Businesses that enjoy network effects tend to have a much greater capacity to deliver outsized returns. They aren’t especially common, but if you can find them you stand to do extremely well — even if it often feels like you are too late.

At its core, a network effect describes a situation where the value of a product or service increases exponentially as its user base grows. Each new user adds not only to the scale of the network but also to its inherent worth. This self-reinforcing growth cycle can create a formidable competitive advantage, and can be extremely difficult to disrupt.

Some good examples on our local market include REA Group (ASX:REA) and Car Group (ASX:CAR). It’s no surprise that each has performed extremely well and each dominate their respective industries. 

In evaluating the strength and sustainability of a network effect you need to considering factors such as the size and growth trajectory of the user base, the interconnectivity and compatibility of the network, and the presence of lock-in effects that discourage users from switching to competitors. 

For example, Articore Group (ASX:ATG) — which operates RedBubble and was previously listed under that name — seemed to have the potential for a good network effect; many online market places do. Nevertheless it has been a rather poor investment, primarily because there is little to no switching costs, and there’s not much of a scale advantage over similar companies.

Contrast that with, say, Technology One (ASX:TNE) or Xero (ASX:XRO) whose products are extraordinarily sticky, albeit with less obvious network effects.

If you do find a company which ticks all of the boxes, there is still the risk of market saturation and diminishing returns. As a network grows, the incremental value of each new user may decline, limiting the potential for future growth. Yes, the company’s position may remain unchallenged, but if shares are priced for continuing strong growth you can still do rather poorly.

Technological disruptions and emerging competitors can also threaten the sustainability of a network effect, eroding the competitive advantage it once provided. For example, some investors are pointing to the rise of AI as a nascent tech that could disrupt Google’s stranglehold on search. 

Regulatory and legal challenges pose another significant risk. As networks grow in size and influence, they often attract the scrutiny of regulators and face legal challenges related to data privacy, antitrust concerns, and other issues. 

Despite these challenges, the potential rewards of investing in businesses with strong network effects are significant. 

What ASX companies can you think of that fit the bill? Extra points if you can find one that is at an earlier stage of development, and for which the market has yet to grasp the true potential.

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