The Original Social Network: A Wide Economic Moat

Way before social networking was as big as it is today, networking was being used to secure an economic moat for many businesses. This type of moat is still used today and is, in fact, one of the strongest and widest moats that a company could have. That being said, the network effect is also the most difficult moat to find and/or create from the perspective of a business owner.

The network effect as an economic moat is exactly what it sounds like. It is the scenario where a company’s product grows in its value because a network is required to use it and, therefore, companies with a larger and stronger network become more successful. A network is an extremely wide moat to have for company because, by definition, it only works if there are users that give to it and users that take from it. A user base that is large and has a high level of integrity makes it harder to penetrate and harder to replicate and, therefore, is a barrier to entry for competitors. Why would users switch to a new network when they know that the amount of users needed for the other side of the transaction doesn’t exist, or is much small than what they currently have? There are very little, or no, incentives to do so.

An example that many people use to describe a network is the credit card industry. In order for user to wants to use credit cards such as Visa or MasterCard, for their shopping, there has to be a decent number of vendors that will accept the credit cards. This is also the case for rewards cards like AirMiles and AeroPlan. People are not going to be incentivized to carry these cards around unless there are retailers that accept them for points. And because these companies have these networks established (don’t disregard how difficult it was to build them) they have this competitive advantage against other potential entrants. And so, you can see that network based businesses could conceivably be a method towards creating oligopolies, or even monopolies. The companies that have an established network will become dominant and further attract more users, making them bigger and stronger, and more valuable. Sometimes even these businesses will begin to consolidate into one. They may be merged or acquired, but the propensity to do this grows the network effect in a nonlinear exponential way.

In one of the previous posts we spoke about software and how it can use switching costs as a moat, but it is important to know that products don’t always only have to have one type of moat. In fact software, like the Microsoft Office suite also uses the network effect as a moat. People are accustomed to using packages like Word and Excel across many organizations. Because of this, it is easier to share documents and collaborate on documents. Users are confident in the other person’s ability to know the package and operate it. This even applies to the usability, for example, of outlook. There have been times where someone has sent an Outlook invite to a person who uses Lotus Notes, the only person in their contact list that uses this, and they had to refuse because it was not compatible. They eventually switched to Outlook.

In fact, as investors, the network effect should be very evident to us in the stock market. It’s one of the largest networks on the planet. If an investor wants to buy or sells a particular stock or a commodity, he has to go to the location where that market exists: a stock or futures market. I challenge any user to try and start their own market and convince these large, high demand companies, to list on it. Network effect in the works! Similar to the stock market, EBay is a great example of a company with a network-based moat. They were one of the first companies to start online auctions. They gathered all of the buyers and sellers into one spot and have made themselves the domain for online auctioning. This leads to the subject of online firms and their networks. The prime example is Facebook. With over a billion users, Facebook has one of the largest networks on the planet. Having looked around the startup space I see many users building competitors to Facebook. All of these clones die off almost immediately because the network that Facebook has built is so huge it becomes difficult to compete with. There is so much leverage domiciled in this network that can be exploited… but that is a subject for a different conversation.

Morningstar’s Pat Dorsey makes a great point about how network moats are the most common in businesses that involve knowledge sharing rather than physical capital. This is because information is non-rival; multiple users can consume at the same time. However, note that this isn’t exhaustive. Network moats can be seen in the physical world as well. One of my favourite network moats to talk about is that of currier services. Companies like Purolator, UPS, FedEx and even DHL have a huge physical network. Their planes, trucks, and carriers are all over the world making it difficult for a new entrant to provide such coverage to any one client. In addition, because this network is already setup and expensed or capitalized, each additional parcel shipped is nearly all profit. Fantastic! Or what about oil pipelines? They are already laid and cover each location to which they need to run? The same applies with rail – the network is up and created and used by many users to transport goods. Even Coca Cola has a fantastic network – their products are available in nearly every country, regardless how poor or rich the people are there. Because of this it is easier for Coca Cola to launch new products internationally.

So what’s next of the networking world? Well, just like how Alexander Graham Bell produced the phone; a product that each person had to accept to reap the advantages, maybe our next step is a green network? Hybrid, electric, of other green fuel-based cars won’t sell until there are fuel stations for them. But there won’t be any fuel stations until people start buying the cars. Here we go!