In this article, we will go in-depth on another of the 6 long-term economic moats: the network effect.

The network effect is unquestionably one of the most powerful of all the economic moats. It takes impeccable timing and tremendous investment to build, but once established it is incredibly hard for competitors to penetrate. Networks also benefit from what can be termed "natural oligarchies" - there is only so much potential business to support a handful of networks in any given industry.

So, what are network effects? Why are they so powerful? What are some examples of business today? Let's take a look.

The Power Is In The Network

Networks are critically important in nearly all areas of life, business and personal.

A network, at its core, is simply a way to connect endpoints. The internet is a way to connect client and server computers together. Phone networks connect telephone endpoints together. Railroad networks connect shipping and transportation endpoints together. Social networks connect human endpoints together.

In business, the network effect is when a single company is able to create and control the means to connect endpoints together, often in a proprietary manner. Clients on one or both ends pay to use the network to transact goods or services between terminals.

This sets up a structurally recurring revenue business model, which is one of the key three things we look for in outstanding businesses.

At a certain scale, network businesses also create natural oligarchies. Large networks are far more beneficial to users on both ends. Each node that is added to a network represents added value to every existing node - in business, another potential customer for EVERY seller on the network, or additional goods and services to choose from for EVERY buyer. Eventually, sellers choose to join the largest network because that is where most buyers are. Conversely, buyers want to use the largest network because that is where the most product selection is.

As you can imagine, once a network is at scale, there is really little competitors can do to draw "endpoints" away from it, aside from hoping the dominant network operator drops the ball in service quality, reliability, or pricing.

Famous Business Networks In History

Perhaps the best way to illustrate the power of the network effect is to talk about a few of the most powerful companies in history.

Let's start with what was almost certainly the most powerful corporation in history: the Dutch East India Company (VOC). The VOC had several remarkable economic moats, but its most powerful was the control of trade routes between Europe and Asia in the 17th century. It set up trade posts (endpoints) all over these geographies, enabling sellers with incredible new economic opportunities and buyers with goods they would never been able to acquire before. The VOC's trading arbitrage on these goods (essentially the fee for using its network) allowed it to grow into a global behemoth that would have been worth almost $8 trillion dollars in today's money. The VOC was brought down by poor financial management and socioeconomic upheaval, which allowed competitors to encroach on their trade routes. But not before the firm dominated for almost 100 years.

In the industrial age, a great example of a powerful network company was the original American Telephone & Telegraph - or AT&T. Originally conceived as a project to commercialize Alexander Graham Bell's telephone patents, AT&T quickly built a collection of regional wired telephone networks (the Bell System) and interconnected them through long-distance lines. Before anyone could even challenge the patent, AT&T had established a near-nationwide wired telephone network. While numerous competitors tried to challenge AT&T on a local level, their inability to provide distance service prevented their ability to pull many customers away. This protected AT&T's monopoly for almost a century until it was broken up by the government.

While network effects were relatively rare (but extremely powerful) in pre-Internet times, the proliferation of computer networks has made them even more prevalent today. Let's take a look at a few examples of modern network effects.

Network Effects Today

Electronic communication has been a game-changing phenomenon that has impacted business at nearly every level since the 1970s.

In particular, it has made the network effects an ever more important part of the business than it was before.

Perhaps one of the starkest examples of this is in the credit card payment networks. Both Visa (V) and Mastercard (MA) were founded in the 1960s as a way for consumers to consolidate credit accounts, which in those days were managed by individual vendors. Consumer acceptance was rapid, and merchants soon began accepting the cards to make more sales.

Today, these two payment networks are enormous, processing hundreds of billions of transactions worth trillions of dollars every year. Their networks are so large (over 30 million merchants and 2.5 billion cards each) that merchants almost HAVE to accept them at this point - and as a result, consumers continue to pay with them. Though many have tried, no competing card network has managed to dent the networks of these two providers in 40 years.

Online marketplaces are also a nice place to build network effects. At scale, sellers will choose to sell on these because that is where most buyers are. Buyers will search on them because that is where the widest variety of products are available. These marketplace networks can either be broad-based and large (such as Amazon (AMZN)) or smaller but strongly focused on specialized niches (like Etsy (ETSY) or Wayfair (W)). Even eBay (EBAY), a company that has grossly neglected its platform for a decade, still is by far the #1 online auction site and one of the largest online marketplaces period. Network effects are hard to break.

One final example of modern-day network effects are social media networks. A company like Match Group (MTCH) monetizes these person-to-person networks in traditional ways, charging access or per-contact fee. A company like Facebook (FB), on the other hand, monetizes its billions-large network by running ads against people's interests (derived from data collected on what they like or follow).

False Network Effects

Like any of the economic moat factors, it is important not to be fooled by "false" network effects.

So when is a network not a competitive advantage?

Unlike some businesses, network effect businesses are most effective when they reach the maximum scale, as the key financial advantage to the model is leveraging fixed costs. There are many competitors to companies like Visa and eBay, and they have developed networks of their own, but it is not an advantage because these bigger networks can supersede them. In most cases, any endpoints on these smaller networks are also on the larger ones. They are not on the smaller system because they have to be, but because they are trying to gain new business from being there. These competitors will always be afterthoughts until they build a larger network, which is quite difficult to do at an economic disadvantage.

In short - always look for the biggest network! The bigger a lead it has on its competition, the better.

Second, investors need to be wary about how the network owner monetizes the business. In order of attractiveness:

1. Per-transaction fees: The network owner takes a small cut of every activity on its network (Visa, eBay, etc.)
2. Access fees: Recurring subscription-like fees paid to access the network (Match.com).
3. Advertising: Network is free to use, but the owner collects user data and allows advertisers to market against it (Facebook, Twitter (TWTR)).

Advertising is the least attractive and most difficult method of monetizing a network. It indicates that the value of the network is external to the company - the company is not providing any intrinsically valuable economic service. This generally indicates that switching networks will be much lower cost to the user. Combined with a less-than-dominant scale, these kinds of businesses does not really have any insurmountable network effect advantages.

Finally, network effects are strongest when the networks are self-contained. If it is possible (or government-mandated) for users on one network to access users on a separate network at little cost, there is limited value. One example of this is the cellular phone networks. While they can boast of having "the largest network in America", the fact is that users usually do not choose AT&T (T) over Verizon (VZ) because the majority of their frequent contacts are on AT&T. Any AT&T user can contact any Verizon user with no extra cost or difficulty.

Conclusion

The network effect is one of the strongest of the economic moat factors, but also one of the hardest to build. Dominant, economically valuable networks have been behind some of the most powerful companies in history, from the Dutch East India company to "Ma Bell" to Visa. Network effects can be established in a wide variety of businesses, but most notably transportation, communication, and marketplaces.

The key things to look for in a network effect are a dominant scale, reliable monetization, and a closed ecosystem. Smaller, non-leading networks do not have reliable network effects. Networks that rely on low-cost interconnections with other vendor networks do not have reliable network effects. Networks that are not monetized based on the intrinsic economic value of what the network provides have dubious value.