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Warren Buffett famously introduced the investment world to the concept of an economic moat and has referred to it many times at shareholder meetings, talks to students, and in his annual shareholder letters. For example, the 2007 annual shareholder letter says that “a truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier…is essential for sustained success”[1]. In a series of articles published over the coming months, we plan to discuss several different categories of economic moat with reference to listed businesses, some of which we may choose to own.
Locking in customers for longer
The first category of economic moat we will take a look at is high switching costs. This refers to attributes of a product or service that make it costly for the customer to switch to an alternative, thereby increasing customer retention, and perhaps reducing marketing, sales, and administration costs too. Locking in the customer for longer may mean you can charge more, or at least discount less, as there is a reduced risk that the customer will switch to a cheaper provider. Stickier customers make for better visibility of revenues, and therefore aid planning for investment and staffing levels, and greater predictability will likely result in a higher valuation for the business.
Switching in financial services risks delays and errors
In the consumer world, there are many situations where it may be too costly in time or money to switch suppliers, and if the product or service is adequate, inertia may set in. This is often the case in financial services such as banking, investment platforms, and ISA and SIPP providers. Even if another service provider has a lower cost or a better reputation than your own, the risks of delays or errors during a move will make you think twice about switching. Of course, high switching costs work both ways: it is hard to lose customers, but hard to win new ones for the same reason. Hence, financial service providers that are actually growing net customer numbers and assets organically are doing rather well: for example, AJ Bell had platform customer numbers of 425,652 and assets under administration (AUA) of £64.1bn at the end of September 2022, compared with customer numbers of 183,213 and AUA of £46.1bn at IPO in late 2018. Those companies that don’t grow organically often end up consolidating others, which is risky, or being consolidated, which can be lucrative for the owners.
Switching software providers risks a loss of data
In the business world, switching costs are a notable feature in the software industry, and as a consumer, you can also relate to this if you think about your use of Microsoft products such as Word, Excel, or Powerpoint. Other alternatives might be cheaper, but there may be interoperability issues and there is a risk of loss of your valuable historic records. For businesses, whether their software is enterprise level (think SAP, Oracle, or Workday) or vertical market specific, the risks of a loss of back data, lack of interoperability with other systems, and the need to retrain your workforce, and possibly customers and suppliers as well, are significant barriers to change.
Retaining customers does require sustained investment
It is however vital for any software provider not to sit on their laurels but to continue investing to improve the product functionality and features. Companies that fail to keep their product refreshed can lose business eventually to a competitor offering a step-change in functionality. This seems to be happening in the enterprise space as Workday, listed in the US, is growing rapidly and apparently taking share from long-time incumbents Oracle and SAP to the benefit of its shareholders and its implementation partners, such as Kainos. Therefore, monitoring the percentage of revenues spent on research and development is important. For example, Alfa Financial Systems, a world leader in the provision of leasing software, spent £29m in 2022 on total investment in product development. This included R&D into future opportunities; development requested by customers; development of future upgrades and modules; and overhead allocated to the engineering teams, and represented 31% of revenues. Craneware, which supplies software to US hospitals to enable monitoring of costs, expensed between 15% and 20% of revenues on R&D in all but one of the last ten years. These are the costs of staying ahead.
Specialist distributors can also demonstrate high switching costs, particularly if the cost of the component or service they supply is small in relation to the value of the finished item and delivery is time-critical. For example, Diploma distributes replacement seals for the repair of earth-moving equipment in North America. The premium price for reliable delivery in a matter of hours is worth paying if the alternative is very costly downtime for an expensive piece of kit. Add in technical advice, breadth of stock, and product customisation, and customers have no incentive to switch supplier.
High switching costs are an economic moat that we see more often than some others that we will discuss in future articles. However, this moat requires regular investment rather than complacency to be sustained.
Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Please note that past performance is not a reliable indicator of future results. Capital is at risk.
This document is for information only and does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. Downing does not offer investment or tax advice or make recommendations regarding investments. This document contains information and analysis that is believed to be accurate at the time of publication but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Downing LLP as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. Downing is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England No. OC341575. Registered Office: St Magnus House, 3 Lower Thames Street, London EC3R 6HD.
