Long-term investors should look for companies that have durable competitive advantages, which are also called "economic moats." There are a variety of types, such as high switching costs, barriers to entry that impede newcomers, or cost advantages, but what they all have in common is that they help businesses succeed over extended periods of time.
When it comes to wide moats, however, a network effect is arguably the greatest advantage a business can have. These eight companies possess this valuable attribute.
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Platform business models are unique
A linear business model might be easier for investors to understand. Take a retailer, for example. Inputs are purchased from suppliers, goods are manufactured at factories, and merchandise is sold via physical locations or online. Commerce occurs in a straight line.
Platform business models are more complex. The companies involved provide arenas for various activities to occur, connecting buyers and sellers or consumers and producers, collecting revenue in some way during the process. The key feature is that their products and services get better and more valuable as their user bases get larger. That's the defining feature of a network effect.
As such companies' user bases grow, those users experience better value propositions, which can discourage them from switching to a competing platform. These businesses also typically operate in winner-take-most markets.
Payments providers connect merchants and shoppers
Within the realm of payments, American Express (AXP 1.11%) falls into this category. It operates its own closed-loop system, connecting 160 million merchant locations with 153 million active cards.
NYSE: AXP
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There are also the two dominant open-loop card networks -- Visa and Mastercard -- each of which has billions of cards in circulation, issued by third-party banks around the globe. Visa and Mastercard are accepted at more than 175 million and 150 million merchant locations, respectively. And they are two of the most profitable enterprises out there.
Dominant internet leaders have clear network effects
In the age of the internet, we've seen more companies pop up with clear network effects. And they have the ability to scale up rapidly to dominate their respective end markets, owing to their digital nature. It's also extremely difficult for new entrants to achieve meaningful success once a leader establishes itself.
Alphabet's (GOOGL 1.70%) (GOOG 1.60%) Google Search connects internet users with the information they are seeking. Additionally, there are advertisers who leverage this activity to target marketing to consumers. With more usage, the company collects more data that refines its algorithm, improving the experience. Google Search has a 90% market share in its space.
For what it's worth, leading streaming platform YouTube, another Alphabet business, also benefits from network effects.
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Meta Platforms has 3.58 billion daily active users across its social media apps. Its network effects stem from the fact that people want to be on the platforms where all their friends, family, and acquaintances are. This is a one-sided network effect, as users are also the ones creating content.
Amazon's online marketplace had 2.7 billion visitors in December. Merchants naturally want to list their merchandise on the site to target that massive customer base. Conversely, more consumers start their shopping journeys there because, with a growing number of third-party merchants making use of the platform, they know they'll likely find exactly what they're looking for.
The gig economy is here
The rise of near-ubiquitous smartphone penetration and faster mobile data speeds has supported the rise of the gig economy. Two companies that are built upon that foundation stand out as attractive investments.
Uber (UBER 2.16%) runs a ride-hailing service that has a presence in over 15,000 cities across the globe. Its drivers can derive greater value from their roles as service providers in the system as more people make use of it, since there are more opportunities to make money. And riders should see better pricing and shorter wait times if there are more drivers.
On the delivery side, restaurants and retailers introduce another group of stakeholders. They reinforce the network's strengths in the eyes of couriers and consumers.
NYSE: UBER
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In the world of alternative accommodations, Airbnb shines. If you're a property owner who wants to generate extra income, it's a no-brainer that you'd make it available on Airbnb. And travelers who want a wide selection of lodging options in whatever city or country they're visiting will probably check Airbnb first. The business counts more than 5 million hosts currently and handles tens of billions of dollars in gross bookings each quarter.
Next time you're looking for a stock to buy, consider a company that benefits from a network effect. That doesn't always guarantee a huge return. But by choosing such businesses, you'll be dramatically raising the quality of your portfolio.
