1 Highly Underrated Moat in Growth Stocks

When it comes to moats, most investors think of advantages like network effects or superior brand recognition. And while those are both very strong competitive edges, there is one underrated moat that can create an incredible advantage for many of today’s high-growth companies.

It’s called switching costs.

Think of switching costs as the hoops a customer has to jump through to switch to a competitor’s product. It could be as simple as paying a fee to get out of a contract like with cellphone service providers or as complicated as reorganizing an entire company’s internal processes when switching integral software products like customer relationship management (CRM) tools.

The harder it is to switch, the wider the moat.

Image source: Getty Images.

Let’s take a look at how switching costs provide a competitive advantage in the following industries and companies:

1. Smartphones

Apple (NASDAQ: AAPL) has some of the strongest switching cost advantages of any company.

On numerous occasions, Samsung has released smartphones with superior features to the iPhone, and yet few choose to make the switch. While branding certainly plays a role, switching costs are an enormous factor in this retention.

To change phones, you’d have to navigate the complex process of transferring your photos and other data from the Apple ecosystem to Android. You’d also have to learn an entirely new operating system in a time when most people depend on their phones on a day-to-day basis for both work and their personal lives.

Lastly, by switching, you would lose the convenience of having your phone seamlessly integrate into the Apple device ecosystem. For those who have invested in more than one Apple device, this is a big hoop to jump through. And with over a billion devices sold, that represents a big chunk of Apple customers.

iPhone users know from experience just how difficult it can be to switch to a non-Apple phone. This barrier to change embodies the power of switching costs and is in no small part why Apple has dominated the industry for many years.

2. Enterprise software companies

Software-as-a-Service (SaaS) companies are some of the biggest benefactors of switching costs, particularly those that serve enterprises. The deeper the integration of the SaaS solution into the daily operations of a company, the more difficult it is for the customer to switch.

This is because, even if a competitor offers a similar service at a lower price, the business will have to leverage its IT team to deploy the new software and migrate any data needed from the old platform. Once that’s complete, they’ll have to train the staff on how to use the new software and go through a period of reduced efficiency while the entire transition takes place.

That process is extremely complex and highly time-consuming. Most organizations would rather stick with their current software provider than go through all that. This makes quality enterprise software products extremely sticky and gives these companies significant pricing power.

This stickiness is evident in the market-beating returns of the major SaaS leaders. Consider the 10-year returns of Salesforce (NYSE: CRM), Adobe (NASDAQ: ADBE), Microsoft (NASDAQ: MSFT), and ServiceNow (NYSE: NOW) vs. the S&P 500 over the same period:

CRM Total Return Level data by YCharts.

As these software companies continue to add additional products and services, they further engrain themselves into the core operations of their clients, only strengthening their moats.

A high dollar-based net retention rate (above 100%) gives investors an indication of the quality of the product and the strength of the company’s switching costs.

3. Medical device companies

While the medical device industry can be poorly covered by the financial media, it offers one of the best opportunities for high switching costs.

This is because healthcare providers such as doctor’s offices and hospitals have the luxury of largely disregarding cost since it’s passed onto the patient and insurance companies. This means they are mainly focused on the functionality of the devices, and if such devices work well, healthcare providers are loath to switch to a competitor.

This can be seen in Masimo‘s (NASDAQ: MASI) domination of the pulse oximeter market (those electronic clips that go over your finger to measure your blood oxygen level).

Their devices are found in 90% of the top hospitals in the U.S., and there is little reason for medical facilities to switch to a competitor because they are state-of-the-art and are ultimately paid for by the patients and their insurance providers.

The ultimate pricing power

As the economy seems to be worsening, brand loyalty alone will begin to lose its pricing power. When people’s wallets get tight, they are likely to start trading in their $5 Starbucks (NASDAQ: SBUX) lattes for cheap, home-brewed Joe.

But the pricing power found in switching costs is strong enough to endure an economic downturn. Switching coffee is easy, but a multibillion-dollar corporation changing its payroll software is a whole other story.

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Mark Blank has positions in Masimo. The Motley Fool has positions in and recommends Adobe Inc., Apple, Microsoft, Salesforce, Inc., ServiceNow, Inc., and Starbucks. The Motley Fool recommends Masimo and recommends the following options: long January 2024 $420 calls on Adobe Inc., long March 2023 $120 calls on Apple, short January 2024 $430 calls on Adobe Inc., short July 2022 $85 calls on Starbucks, and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.

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