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.
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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 (NASDAQ: ETSY) 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 (NYSE: UBER). 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 …….