Berkshire Hathaway Warren Buffett

Sustainable Competitive Advantages: Switching Costs

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Q4 hedge fund letters, conference, scoops etc

Berkshire Hathaway Warren Buffett

In one of the earlier articles in our series, we identified six distinct sources of competitive advantages. Our nine-part analytical series on the analytical framework for evaluation and assessment of economic moats is designed to develop a deeper understanding of different types of competitive advantages and an appropriate analytical framework. This is the sixth article in the series and focuses on switching cost as the source of a sustainable competitive advantage.

Warren Buffett on his acquisition of stake in IBM

Explaining his rationale for acquiring shares of IBM, Warren Buffett compared IBM to the auditors and law firms of a big company. The common thread among the three was the difficulty that the client faces in switching from one service provider to another. He said, “The IT departments… they very much get working hand in glove with suppliers. And that doesn’t mean things won’t change but it does mean that there is a lot of continuity to it. And then we went around to all of our companies to see how their IT departments functioned and why they made the decisions they made. And I just came away with a different view of the position that IBM holds within IT departments and why they hold it and the stickiness and a whole bunch of things”.

Defining switching-cost moats

Switching-cost moats, as the name suggests, exist when the customer faces significant costs in the process of switching from one service provider to another. The switching cost may emanate because the customer needs to incur these costs to ensure a smooth transition or could be driven by economic implications related to potential loss of business or inconvenience to the customer’s clients.

Switching cost-based moats fall squarely in the category of competitive advantages that arise from customer captivity. There are two primary forms of such captivity. The first one is a result of customer’s choices while the second one is a matter of barriers that the customer faces in leaving the ecosystem of the current supplier. In one, the customer chooses to be captive and in the other, it is externally imposed.

We classify customer’s choice-based captivity moats as consumer-preference moats; a moat type that was a subject of one of our previous articles. This article discusses moats where customer’s captivity is driven by barriers that the customer faces when switching from existing supplier to another one. Such moats are commonly known as switching-cost moats.

Analytical framework: Switching costs and sustainable competitive advantages

For switching costs to lead to sustainable competitive advantages, two critical elements need to be present: customer captivity and pricing power. These are the same factors that act as critical elements for consumer-preference moats. As discussed, switching cost-based moats fall in the category of moats that arise from customer captivity, i.e., the same category in which consumer-preference moats belong. The commonality of category drives the commonality of critical elements for the analytical framework.

This in turn raises an important question. Why have a distinct classification for these moats if the analytical framework shares the same driving elements? We offer two reasons. While the driving elements are the same, there are differences in ancillary factors that have a significant bearing on the application of the analytical framework. And two, there are important differences between the two type of businesses driven by differences in customer’s behavior towards these two class of businesses as in one case the customer chooses to continue using the same product while in the other one, her ability to switch is materially reduced.

The switching costs that give rise to truly dominant moats are not one-time costs. Instead, the customer continues to incur additional cost or suffers inconveniences over an extended period of time when switching from its existing supplier.

Read the full article here by Baijnath Ramraika, Prashant Trivedi, Siddhi Gujar – Advisor Perspectives

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