The term “economic moat” describes a company’s ability to maintain its competitive advantages and defend its long-term profitability. This moat investing education series explores the five primary sources of moat, according to Morningstar: 1) switching costs; 2) intangible assets; 3) network effect; 4) cost advantage; 5) efficient scale. Here we explore the concept of network effect.
Growing Reach Puts Network Effect in Play
The “network effect" moat source has become more relevant as our world has grown more digital. It describes the phenomenon where the value of a product or service increases as the number of its users grows.
Network Effect: As more people use a company’s product or service, the value of that product or service increases for both new and existing users.
The internet is a good example. It originally had few users outside the military and research science spheres, but its expanding user base exploded its reach and impact. More recently, companies like Facebook and Google have been labeled network effect paragons. Morningstar posits that a network effect can help a company to increase its advantages over competitors, and is often an important source of a company's moat.
The term "critical mass" is often used in connection with the network effect. In game theory, this means that not all game participants need to be convinced for a strategy to succeed, just a very specific portion of them. If this participation threshold is exceeded, the strategy is likely to succeed of its own accord. The network effect works in similar fashion. If the user base for a product or service reaches a critical mass, the network is likely to expand under its own power. Ultimately, however, a company’s ability to monetize a network is also important to consider before network effect can be assigned as a moat source.
Network Effect in Action
Visa (V) dominates the global electronic payments industry. The company controls approximately half of all credit card transactions and an even higher portion of debit card activity.1 It is a great example of how the network effect can create a powerful competitive advantage. According to Morningstar, “Visa has almost 16,000 financial institution partners, 3.4 billion Visa cards in circulation, and over 50 million merchants accepting Visa.”
Alphabet (GOOG), with a global share of over 80%, leads the online search market. The company’s network effect comes primarily from its Google products, which includes search, Android, Maps, Gmail, YouTube and more. In Morningstar’s view, “Google has the world’s most widely used search engine, and such a large and growing user base has created a network difficult to replicate.”
DISCLOSURE
1Source: The Nilson Report
Company-specific information based on Morningstar analyst notes last updated as follows: Visa: 3/26/2020; Alphabet: 4/9/2020.
Please note that Van Eck Securities Corporation (an affiliated broker-dealer of Van Eck Associates Corporation) may offer investments products that invest in the asset class(es) or industries discussed in this commentary.
This is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.
All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future results.
