The term “economic moat” describes a company’s ability to maintain its competitive advantages and defend its long-term profitability. This moat investing education series explores the five primary sources of moat, according to Morningstar: 1) switching costs; 2) intangible assets; 3) network effect; 4) cost advantage; 5) efficient scale. Here we explore the concept of switching costs.

Key Takeaways:

• Switching costs make it expensive and/or inconvenient for customers to leave a company.
• High switching costs ultimately give companies pricing power and reduced churn.
• Investors can utilize the concept of switching costs to identify companies with durable competitive advantages.

What Are Switching Costs?

Switching costs refer to the financial and non-financial factors that deter customers from switching to alternatives. Switching costs can include termination fees, setup expenses, additional charges, time-consuming tasks like data transfer, retraining, and the risk of a new product falling short of expectations. In other words, switching costs are present when a customer’s cost of switching to a new supplier exceeds the value they would enjoy from making the switch. Switching costs endow the incumbent supplier or provider with pricing power that can, in turn, lead to economic profits.

From an investment perspective, understanding switching costs is important because they can provide a company with the leverage to increase prices and potentially deliver higher profits over time. Switching costs also create barriers to entry in certain industries, making it difficult for new competitors to gain ground. This stability can offer more secure and promising investment prospects.

Types of Switching Costs

Not all switching costs are the same. They can take on several forms, with the strongest competitive moats often being built on a combination of more than one type:

• Financial Switching Costs: These are the direct monetary costs associated with leaving a provider. These can include early termination fees, contract penalties, implementation expenses, as well as the cost of purchasing new software or hardware. They are among the most visible forms of switching costs, most seen in telecommunications, enterprise software, and banking.
• Procedural Switching Costs: These arise from the effort, disruption, and time involved in switching providers, such as data migration, workflow reconfiguration, and the risk that new software underperforms during the transition. The longer a customer has used a product, the higher those costs tend to become.
• Learning-Based Switching Costs: When someone has invested significant amounts of time to master a product, platform, or system, that expertise becomes a switching cost. Retraining staff on a new platform is costly and risks lost productivity, making this a durable form of lock-in in professional and enterprise contexts.
• Relational Switching Costs: These reflect the psychological and social dimensions of switching, including aspects like brand loyalty, the loss of accumulated rewards, relationship history, and the comfort of familiarity. While harder to quantify, relational switching costs can be powerful retention forces, particularly in consumer-facing industries.

Understanding which type(s) of switching cost underlie a company’s moat can help investors assess its durability.

Why Switching Costs Matter for Investors

Analyzing switching costs helps investors evaluate the stickiness of a product or service within its target market. Higher switching costs indicate greater customer retention, reducing the likelihood of customer churn. This stability provides insight into the sustainability and profitability of an investment.

Investors should also consider the impact of switching costs on market dynamics. Industries with substantial switching costs give companies a competitive advantage. Customer retention due to high switching costs leads to reduced price sensitivity and increased customer lifetime value.

By understanding the factors influencing switching costs, investors are in a better position to evaluate market opportunities and identify investments with competitive advantages. Incorporating switching costs into investment strategies provides a comprehensive perspective and enhances the potential for long-term investment success.

How Do Companies Use Switching Costs to Build Moats?

The term “economic moat” describes a company’s ability to maintain its competitive advantages and defend its long-term profitability. Powerful moats can be built on switching costs, which lock customers into a company’s unique ecosystem and make it expensive to move. In the examples below, we demonstrate how companies use switching costs to their advantage and grow over time.

Examples of Switching Costs in Action

Gillette Razor Blades

King Camp Gillette, the inventor of the first mass-produced safety razor, was one of the first entrepreneurs to optimize the switching cost approach to lock in customers. In 1902, Gillette developed and began selling inexpensive razors with disposable blades that he had patented. This ensured Gillette a constant high demand for blades, as customers who considered other blades quickly realized that they would incur the cost of a new razor as well.

Stryker Corp (SYK)

Stryker Corp. (SYK) is a top-tier competitor in several medical markets. These include orthopedic implants, surgical equipment, endoscopy, and neurovascular devices. Since switching costs can be significant for surgeons when it comes to orthopedic implants, this is, according to Morningstar, Stryker’s “moatiest division” in support of the company’s wide economic moat. Morningstar adds, “Relative to other specialists, an orthopedic surgeon’s skill and experience can play an outsize role in the clinical outcome for the patient. These factors leave surgeons reluctant to train and master multiple instrumentation systems.”

Microsoft (MSFT)

Microsoft Corp. (MSFT) is among the most cited examples of switching costs in the world of enterprise software. Its suite of productivity and cloud products is embedded into the daily operations of organizations across virtually every industry. According to Morningstar, Microsoft earns a wide economic moat, with switching costs identified as the primary source. This dynamic grows stronger as organizations adopt more Microsoft products; each additional one increases integration across the enterprise and raises the cost and complexity associated with switching providers down the road.

Tyler Technologies Inc. (TYL)

Tyler Technologies (TYL) builds the core software that runs cities, counties, courts, and school districts, covering financial management, court case management, public safety, and payments. Morningstar assigns Tyler a wide economic moat arising primarily from switching costs, with intangible assets as a secondary source. The lock-in is unusually durable because these are systems of record: replacing one means re-engineering business processes, migrating decades of records, and retraining staff. Many customers still operate core systems more than 20 years old. Morningstar notes that Tyler's customer retention has held near 98% or better for years, which it describes as best-in-class. That retention is aided by the fact that local governments are generally not acquired by their peers and rarely cease operations.

Conclusion

Understanding and capitalizing on switching costs is essential for investors seeking to identify companies with sustainable competitive advantages and long-term profitability. Switching costs act as barriers that deter customers from switching to alternatives, providing companies with pricing power and customer retention. By analyzing switching costs, investors can evaluate the stability and sustainability of investments, identify companies with strong market positions, and recognize industries with high barriers to entry, all of which are key inputs to building a durable portfolio with long-term value.

As technology continues to evolve, the nature of switching costs is shifting too. Areas from proprietary data to deeply integrated software systems to digital ecosystems are increasingly becoming the new frontier of customer lock-in. This makes the ability to identify and evaluate switching costs more valuable than ever for investors.

For investors looking for a way to add companies with durable competitive advantage or “moats” to their portfolio, VanEck’s suite of moat investing strategies is powered by Morningstar’s equity research team, which seeks quality companies trading at attractive valuations. The ETFs below offer access to US moat companies:

• VanEck Morningstar Wide Moat ETF (MOAT): companies with a wide moat rating, which means Morningstar believes the company is likely to sustain its competitive advantage for at least the next 20 years.
• VanEck Morningstar SMID Moat ETF (SMOT): small and mid-cap moat companies.
• VanEck Morningstar Wide Moat Value ETF (MVAL): wide moat companies within Morningstar’s value style category.