square in the credit card reading business (payment processing software). Despite Amazon undercutting its adversary’s price by 30%, it was unable to compete with the already established infrastructure and network built by Square. As a matter of fact, a year after launching its card reader, Amazon stopped making the product and mailed a Square card reader to all of its business customers. This case study is the perfect illustration of how hard it is to disrupt an already established network, especially seeing that the company trying to go up against Square was Amazon.

‍Scalability Is Important

To create a business ecosystem that provides additional value for every new user added, the company at hand must have the potential to scale with as little friction as possible. An example of this would be how a traditional business like the Fairmount Hotel would require a significant amount of upfront capital just to open a new location in a different city. There is even more additional friction to its growth potential when you consider all the carrying and maintenance costs that come with running an actual hotel. This wouldn’t be the case for an internet-based company like AirBnB, whose business model is focused on creating a global network of short-term rentals. To put things into perspective, AirBnB offers its 150 million users the option of choosing from over 7 million rental properties around the world. From a math standpoint, the company has created a network that can facilitate 150million X 7 million potential connections. For a more visual representation of the relationship between capital requirements and scalability, see the graph below.

Source: ShawSpring Partners

Another illustration you might find useful is the juxtaposition of Amazon' Kindle’s books business against Amazon Retail books. On the one hand, Amazon retail must purchase book inventory on a first-party basis before shipping it to consumers. On the other hand, Amazon Kindle e-books are sold by authors via the Internet, which is a dramatically more capital-efficient and fluid value chain.

Source: ShawSpring Partners

Why the number of new users added isn’t always a good metric.  

While the number of new users added is a good metric for predicting the future growth potential of a company, it doesn’t necessarily tell you much about the value being added to people in that network. As a matter of fact, it tells you more about a company’s potential to attract new customers rather than its ability to lock in and retain already existing clients. Investors should not be deceived by these numbers because in most cases, poor business planning can result in the existing network getting worse with every additional user. This phenomenon is what is referred to as ‘Negative Network Effects’. An example would be how a company like Rolex might have a negative network effect after a certain scale. You want Rolex watches to be popular if you own one, but you also don’t want everyone to have a Rolex or it loses all of it’s exclusivity.

Investors should also take their research beyond looking at the number of monthly users added and dive deeper into looking for metrics that are unique to that business. Here are some interesting stats on LinkedIn for you to consider.

Source: Linkedin.com

While the company was able to grow its users by 64% from 2009 – 2010, its number of unique visitors and page views grew by 81% and 96% respectively. If you had a vested interest in LinkedIn’s future, these are extremely good metrics because they indicate that its existing users are finding more value in the services offered in its network. In turn, LinkedIn has been able to position itself as the number one social media platform for people seeking to connect with professionals across different industries.

Putting it all together

When researching or investing, it is important to assess whether a company has or will have the resources necessary to build an ecosystem of sufficient scale. For a business to maintain its leadership position, there must be no way for an entrant to build supply and demand such that it creates a similar value proposition for the ecosystem. Understanding how Network Effects work and what to look for can go a long way in enhancing your investment returns and picking superior internet-based companies to add to your portfolio.

-Kondwelani Kalinda, Licensed Assistant

Kondwelani Kalinda is a Licensed Assistant at Endeavour Wealth Management with iA Private Wealth, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Kondwelani Kalinda who is a Financial Planning Assistant for iA Private Wealth and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.