Competitive advantages are important in all aspects of life. Whether it's the advantage the Green Bay Packers have in December when they play at home or the cost advantages Wal-Mart has over mom-and-pop stores, such advantages are integral to enduring success in a dog-eat-dog world.
One type of advantage that is misunderstood and generally overlooked in the investing world is that of the network effect. For the purposes of this article, let's define network effect as:
The effect that occurs when someone becomes a user of a service, thereby increasing the value of the service to all other users.
It sounded pretty confusing the first time I read it. So let's unpack the term below, and at the end, we'll see how the network effect plays a huge role in the market's hottest field: social media.
What program do you write with?
Perhaps the most dominant form of network effect over the past 20 years comes from Microsoft's (Nasdaq: MSFT ) Office suite. Specifically, I'm talking about Microsoft Word. For me, it's hard to imagine a world that doesn't use Word. In the early days, as people adopted Word, it became more valuable to users; their documents were readable on more and more systems. As Word became the format for writing documents, people had little choice but to adopt the software.
Telecommunications
When I had to buy my first cell phone in college, I checked with all of my roommates to see what carrier they were using. Because almost all companies offer free calls to users of the same network, we all wanted to be on the same network.
Though I'm proud to say I'm not quite as cheap as I was in college, I still like saving money; I still check to see what service my friends and family are on before deciding on a provider. Companies such as Sprint Nextel (NYSE: S ) , AT&T (NYSE: T ) , and Verizon all use this to their advantage. The more subscribers they get, the bigger their network is, and the more attractive it is to sign up with them.
Travel sites
If you sit down and think about it for a while, travel sites are able to exploit this effect as well. For every user who bids for something on priceline.com (Nasdaq: PCLN ) , hotels, airlines, car rental companies, and other travel-related providers become more willing to offer deals. They know that priceline is the watering hole where all of their potential customers go.
The same can be said for Travelzoo (Nasdaq: TZOO ) , which has begun offering "Local Deals" as part of its service. In fact, at the top of each page that offers a deal, the company states: "The collective buying power of our subscribers helped us negotiate this deal." [emphasis added] That's a textbook example of the network effect.
The next bubble?
With the astounding bump that social-media site LinkedIn (NYSE: LNKD ) got at its IPO, many have started wondering if there's a new bubble forming among social media companies. If that's true, one of the things investors have to keep their eye on is the network effect.
If my brothers and I were the only ones on Facebook, LinkedIn, Twitter, or any other social media site, it wouldn't have much value to the community at large. But as more people join, these sites become exponentially more valuable.
But here's the catch ...
While the network effect can, as I said above, increase the value exponentially with each additional user, the reverse is true as well. Just as value can go up, it can decrease exponentially once users start switching away from a service. That's why investors in Activision Blizzard (Nasdaq: ATVI ) , a gaming company that benefits from the network effect, are spooked by the loss of 600,000 users from their World of Warcraft platform in a single quarter.
If you want to keep an eye on such effects, watch the stocks that benefit from them:
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