What are Moats? Part 3: Switching Costs
A truly great business must have an enduring "moat" that protects excellent returns on invested capital.
— Warren Buffett
In this article, we build on the life lessons of Warren Buffett, who included the above statement in his 2007 Shareholder Letter to emphasize his investment philosophy. Moats provide a competitive advantage and, consequently, pricing power. The importance of moats is discussed in Part 1. This week, we focus on Switching Costs.
Companies with a moat based on Switching Costs have pricing power as it is difficult for their customers to switch to competitors. These barriers can have various foundations, often related to high financial, emotional, labor-intensive, and/or knowledge and data-related switching costs.
High financial switching costs arise when customers, whether businesses or consumers, will pay a significant price to switch to a competitor. For example, stockbrokers may charge substantial fees when consumers wish to switch to another broker and transfer their stocks (without having to sell them, transfer money and buy them again). Or think of companies that are so dependent on certain contractual obligations that switching to a competitor would incur a large penalty (exit fees).
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In addition to high financial barriers, there are also significant time and labor-intensive switching costs. A prime example is the German company SAP, which provides ERP software to its clients, forming the backbone of their business processes. Integrating an ERP system is both time-consuming and labor-intensive. Depending on the size of the company, a full implementation can take several years. Once integrated, these companies are unlikely to consider undertaking another such costly project, given the associated financial, time, and labor costs. Moreover, it would take considerable time to train all employees on a new ERP system and ensure they are adequately acquainted with it.
Another example is a company like Apple. Once you, as a consumer, are integrated into the Apple ecosystem with an iPhone, Apple Watch, MacBook, and/or iPad, all connected to the same iCloud, switching one of these devices to a competitor becomes less attractive, as the value derived from their interconnectedness would diminish.
In the next article – part 4 of this series – we will focus on the Network Effect moat of companies.
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