As a long-term investor, you understand the incredible wealth you can build over decades by simply buying quality businesses and continuing to hold them. But how exactly do you identify "quality" businesses?
There are many attributes of great companies, but one thing they all have in common is some sort of competitive advantage. The ability to recognize when a company has an edge over its competition is integral to successful investing, which is why it's incredibly important to understand two of the greatest competitive advantages in business: network effects and counter-positioning.
Let's break down what they are and how to identify companies exhibiting these advantages.
Network effects is a phenomenon where a network exponentially increases in value with every user that joins. According to a study by NFX.com, nearly 70% of all the value generated by Silicon Valley is attributed to network effects.
A simple example of a network effect is the internet itself. When the internet first came online, there was pretty limited value. In fact, the first version of the internet was created by the U.S. government for military use only, so the value was limited to internal users within the U.S. Department of Defense.
But once the internet became publicly accessible, its value quickly rose as more users began interacting on the network. The key takeaway is that the users drove value creation. Without them, the network would be dead in the water. And as more users joined, the value increased exponentially.
Network effects in the market today
Today, network effects are seen all over technology companies, from Meta Platforms to Airbnb. But not all networks are created equal. The utility and experience of the network impacts the strength of the competitive advantage.
Etsy (ETSY 2.56%) has a strong network effect because it is a unique marketplace. As more sellers and users joined the platform, the value on both sides of the network increased dramatically. This is largely due to the unique experience that has improved with every additional added node.
An example of a limited-advantage network effect is Uber (UBER 0.34%). When Uber launched its ride-hailing service, it actually had a powerful network effect. As more drivers joined the network, the value proposition to users increased dramatically, as they could hail rides to more places. But the utility of the service is to get from point A to point B. That's it.
So, when Lyft (LYFT 3.29%) launched a competing network, both drivers and riders were happy to go to whichever platform offered them the best value. This has ultimately sparked a race to the bottom in terms of pricing for these two companies. While it exists, the network effects of Uber and Lyft are weak at best.
Counter-positioning takes place when an industry newcomer adopts a superior business model and the incumbents do not mimic the change out of fear of damaging their business.
This is such a powerful advantage because the disruptor puts the market leaders in a tough position. As you might expect, it's very difficult to shift your entire business model, especially if you're a multibillion-dollar corporation. So the incumbent is forced to take on the incredible risk of trying to completely pivot its business model or continue to operate under its existing model, knowing it's inferior to the newcomer.
This example is perfectly illustrated in the Blockbuster and Netflix (NFLX -0.38%) saga. Netflix, the newcomer, adopted a unique and eventually superior business model: subscription entertainment, first by mail and then via streaming.
By contrast, Blockbuster's business model relied on opening as many stores around the country as possible. So when Netflix came on the scene, Blockbuster was forced to make a choice: Either pivot the business away from in-person rentals and switch to a subscription model or stay the course. We all know what they decided and the end result.
From the incumbent's perspective, there is no good choice. But often these companies elect to stay the course because it feels like the lesser risk, or they doubt the viability of the new model.
Counter-positioning in the market today
A present-day example of this phenomenon is unfolding between Tesla (TSLA -1.05%) and the existing automotive OEMs. Tesla's business model does not include advertising or the use of dealerships for distribution, which allows it to enjoy higher margins. At the same time, incumbents such as Ford Motor (F 2.12%) and General Motors (GM 9.38%) rely heavily on advertising to capture mindshare and are beholden to the dealership unions, which Tesla has sidestepped.
Only time will tell if the incumbents are making the correct decision by staying the course.
Identifying competitive advantages is an advantage
As an investor, your ability to recognize both the existence and strength of competitive advantages gives you a huge edge. It requires you to become extremely familiar with both the industry and the business models of the players within it.
While this takes a tremendous amount of work, it's the key ingredient in building conviction, and, in turn, long-term outperformance.