Investing in companies with sustainable competitive strengths is crucial when it comes to generating superior returns from your Investments. The network effect provides one of the most powerful sources of self-sustainable competitive advantages, and companies like eBay (NASDAQ:EBAY), Amazon (NASDAQ:AMZN), Priceline (NASDAQ:PCLN), Netflix (NASDAQ:NFLX) and Google (NASDAQ:GOOGL) are in a position to profit from the power of networks for years to come.
Supply, demand and value
The network effect happens when the value of a product or service increases as more people use that product or service over time. This can be a remarkably effective source of competitive advantages for a company: more users make the service more valuable, and this attracts even more users, creating a virtuous cycle of self-sustaining growth.
eBay benefits from the network effect in two separate business lines that interact among each other: both Marketplaces and PayPal are textbook examples of the network effect at work. Buyers and sellers want to go to the e-commerce platform which guarantees plenty of counterparts, so they attract each other in the search for the best products and prices. The same goes for a payment system like PayPal, more users make the service more useful and trustworthy.
The company has 124 million users in its Marketplace platform, a year over year increase of 14% during the last quarter. PayPal is growing even more rapidly with a 17% increase in active registered accounts to 137 million as of the third quarter. eBay has already gone through the inflection point in creating self sustaining growth in both Marketplace and PayPal, and that´s a great thing for investors in the company.
When it comes to online retail, no company in the world matches Amazon, another renowned beneficiary from the network effect. The more people shop at Amazon, the better the recommendation engine gets, which, in turn, helps people buy more stuff from the company.
This has been a crucial advantage for the company since the beginning, but Amazon has developed additional sources of competitive strengths as it became bigger and more diversified over time. Economies of scale allow the company to operate with aggressively low prices, and its dominant size makes it viable to continue building its amazingly efficient distribution network and providing a differentiated service to customers.
Online travel agency Priceline is another noteworthy example to consider. Travelers want to go where they can find more and better deals, and companies like hotel operators, airlines and car rental businesses choose to partner with the online travel companies that can bring in more customers. Ratings and recommendations also strengthen the network effect.
The company has outgrown competitors like Expedia and Orbitz Worldwide by a considerable margin through the years, and it now has more than 355,000 hotels in its Bookings.com reservation platform, an annual increase of 45% as of the last quarter. The company is getting better as it becomes bigger over time, and that´s good news for both customers and shareholders in Priceline.
The value of information
Netflix has access to enormous amounts of information regarding the viewing habits and tastes of its more than 40 million members, and successful original productions like House of Cards and Orange is the New Black prove that the company knows how to leverage that information. Kevin Spacey and director David Fincher are quite popular among Netflix subscribers, and so is the British version of House of Cards. Combining these data points, Netflix had good reasons to anticipate that its version of the show was going to be a success.
The company analyzes every detail it can possibly track: not only ratings and recommendations but also geo-location, device information, social media interaction and other data sources. This is critical when it comes to creating new content or buying it from other sources, and it puts Netflix in a position of strength versus other industry players.
Google is no stranger to the dynamics of the network effect. The company understands that more users for its services; Search, Gmail, Chrome, Maps, etc., mean better information for Google, and this information becomes very useful to increase the quality those services and to target advertising as efficiently as possible.
That´s why everybody loves Google: the company provides many popular services and applications for free, and 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 and a profitable business model for investors.
The network effect is a very powerful and 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, so it's a factor to consider when making investment decisions. These five companies are in the right position to benefit from the power of the network effect for years to come.
Andrés Cardenal owns shares of Amazon, Google, Netflix and Priceline. The Motley Fool recommends Amazon.com, eBay, Google, Netflix, and Priceline.com. The Motley Fool owns shares of Amazon.com, eBay, Google, Netflix, and Priceline.com. 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.