An Investor's Guide to Switching Costs

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.

Introduction: 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 deliver hefty 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.

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 insights 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 Companies Use Switching Costs 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.

Customers Get Locked-In by Switching Costs

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.

Switching Costs: When it would be too expensive or troublesome to switch away from a company's products, that company often enjoys pricing power.

Not just monetary in nature, switching costs can also be measured by the effort, time, and psychological toll it takes to switch to a competitor.

Switching costs provide a company with the leverage to increase prices and deliver hefty profits over time. They are a key competitive advantage and are evident in a range of industries, from banks, to computer software/hardware, to telecoms, among others.

Examples of Switching Costs in Action

Gillette Razor Blades – Designed to Create Brand Attachment

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 a number of 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, one of Stryker’s “moatiest divisions” 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.”

Salesforce

Salesforce.com Inc. (CRM) is a leader in providing cloud-based solutions that address many aspects of customer acquisition and retention. According to Morningstar, its salesforce automation application is “mission-critical software that helps drive revenue for users.” Morningstar notes the high organizational risk of moving away from the platform, as well as the time, expense, and lost productivity associated with the implementation of a new application.

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.

Recognizing and understanding switching costs empowers investors to evaluate market opportunities, identify companies with competitive advantages, and make informed investment decisions. Incorporating the concept of switching costs into investment strategies can lead to long-term success and capitalize on the value created by companies with strong customer loyalty and high barriers to entry.