High Switching Costs as a Moat: Some Examples

How to win through downside protection

Hi Everyone,

Economic moats are structural and sustainable qualities that are inherent to a business and allow them to generate excess economic returns for an extended period. The primary test of an economic moat is pricing power. You want a business that is able to raise prices over time without losing customers to other competitors.

In this article, we will be focusing on one particular aspect of moats: high switching costs. They refer to the barriers that make it difficult for customers to switch from one company's product or service to another's.

The tech sector offers some of the clearest examples of the power of switching costs. For corporations, changing software providers can be costly, particularly if the software is integrated into the business's key operating practices. IT departments often resist change due to the difficulties of learning new software, customizing it, and training users. Additionally, switching to a new software program can result in lost productivity and security risks, and a failed rollout can result in significant costs.

Due to these high switching costs, software companies that provide business-oriented solutions can be considered reliable sources of annual revenue through license renewals, with relatively low technology risks.

Look for companies that integrate with the customer’s business and get a huge payback for renewals. Enterprise software, and data processors, are examples that integrate tightly with customers’ businesses. SAP SE SAP 0.00%↑ and Intuit INTU 0.00%↑ are such examples.

But high switching costs don’t only apply to software companies, they can also be found in the industrial sector. Otis OTIS 0.00%↑ is a company that comes to mind. Otis is the world's largest manufacturer of vertical transportation systems, principally focusing on elevators, moving walkways, and escalators. Once their elevators are installed, it’s insanely expensive to replace them, and Otis can take care of the maintenance and enjoy the recurring income.

For some reason, one company gets rarely mentioned when it comes to switching costs: Apple AAPL 0.00%↑

Have you ever tried moving all your data/music/movies from an iPhone to an android phone? Yes, it’s possible, but it’s much more convenient to stay within the Apple ecosystem once you’re in. Each time you buy a new device you just need to log in with your username and synchronize your data. No file converting, no looking up for instructions, etc. Once a user has decided to use an iPhone, he’s likely to stay with them out of convenience.

“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

- Warren Buffet - 

This Buffet quote perfectly sums up the attitude that many investors need to overcome. The growth stocks that everyone is chasing are not the ones that can capture the biggest market share in the shortest amount of time but are the ones that have inherent durability in their business model that prevents them from losing customers.

A great example of a trap investors fell into is Fiverr FVRR 0.00%↑. Where’s the competitive advantage? Since the IPO their shares had an astronomic rise, and the stock became a 10-bagger in 2 years, just to fall back from 300$ to 30$. Investors ignored that their business model has little protection against competition. Why should users stay on their site? What prevents them from switching to another platform? Those who ignored these simple indicators became bagholders.

And with the coming rise of A.I. tools like ChatGPT mundane tasks that have been outsourced to gig workers can become a thing of the past (although A.I. can lead to a short-term boost in productivity for the gig economy).

Final thoughts

A problem that growth stock chasers are missing is that such companies often don’t have a strong moat that would protect them. Therefore the growth rates are not sustainable. Oftentimes a high market share is considered a moat, which couldn’t be further from the truth. If a company has the first-mover advantage, it can win a high market share in a short amount of time, but that also means that there’s money to be made in this sector. And money attracts competition.

“Hot Products” are also not a moat. They can generate high returns for a short period of time, but only sustainable returns make a moat. The same applies to disruptive technology. Before you fall into the trap of chasing a new high-flying stock just because its market share is growing, check how well-protected its business is against the competition. Because sooner than later their dominance will fade.

I want to finish this article with a famous quote from the legendary investor Peter Lynch:

“Go for a business that any idiot can run – because sooner or later any idiot probably is going to be running it.”

Look for safety in the business model, because a moat not only protects against competition but also allows the management to make mistakes without ruining the whole business.

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I hope you learned something today, until the next issue. 👋

Disclaimer: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from my research. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.