Network Effects: The Moat Competitors Can’t Match

Network Effects: The Moat Competitors Can’t Match

An economic moat is a structural feature that allows a firm to sustain excess returns and few sources are as powerful as network effect. At its core, a network effect occurs when the value of a good or service increases for both new and existing users as more customers join the network.

This creates a virtual cycle where increased value draws in more users, further strengthening the company's competitive position.

The Power of Network Effects

Unlike traditional supply side economies of scale that focus on production volume, network effects are driven by demand side economies. The true power of the moat lies in the fact that the value of the network increases exponentially, often as a square of the connections. While the cost to maintain it only increases linearly.

Once this flywheel effect is triggered, customer acquisition costs typically decrease, allowing the company to generate substantial economic profits.

We see this manifest in several ways.

WhatsApp Increases in Value as Users Grow

Direct networks like WhatsApp become more attractive to newcomers as the existing user base grows. Two-sided marketplaces such as Amazon or Uber thrive because more buyers attract more sellers and vice versa.

Customer Data Improves CrowdStrike’s Performance for All

We also see indirect or direct networks like CrowdStrike, where data from one customer is used to improve the security posture for the entire client base.

Finally, platforms like the Apple App Store create a massive ecosystem where developers and users are mutually locked in. However, being a popular product isn't enough to claim a moat.

Critical Mass, Not a First Mover: MySpace Was First, but Lost

To be a sustainable advantage, a network must achieve critical mass, whether its value to the user exceeds the value of the individual product or competitor.

Requires Monetization: Twitter (X) Had Users, but Not Profit

Furthermore, it must be effectively monetized. As we've seen with Twitter or X, a network can grow its user base consistently, but fail to be a mode source if it cannot translate that growth into actual profit.

While rare, appearing in only about 6% of Morningstar's coverage,

Network effects represent over 21 trillion in market cap, proving they are gold standard for long-term defensibility.

Airbnb is a classic example of a network effects business. Network effects occur when the value of a particular good or service increases for both new and existing users as more customers use it. Airbnb has a marketplace network of renters on one side and consumers or visitors on the other.

Airbnb: Two-Sided Marketplaces Hold Both Direct and Indirect Network Effects

As more properties come into the network, it attracts more consumers. As more consumers use Airbnb, it makes it more attractive for property owners to join. In both cases, not only do the new property owners or consumers benefit, but the incumbents do too.

Companies Can Employ These Strategies to Build Network Effect

The first piece of these types of network effect businesses is getting a jumpstart. This is often discussed as the cold start problem or the chicken and the egg theory. Usually a marketplace network has to focus more on attracting one side of the network than the other. In Airbnb's case, it had to attract a sufficient number of renters before the network offered enough value. From there, in order to have a wide economic moat from network effects, the business has to generate excess returns on capital.

We see two main stumbling blocks for network effect businesses that haven't carved out a wide moat. First again is critical mass. So the business has to be big enough or there has to be a big enough network to cover the operating costs. Second is effective monetization thereafter. For a marketplace like Airbnb, we think it's a bit straightforward as it involves collecting a reasonable fee on transactions. Although users on both sides have to see enough value in a network to pay those fees. And that's not always the case with lesser networks.

Google: Complementary Network Effects Can Have a Compounding Effect

Outside of a marketplace, there are also monetization issues. For a direct network like social media, it often requires effective pricing on ads. For some businesses like Google Search, they benefit from indirect network effects where the data allows for a better product to attract more users, which improves the data even further, and the flywheel continues.