Morgan Stanley Research Reveals how we just don't want to miss out - AKA the Network Effect

Morgan Stanley Research Reveals how Network Effects: How Connections Create Value - We can all learn from Sheep and Cattle

Network effects refer to the phenomenon where the value of a product, service, or platform increases with the number of its users. Creating these effects is challenging and costly, but essential for startups' success, and about 70% of global tech equity value is driven by firms utilizing network effects. Although building and maintaining a network is neither easy nor cheap, a thriving network can create outsized returns and provide a business with pricing power and scalability. In 2023, investors should focus on market leaders with mature network effects, as they act as an intangible asset that is crucial for the success and defense of many modern business models.

The Importance and Challenges of Network Effects in Today's Business Landscape:

The principle that the value of a product or service grows as more users engage is pivotal to the success of many contemporary companies. For instance, social media platforms like Facebook rely on this effect; the more users join, the more valuable the platform becomes as a space for connection and advertisement. Similarly, online marketplaces such as eBay benefit from network effects as increased numbers of buyers attract more sellers, and vice versa. Despite contributing to about 70% of global tech equity value, the section underscores that creating and maintaining network effects is fraught with challenges. It requires strategic planning, significant investment, and continuous innovation. The ride-sharing service Uber, for example, had to invest heavily in both driver incentives and customer promotions to establish its network, a complex and costly process that played a crucial role in the company's market dominance.

We could all follow the wisdom of "Listening to Maturity"

With funding becoming tighter in 2023, it pays to examine companies that rely on network effects. It highlights the wisdom of investing in market leaders who have already established mature network effects, as they are more resilient and poised for success.

One example detailed in this section is Amazon's e-commerce platform, where a vast number of buyers and sellers interact. The substantial user base creates a self-reinforcing cycle where more sellers attract more buyers, and more buyers attract more sellers. This mature network effect acts as a protective barrier or economic moat, making it difficult for new entrants to compete. Investors looking for stable returns in 2023 might find Amazon a safer bet due to this robust network.

Another instance is Microsoft's LinkedIn, where the value of the platform increases with the number of professionals joining. With its established user base, LinkedIn has created a network that offers unique value to job seekers, recruiters, and advertisers alike. Similar to economies of scale, this network acts as a shield against competitors and could make LinkedIn an attractive investment opportunity.

Lastly, the case of Airbnb illustrates how brand equity can intertwine with network effects. The more hosts and guests use the platform, the more trusted and recognized the brand becomes. This recognition, combined with the network effect, gives Airbnb a competitive edge that could be appealing for investors in a tighter funding environment.

These examples underline the importance of mature network effects in investment strategy, serving as a guideline for public investors seeking opportunities that offer both growth potential and a degree of security in 2023.

Original Articles Key takeaway:

A company's network effect, or connections/network of users, is a powerful intangible asset that can make or break a startup

A positive network effect occurs when the value of a product, service or platform increases with an increase in users

About 70% of global tech equity value is derived from companies relying on network effects

Network effects create scalability, pricing power, and outsized returns, but they are difficult and resource-intensive to create

Successful platforms with network effects have a layer of insulation from failure provided by their users, creating economic moats to protect them

Increasing pervasiveness of network effects is driven by the accelerated use of digital communication services and recognition of their value by companies and investors

Competition for a finite number of users will only increase as network effects become more common, creating an opportunity for market leaders with the strongest, most mature network effects to grow even larger

Investors should focus on market leaders with strong network effects and the ability to preserve cash and manage working capital.

Original Article:Network Effects: How Connections Create Value

James Martignoni Engineering