Switching Costs Build Moats and Retain Customers
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 US) is a major player in a number of medical markets. These include medical and surgical equipment, neurovascular products, and orthopedic implants. Since switching costs can be significant for surgeons when it comes to orthopedic implants, this is, according to Morningstar, one of Stryker’s “moatiest segments” in support of the company’s wide economic moat.
Salesforce.com Inc. (CRM US) 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.
DISCLOSURE
Company-specific information based on Morningstar analyst notes last updated as follows: Stryker Corp.: 12/17/2018; Salesforce.com, Inc.: 3/22/19
This commentary is not intended as a recommendation to buy or sell any of the named securities. Holdings will vary for MOAT and MOAT Index.
Issued by VanEck Investments Limited ABN 22 146 596 116 AFSL 416755 (‘VanEck’). VanEck is a wholly owned subsidiary of Van Eck Associates Corporation based in New York, United States. VanEck Vectors ETF Trust ARBN 604 339 808 (the ‘Trust’) is the issuer of shares in the VanEck Vectors Morningstar® Wide Moat ETF (‘US Fund’). The Trust and the US Fund are regulated by US laws which differ from Australian laws. Trading in the US Fund’s shares on ASX will be settled by CHESS Depositary Interests (‘CDIs’) which are also issued by the Trust. The Trust is organised in the State of Delaware, US. Liability of investors is limited. VanEck Associates serves as the investment adviser to the US Fund. VanEck, on behalf of the Trust, is the authorised intermediary for the offering of CDIs over the US Fund’s shares and issuer in respect of the CDIs and corresponding Fund’s shares traded on ASX.
Nothing in this content is a solicitation to buy or an offer to sell shares of any investment in any jurisdiction including where the offer or solicitation would be unlawful under the securities laws of such jurisdiction. This is general information only about financial products and not personal financial advice. It does not take into account any person’s individual objectives, financial situation or needs. Investing in international markets has specific risks that are in addition to the typical risks associated with investing in the Australian market. These include currency/foreign exchange fluctuations, ASX trading time differences and changes in foreign laws and tax regulations. Before making an investment decision in relation to the US Fund you should read the PDS and with the assistance of a financial adviser consider if it is appropriate for your circumstances. The PDS is available at www.vaneck.com.au or by calling 1300 68 38 37.
Past performance is not a reliable indicator of future performance. No member of the VanEck group of companies or the Trust gives any guarantee or assurance as to the repayment of capital, the payment of income, the performance or any particular rate of return from the US Fund
Published: 22 April 2019