Switching Costs Build Moats and Retain Customers
September 27, 2022
Read Time 2 MIN
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.
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.
An Early Example: 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.
Switching Costs in Action
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.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.
Company-specific information based on Morningstar analyst notes last updated as follows: Stryker Corp.: 7/27/2022; Salesforce.com, Inc.: 5/31/2022.
Please note that VanEck may offer investments products that invest in the asset class(es) discussed herein.
This is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.
All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future results.
January 11, 2023
Though 2022 ended without a Santa Rally, strong stock selection contributed to the Morningstar Wide Moat Focus Index outperforming the S&P 500 Index for the year.
January 11, 2023
The Morningstar US Small-Mid Cap Moat Focus Index, which applies Morningstar’s moat investing philosophy to smaller-cap companies, delivered impressive results to end 2022.
December 15, 2022
Current valuations are setting up a potential run of long-term outperformance for small- and mid-cap stocks.