When it comes to making smart investment decisions, buying companies with strong and sustainable competitive advantages is of utmost importance. The network effect is a powerful driving force positioning these companies for growth over years to come.
The network effect is a phenomenon whereby the value of a product or service is increased when more people use it. It can be a fantastic advantage for the companies benefiting from it: More users make the service more valuable, which attracts more users and increases the value of the service. This dynamic creates a virtuous cycle of self-sustainable growth over time.
Social networks are a typical examples about how this works; being on Facebook (NASDAQ: FB ) would be quite boring if you were the only person using the service. But that's not the case by any means: Facebook had 699 million daily active users on average and 1.15 billion monthly active users as of June 2013.
This means there is a high probability you will find many of your friends, family, and other people on the social network. The more the merrier, and Facebook has become the leading social network on the planet, which is a huge competitive asset for the company.
Users attract more users. The company then needs to find a way to monetize that big and growing user base, and Facebook is moving in the right direction in that area.
Revenue from advertising was $1.60 billion in the last quarter, representing 88% of total revenue and a 61% increase from the same quarter last year. Mobile ads accounted for 41% of its total ad revenue in the second quarter, up from 30% in the first quarter of the year, so the company seems to be successfully adapting to the mobile revolution.
LinkedIn (NYSE: LNKD ) benefits from the same advantage: Users need to be on LinkedIn because professional contacts, potential business partners, and job recruiters are using the platform. Hiring companies want to go where all the good candidates are, especially in the case of LinkedIn, the place where they can even contact people who didn't necessarily apply for a specific job.
With more than 238 million members and 20,200 companies using its services, LinkedIn has already achieved critical mass, and the company is benefiting from the self-sustainable competitive advantage provided by the network effect. The bigger LinkedIn gets, the more valuable the service becomes for both hiring companies and professionals, and this at the same time attracts more users from both sides.
The big cash generator for LinkedIn is talent solutions for employers, which provided 56% of revenue in the last quarter, another 20% of sales came from premium subscriptions and the remaining 23% was produced by advertising. Revenue during the quarter was $363.7 million, an increase of 59% compared to $228.2 million in the second quarter of 2012. LinkedIn is having no problem at all when it comes to monetizing its user base.
Information and quality
Google (NASDAQ: GOOG ) is no stranger to the dynamics of the network effect. The company feeds itself with the information provided by users. The more we use services like Search, Maps, and YouTube, among others, the better those services get. Google gets better when it attracts more users, and it gains users as it becomes better.
That´s why everybody loves Google: The company provides many popular services and applications for free, all it asks for it exchange is for us to tolerate some advertising and to allow the company to benefit from the information we provide. Privacy issues aside, that's a fairly convenient deal for users.
Like Facebook, Google makes most if its money from advertising, and the shift of users from desktops to mobile devices is pushing down costs-per-click rates on an industrywide basis. Google experienced a 6% decline in prices during the last quarter; however, the company still delivered a 23% increase in volume, which more than compensated the decline in prices.
Card companies like Visa (NYSE: V ) and MasterCard (NYSE: MA ) provide other alternatives to position your portfolio to profit from the power of networks. Merchants need to accept cards that bring in lots of customers, and customers prefer to use cards that are widely accepted among merchants.
As these Visa and MasterCard grow, their services become more valuable to both users and merchants, and brand recognition provides an extra source of strength to the business. Once Visa and MasterCard have built their gigantic networks, these companies make a commission on every transaction, but their costs are relatively fixed.
For this reason, Visa and MasterCard enjoy gigantic profit margins in the area of 60% operating margin for Visa and 55% for MasterCard, and they have both delivered earnings-per-share growth rates above 18% annually over the last five years.
While Visa is the industry leader, MasterCard is growing faster in emerging markets, and both companies are positioned for growing sales and profits in the long term, all thanks to the power of the network effect.
The network effect is a potent and self sustainable source of competitive advantages. It's also an important driving force behind the success of many of the most remarkable growth stories of our time, and these five companies stand to profit from the power of networks over years to come.
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