How to Choose Good Stocks: Look for Companies with High Switching Costs

Last Updated on March 10, 2022

When switching costs are high, a company can hold customers for life!

In a highly competitive market, where companies struggle to get repeat business from the same client, what is it that helps a company lock in its customers for life? It is the advantage of having ‘High Switching Costs’. These costs are monetary, psychological, time, and effort — which makes switching from the product almost impossible.

Almost all of us use computers. And the two software products almost all of us use are Microsoft Windows and Microsoft Office. If a new alternative program, which is even significantly better in terms of features, ease of use, etc. is launched, would people use it instead of these? Most people would not.

What keeps us from doing this? The costs involved. Is it only the monetary cost, we are talking about? No. It would definitely require a significant amount of money to shift, especially for a company, but what’s more important is the psychological cost. Switching will mean dealing with the unknown— to software which we don’t know much about. Learning it, using it, and becoming familiar with it will take a lot of time and effort. Add to this the innumerable applications which work well on Windows; we will forever worry whether the new one will work as well. Considering all this, you would rather stick with Windows and Office and keep purchasing their latest upgrades, sometimes grudgingly. The same is true for browsers and chat messengers (even though these are free).

Switching as a moat works for complicated products and services, as well as for something we all use every day, the morning newspaper. If you think changing your current morning newspaper, which hardly costs anything, is a simple decision, ask someone who has moved, e.g. from Chennai to Mumbai. You just don’t enjoy your morning ritual anymore. The reason: you have got used to your newspaper, its style, typeface, layout, etc.

When is a switching cost an effective competitive edge?

A company has switching cost as its competitive advantage when clients find the cost/effort of switching from any of its products/services not worth the trouble. If switching would mean developing a new system, educating employees to use it, investing time with the new vendor, developing capabilities that are not core to the business, or simply changing an entrenched habit, chances are that customers will not switch. Also, if customers are happy with the products and services of their current suppliers, they are inclined to give additional business to the same suppliers than find and work with new ones. Usually such additional business comes with higher margins. Hence, having the advantage of switching costs ensures repeat business and new business from the same customer. This results in higher sales and profits. Such companies are also able to pass on cost increases to the customer either through price escalation clauses or renegotiations, thereby protecting margins.

Today, IT systems form the backbone of operations for most companies. Any company would like to have a stable and reliable system. Changing from one service provider to another could lead to serious problems, putting the entire business in a tizzy. IT Companies like Infosys and TCS get around 95% of their business as repeat business from the same customers. The costs involved in the implementation of the system and training of employees — sometimes across the globe — make it difficult for customers of these companies to shift from them.

Do you have investments in companies that are difficult/impossible to switch from? Find a few companies which have this moat and add them to your Stock Watchlist.

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