The Power of the Network Effect

The power of a company's business model is often the most important aspect we look at in investing. A business model can tell us what kind of margins we can expect, whether competitors will be able to take away share easily, and the long-term power of a company.

One thing I like to look for is businesses that can take advantage of something known as the network effect. The network effect is nothing more than a reinforcing loop in which a critical mass of customers makes your product more attractive, which then leads to more customers using your product. The cycle can go on and on. Sounds like it's too good to be true, right? Yet some of the most successful stocks in recent memory have ridden the network effect to business success.

Are you using a PC to read this article? Do you have a smartphone or tablet? The makers of these devices rely on attracting developers to make them more attractive to potential users. More users attract more developers, which in turn entices still more users to the platform. In the early days of the PC, Bill Gates knew he had to get the Microsoft (Nasdaq: MSFT  ) operating system into as many hands as possible to make users "PC literate." By doing so and making its products the corporate standard for operating system and office software, Microsoft was able to leverage the network effect to PC domination.

Apple (Nasdaq: AAPL  ) was a little late to the network effect game with its Mac in the 1980s, but it learned a thing or two in the process. Apple's iPod led to iTunes, which eventually turned the music industry upside down. Why? Because millions of users attracted record labels, which gave iTunes more content, which attracted still more users.

Simply hit the repeat button to see what happened with the iPhone and Google's (Nasdaq: GOOG  ) Android phones. Sales spiraled higher as apps were added, sales increased, leading to more apps and ... well you know how the story goes.

Who's next?
Facebook and Twitter are two of the biggest names leveraging the network effect right now. As users have signed up for these sites, they become not only more attractive but a near must-have for many of us. That's why investors are willing to pay seemingly absurd prices for these companies. But since they are private, most people can't invest in them. So here are two public companies I think will continue to benefit from the network effect.

Stock exchanges are a great example of the network effect at work every day. Exchanges rely on market makers to provide liquidity, and market makers only make money if people trade actively on that exchange. That's why recent merger news is good for everyone in the business.

The London Stock Exchange is merging with TMX Group, which operates the Toronto Stock Exchange, to create one power exchange. Earlier this month, Deutsche Borse announced plans to merge with New York Stock Exchange parent NYSE Euronext (NYSE: NYX  ) . Rival Nasdaq OMX Group (Nasdaq: NDAQ  ) is reportedly considering a hostile bid for the NYSE, potentially bringing on other exchanges as partners in a takeover attempt.

No matter who comes out on top, everyone wins. Fewer, bigger, more powerful exchanges could lead to paying lower incentives to attract market makers. That's one reason why the market has applauded the merger talk by bidding up shares of many exchange companies over the past few weeks. Just make sure you're not left in the cold, holding shares of the last small exchange standing.

Activision Blizzard (Nasdaq: ATVI  ) is also riding the network effect to wild success with World of Warcraft. Without millions of users, the game would be just another title on a store shelf, but the interaction with other users makes the game even more attractive to new players. In the process, Activision is laughing all the way to the bank. Competitors like Electronic Arts (Nasdaq: ERTS  ) have to hope that blockbuster games live up to their billing, leading to a boom-and-bust cycle. But Activision has found a way to capture a constant revenue stream.

Even the Fool's Motley Fool CAPS uses the network effect to give investors a broad view of what other investors think of a stock. With 170,000 users, we can get a good feel for what a broad range of investors are thinking, making the tool much more powerful than it would be with only a small number of members.

Interested in reading more about one of these stocks? Add it to My Watchlist, and My Watchlist will find all of our Foolish analysis on this stock.

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Fool contributor Travis Hoium does not have a position in any company mentioned. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings or follow his CAPS picks at TMFFlushDraw.

Google, Microsoft, and Nasdaq OMX Group are Motley Fool Inside Value picks. Google and NYSE Euronext are Motley Fool Rule Breakers recommendations. Apple and Activision Blizzard are Motley Fool Stock Advisor selections. The Fool has written puts on Apple. Motley Fool Options has recommended a synthetic long position on Activision Blizzard and a diagonal call position on Microsoft. The Fool owns shares of Activision Blizzard, Apple, Google, Microsoft, and Nasdaq OMX Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (1)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 24, 2011, at 10:39 AM, bottomfisherman wrote:

    That is if ATVI can keep WOW inovative and interesting which at present they are not and will continue to lose subscribers and "riding the network effect" will mean nothing. They need another online game to keep up with increasing competition, i.e: DC Online and if Marvel ever gets the hint they too could field an online game.

  • Report this Comment On February 24, 2011, at 5:41 PM, Calm127 wrote:

    Bottom-

    Have you checked the sheets on DCU yet?.. Or perhaps read a review or two?

    I'd be suprised if it lasts as long as APB, the other MMO that was supposed to kill WoW... Also, I guess Rift is supposed to kill WoW, too. I guess we will see how that goes.

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