2 Competitive Advantages Driving Stock Returns | Smart Change: Personal Finance

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As a long-term investor, you understand the incredible wealth you can build over decades simply by buying and maintaining quality companies. But how exactly do you recognize ‘quality’ companies?

There are many characteristics of great companies, but one thing they all have in common: a kind of competitive advantage. The ability to recognize when a company is ahead of the competition is integral to successful investing. That’s why it’s incredibly important to understand two of the biggest competitive advantages in business: network effects and counter-positioning.

Let’s take a look at what they are and how we can identify companies that exhibit these benefits.

Image source: Getty Images.

Network Effects

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Network effects is a phenomenon where a network increases in value exponentially with every user who joins. According to a study by NFX.com, nearly 70% of all value generated by Silicon Valley is attributed to network effects.

A simple example of a network effect is the Internet itself. When the internet first came online, there was pretty limited value. In fact, the first version of the Internet was created by the US government for military use only, so its value was limited to internal users within the US Department of Defense.

But once the Internet became accessible to the public, its value quickly increased as more users began to interact on the network. Most importantly, the users have stimulated value creation. Without them, the network would be dead in the water. And as more users joined, the value increased exponentially.

Network Effects in Today’s Market

Today, network effects are seen everywhere in technology companies, from Metaplatforms until Airbnb† But not all networks are created equal. The utility and experience of the network influences the strength of the competitive advantage.

Etsy (NASDAQ: ETSY) has a strong network effect because it is a unique marketplace. As more merchants and users joined the platform, the value on both sides of the network increased dramatically. This is largely due to the unique experience that has been enhanced with each additional node added.

An example of a network effect with limited benefit is: Uber (NYSE: UBER)† When Uber launched its ride-hailing service, it had a powerful network effect. As more drivers joined the network, the value proposition for users increased dramatically as they could encourage rides to more places. But the utility of the service is to get from point A to point B. That’s all.

So when Lyft (NASDAQ: LIFT) launched a competitive network, drivers and riders alike were happy to go to the platform that offered them the best value. This ultimately led to a race to the bottom in terms of pricing for these two companies. While it does exist, Uber and Lyft’s network effects are weak at best.

Counter-positioning

Counter-positioning happens when a new entrant to the industry adopts a superior business model and the incumbents fail to mimic the change for fear of harming their business.

This is such a powerful advantage because the disruptor puts the market leaders in a difficult position. As you would expect, it is very difficult to change your entire business model, especially if you are a multi-billion dollar company. So the incumbent is forced to take the incredible risk of trying to completely flip its business model or continue operating under its existing model, knowing it is inferior to the newcomer.

This example is perfectly illustrated in the Blockbuster and Netflix (NASDAQ: NFLX) legend. Netflix, the newcomer, used a unique and ultimately superior business model: subscription entertainment, first by mail and then via streaming.

Blockbuster’s business model, on the other hand, was based on opening as many stores as possible across the country. So when Netflix came on the scene, Blockbuster had to make a choice: either turn the company away from personal rentals and move to a subscription model, or stay on track. We all know what they decided and what the end result is.

From the incumbent’s perspective, there is no good choice. But often these companies choose to stay on track because it feels less risky, or because they doubt the viability of the new model.

Counter-positioning in today’s market

A contemporary example of this phenomenon unfolds between Tesla (NASDAQ: TSLA) and the existing automotive OEMs. Tesla’s business model does not include advertising or using dealers for distribution, allowing it to take advantage of higher margins. At the same time, incumbents such as Ford Motor (NYSE: F) and General engines (NYSE: GM) rely heavily on advertisements to capture mindshare and are tied to dealer unions, which Tesla has circumvented.

Only time will tell if the incumbents are making the right decision by staying on track.

Identifying Competitive Advantages is an advantage

As an investor, your ability to recognize both the existence and strength of competitive advantages gives you a huge edge. It requires you to become extremely familiar with both the industry and the business models of the players in it.

While this takes a tremendous amount of work, it is the key ingredient to building conviction and, in turn, long-term outperformance.

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Randi Zuckerberg, former director of market development and spokeswoman for Facebook and sister of Meta Platforms CEO Mark Zuckerberg, serves on the board of directors of The Motley Fool. Mark Blank holds positions in Airbnb, Inc. and Tesla. The Motley Fool holds positions in and recommends Airbnb, Inc., Etsy, Meta Platforms, Inc., Netflix, and Tesla. The Motley Fool recommends Uber Technologies. The Motley Fool has a disclosure policy.

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