Investors looking for companies that offer long-term outperformance want what Warren Buffett describes as a moat, a defining characteristic that defends it from the competition. Some industries are not very conducive to building a differentiated brand.
Where a business cannot stand out to attract customers, it might as well make it hard for customers to leave.
$1 Billion Business
AOL shows us how well high switching costs affect a company’s bottom line. Today, the company still sells millions of subscriptions – even if you haven’t seen a “free trial” CD in quite some time. The Wall Street Journal reported that 40% of its revenues ($1 billion) were derived from dialup subscribers at the time of its TechCrunch acquisition a few years ago.
The truth is that picking up the phone is too much work for people, even if the savings are worth several hundred dollars per year. Serious switching costs, like a fee for cancelling, would only make it more difficult for people to cancel and move service. And just imagine if AOL actually had a product worth buying in the first place!
(Revenues are naturally in decline, but only at a rate of 15% annually. Incidentally, people seem to move once every six years.)
No Finance Experience Necessary
The best part about finding businesses with high switching costs is that it doesn’t take a whole lot of work. Think about just about any choice that would come with some kind of cost:
- Cell phones – There’s a massive early termination fee for a reason; it keeps phones cheap and customers to wait for another phone upgrade rather than moving to a new service.
- Gasoline – Gas and oil aren’t going anywhere. Electric cars may be cheap, but the switching costs for infrastructure are huge!
- For-Profit Colleges – Credits earned at a for-profit university usually are not transferable to other schools. So, by the time you realize that a for-profit school is likely a waste of cash, it’s already too late – you might as well finish!
- iProducts – Apple uses switching costs to its advantage all the time. The similarity between iPhones, iPods, and iPads isn’t accidental; it reduces development costs while increasing the switching cost for consumers. Why learn a new operating system when you can use one you already know? The iPhone was the first workable cell phone for iPod-toting soccer moms.
- Online shopping – Amazon’s Prime creates a switching cost for every transaction; once you’re in you won’t want out. And you’ll never want to pay shipping. Let’s not forget the annoyance of signing up for a new account at a new retailer, regardless of what kind of account you use.
- Renting – Buying a home is expensive. Shopping for a home is draining. The switching costs are huge any many with this one. Oh, and never forget the actual part called moving! (Don’t forget to cancel your AOL subscription.)
- Investments – Want to move your retirement plan? That’ll be 37 pages and $500. Want to switch mutual funds? That’ll cost you another sales load of 5.25%.
- Pennies and Dollar Coins – Plenty of pricing systems, vending machines, change machines and cash registers would need to be switched for dropping the penny or switching to dollar coins instead of bills.
Switching Costs are Behind Every “Ugh!”
Any time you find yourself disappointed with the outcomes of a choice, you’ve found a possible alternative protected with a switching cost. Most of the time, the switching cost is merely emotional – it’s a change of pace. Others can be much closer to our wallets like exit fees, or more time consuming like searching costs.
The next time you say “Ugh” you might want to see if the reason is a switching cost, and the producer is a public company. Each complaint could be a big benefit to your retirement portfolio. All things being equal, wouldn’t you want to hold onto the companies with loyal customers? Why not recognize that some of the things we dislike about a business might make it an excellent investment?
Have you noticed any switching costs in your daily life? Are there any products to which you are loyal just because of the costs to switch?