Switching costs are easy to understand. Simply stated, these are the costs incurred by a consumer or business when a brand, product, or service changed is made.
In many cases, consumer products carry negligible switching costs, but in business, that’s not the case. At the corporate level, switching costs aren’t just monetary. They can include lost time and reduced efficiency. Some companies, including some residing in the VanEck Vectors Morningstar Wide Moat ETF (CBOE: MOAT), provide such vital services and have such loyal customers that they are able to use switching costs to their advantage. As in they compel customers to stick with them over moving to a competitor.
“Switching costs are present when a customer’s cost of switching to a new supplier exceeds the value they would enjoy from making the switch,” said VanEck in a recent note. “Switching costs endow the incumbent supplier or provider with pricing power that can, in turn, lead to economic profits.”
The Morningstar Economic Moat Rating methodology assigns an economic moat rating to companies, but in addition, it focuses on companies exhibiting attractive valuations relative to its price. Furthermore, the indexing methodology uses five sources of economic moats, including intangible assets with brand recognition and pricing power, switching costs, strong network effect, cost advantage helps companies undercut competitors on pricing, and strong scale.
Where Switching Costs Matter
At the sector level, no group, in particular, has a monopoly on switching costs, but the healthcare and technology sectors are among those with deep switching costs advantages. Fortunately for MOAT investors, the ETF allocates about 40% of its combined weight to those groups.
“Switching costs provide a company with the leverage to increase prices and deliver hefty profits over time,” according to VanEck. “They are a key competitive advantage and are evident in a range of industries, from banks to computer software/hardware, to telecoms, among others.”
As a way to better target quality companies, investors can look to an ETF strategy that screens for companies with a strong economic moat or competitive advantage to keep them protected through any market condition. The economic moat investment strategy can help investors achieve improved long-term, risk-adjusted returns by focusing on quality companies that help limit downside risk while still participating in potential gains.
Cloud software provider Salesforce.com (NYSE: CRM), a MOAT holding, is an example of a tech name with switching cost advantages.
“According to Morningstar, its salesforce automation application is ‘mission-critical software that helps drive revenue for users,’ notes VanEck. “Morningstar notes the high organizational risk of moving away from the platform, as well as the time, expense, and lost productivity associated with the implementation of a new application.”
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.