Network effect: A proven way to create a moat

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. Each week, we’ll write a new blog focused on each of these sources of moat.

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 monetise a network is also important to consider before network effect can be assigned as a moat source.

Network effect in action

Visa 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.¹It 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, 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.”

¹Source: The Nilson Report