Network Effect — One of Technology's Most Powerful Forces

Over the last 25 years, global internet adoption, the rise of cloud computing and the explosive growth and usage of smartphones have impacted nearly every aspect of our lives. However, the impact of these technologies isn’t limited to individual consumers. Several companies in the technology sector have benefitted greatly from the “network effect”–the phenomenon where the value of a product or service increases as more people use it.

Take Facebook and Instagram as examples. As more users join the apps, the more likely they are to find friends, family and groups to engage with through pictures, videos and posts. Additionally, users are unlikely to switch to a competing social network if it doesn't have a user’s personal connections. For established platforms, network effects discourage existing users from leaving a platform and create barriers to entry for competitors, thus establishing a strong competitive moat around the business.

Firms that benefit from network effects also gain scale advantages, spreading high fixed operational costs over a wide user base, leading to a high incremental profit business model. This highly profitable model also allows management teams to put capital back into the business to strengthen their network and expand into adjacent market opportunities through product bundling. Thus, management teams can reinvest profitable cashflows at attractive rates, compounding a firm's value.

Compared to 10 years ago, building a software product, especially one geared towards consumers or collaboration, has become easier due to the rise of cloud computing platforms (e.g., Amazon, Microsoft and Google, among others) and the availability of open-source software. These tools allow agile software development teams to quickly develop, and frequently refine, a product. Additionally, advertising platforms including Google and Facebook have refined their digital advertising techniques to help businesses market new software to prospective customers quickly and efficiently. Given the attractiveness of the software sector, early-stage software companies have an easier time raising venture capital for building and marketing their products. At the same time, new software offerings face steep competition from large technology companies who might be fearful of losing their moat, especially if a new product has the potential to lure away existing users. These factors create fierce competition for newly launched software products, as copycats emulating a successful product quickly emerge. We often find that commercially successful tech offerings not only have innovative features providing utility to users but also have product features to kick in the network effect mechanism as part of their product strategy. These products often attract new users by word of mouth and viral marketing at little to no cost and increase user engagement over time. In turn, the number of inactive customers declines as more users adopt the technology, increasing ultimate network value. In other words, network effects create significant barriers to entry for new competitors, even if they quickly replicate a product or have vast financial resources to compete. Given the intense competition in the tech sector, we believe successful network effect products are well positioned to thwart competition.

At Diamond Hill, we are business analysts and look at fundamental factors when estimating a company's intrinsic value. Given that network effects can be a crucial pillar of our thesis, we always assess and monitor whether a company's network is growing or shrinking over time. To evaluate the health of network effect products, we:

• Evaluate user engagement levels

• Review a company's customer acquisition method and associated costs

• Estimate a product’s ability to generate attractive economics while providing pivotal utility to network participants

Other risks we monitor regularly are user churn, market saturation, spam, competition and regulatory intervention that may weaken network effect advantages.

Since user acquisition and retention are crucial to network effects, we closely track several usage-based statistics to evaluate user engagement. These statistics help us evaluate user retention and ascertain the ongoing utility of the product amongst the customer base. Examples include:

• Daily active users (DAU) and engagement levels for Facebook (Exhibit 1)

• Annual search query growth on Google

• Number of video minutes watched on YouTube

• Number of Microsoft Office 365 subscribers

Exhibit 1: Facebook’s Daily Active Users & Engagement

Source: Meta Platform filings.

When evaluating customer acquisition costs, we look for product features that can acquire new customers inexpensively or for free. Usually, this efficient customer acquisition method works when existing users are incentivized to invite or refer their network of friends to the product. This keeps customer acquisition costs low, fighting against the natural rise of expenses, as newer customers are harder to attract and products face copycat competition.

Periodically, we assess the ability of a networked product to accelerate revenue generated from its user base by providing add-on products or services and gauge how companies reduce costs through improved operations, as they have insight into the networked product's usage patterns. We also evaluate if the business model is improving with time, as products can provide more value to network participants as networks grow.

As intrinsic value investors, we invest with a long-term mindset and seek businesses with sustainable competitive advantages at reasonable valuations. We occasionally uncover companies who enjoy the network effect competitive advantage yet the market (because of its shorter-term outlook) underestimates the duration and magnitude of a firm's network advantage. This underestimation often leads to mispricing, allowing us to purchase these companies at a discount to our estimates of intrinsic value. Today, we own several companies we believe benefit from network effect, including Meta Platforms (previously Facebook), Alphabet (formerly Google), Nasdaq, Microsoft, Alibaba and Tencent. Given the attractive characteristics of companies that benefit from network effects, these firms have the potential to increase their intrinsic value over time, providing value to our clients.