Network Effect MOAT

Nikhil Singh, Senior Analyst - Investment and Research

Have you ever wondered why internet companies like Meta, Amazon, Zomato etc. took losses in the initial years to attract more users to transact on their platforms? Why did these companies take significant time to earn profits? Why is it tough for any other company to disrupt these businesses and take the pole position?

Today, we will try to find out the answer to all these questions. This will also help you understand the internet businesses more effectively which are very difficult to understand from the traditional perspective.

To understand Internet businesses you first need to understand the concept of the “Network Effect” which simply means the products or service becomes more valuable as more people use it. Put simply, the network effect creates a positive feedback loop—more users attract even more users, which increases the overall value for everyone involved. Network effects can be divided into 2 categories as follows:

 

 

The Network Effect is one of the most underrated and often ignored strengths that Internet businesses have over traditional physical businesses. The reason for that is that creating a network effect takes time (sometimes years) and sometimes it may not fructify at all.

However, given that the Internet has now become a utility and not a luxury anymore the Internet businesses are here to stay and you can’t keep ignoring them anymore. So even if understanding that a business is successfully creating a Network Effect is difficult but is still worth your time as it gives you an edge over other investors. Also, given that Internet businesses are not restricted to any geography or country the scope of wealth multiplication from investing in such businesses is immense.

Now, let us understand the example of a few Internet companies that have successfully demonstrated the creation of Network Effect in their businesses.

Zomato

Zomato started as a restaurant listing business, where more content drove more value for customers which drove more restaurant content and number of customers. Today, it has evolved into a delivery business network effect. More restaurants on the platform have led to higher deliveries, resulting in lower cost per delivery, in turn, driving more customers to the platform, in turn, leading to more restaurants, and so on.

 

 

Nykaa

Nykaa has created a strong moat and customer pull around its platform by delivering authentic goods, exclusive brands and highly engaging content. More customers on the platform, in turn, has attracted more brands on the platform with exclusive offers thus creating the flywheel effect. More customers, more data and purchasing patterns, and hence, more customization and the birth of private brands increasing the offering on the platform, and hence more customers.

 

 

Conclusion

Considering India could have ≈1billion+ internet users by 2025 as per Redseer Estimates, India is on the cusp of a digital revolution. With the government investing significantly in the digital public infrastructure over the past 10 years the cost of transacting online has come down significantly. Additionally, India enjoys one of the lowest internet charges per GB of data used globally.

All these factors combined with favourable demographics and rising per capita income make the strong case for the internet businesses to thrive in the future and create substantial wealth for its shareholders.

However, as an investor, you should also be careful that like in the past not all businesses will create wealth. So, the task of evaluating and identifying the great businesses remains the same. It’s just the way of looking at the business that needs to be changed with the changes in dynamics of how businesses interact with their consumers and make money.