Saturday, April 28, 2012

The Little Book That Builds Wealth: Chapter 4

Morningstar's equity research director authored this book on identifying companies with competitive advantages. Dorsey separates competitive advantages into four categories, providing a framework for understanding how wide a moat a company really has. The book is full of examples of companies Dorsey believes have moats, and the reasons why their moats are likely to last - or not!

This chapter is about the second category of competitive advantage: switching costs. When switching costs are high, firms are able to charge existing customers a little bit more than they otherwise could, and this often leads to strong returns on capital.

Switching costs come in a variety of flavours, from tight integration with a customer's business to high retraining costs. Dorsey uses a multitude of examples to illustrate how prevalent high switching costs are.

For example, deposit account turnover rates at US banks are just 15%. Not only does it take a chunk of time for a customer to switch accounts to a competing bank, but there is the added stress of a potential missed bill payment or absent pay-cheque as a result of the switch, keeping most customers locked in with their bank.

Some individual examples are cited, including Intuit, with its QuickBooks software. While strong competitors such as Microsoft may try to erode its space, the competition is mostly unsuccessful, as a business that has already entered its data into QuickBooks is unlikely to be willing to change to a competing software program unless there is a very compelling reason.

Oracle databases don't just lock in data but also customers. To switch out of Oracle, not only would a customer have to incur the expense of moving all of the data itself into a competing database, but also alter all of the software programs (e.g. web programs) that access these databases.

One group of industries noticeably absent from the discussion on switching costs are consumer-oriented segments such as retailers and restaurants. This is because it's very easy for a consumer to shop for clothes at a different store or drive a few miles to save a few cents a gallon on gas.

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