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Jae Jun
Jae Jun
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Product Quality-Based Switching Costs Alone Are Not Enough

I had an interesting email exchange with a reader this week about switching costs that I think warrants a discussion. I’ve expanded and clarified my replies

November 10, 2019 | About:

I had an interesting email exchange with a reader this week about switching costs that I think warrants a discussion. I’ve expanded and clarified my replies, but I largely took the reader’s responses as is.

Is product quality even a switching cost?

Reader Mat wrote:

"I read your notes on Pat Dorsey’s investment philosophy. I wanted to get your thoughts on a lock-in based moat.

Dorsey claims that having a product with a high benefit to cost ratio creates a switching cost moat. I think I disagree; I would say it is a weak lock-in moat.

Most lock-in effects are created by having something 'sticky' (for example, Oracle, where you put all your data into the database and it becomes hard to move it out). But this type of moat doesn’t have anything conventionally sticky.

Basically, Doresey is arguing that having superior product quality compared to the next best product can be seen as a switching cost. What are your thoughts on this? Do you think this is a real lock-in effect?"

To which I replied:

Maybe another way to look at this is through pricing power. When companies demonstrate that they can charge a premium versus competitors, they have an economic moat.

A Warren Buffett (Trades, Portfolio) quote comes to mind here:

"Basically, the single-most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business."

What enables companies to charge more? In this context, having a vastly superior product could absolutely justify a price premium.

Should we categorize this as a “switching cost”? Let’s think about it.

I agree that it’s not the same kind of cost in terms of time and effort that would be required to move your data out of an Oracle (NYSE:ORCL) system. It can be very quick and easy to just use a different product. However, if that comes at the cost of it doing what you need it to do, or you need to use 10 times more of it to get the job done, then that, too, is a real cost of switching.

Let’s return to Dorsey’s definition of a switching cost: “The cost of switching to a competitor outweighs the cost or product benefits of a new and better product.”

I think this is a good definition, and I think product quality meets this bar.

Is product quality a sustainable competitive advantage?

Mat had an interesting take on that:

"I find it interesting that a vanilla product quality-based switching cost does not get bigger as the user continues to use it (unlike, a traditional switching cost — e.g., the Oracle database).

The example that Dorsey gives for the product quality-based switching cost is the mining machine lubricant. It leads me to the question: how do you properly execute on a product quality-based switching cost strategy?

As you mention, it seems that product quality-based switching costs only works when the product incorporates something like a trade secret or patent to give it the quality advantage that competitors can’t replicated.

Without that, this isn’t a strong competitive advantage: the product quality will be competed away. Strong intangible assets like essential patents (e.g., Qualcomm’s 3G patents) are needed to get this play right."

There are several great points here.

One aspect of switching costs is that the more a customer invests, the less likely they are to switch.

Oracle is a great example. Customers naturally increase their investment in Oracle by putting more data in, training developers and users and buying related add-ons.

However, there is also a different kind of dynamic that is helping to make Oracle’s switching costs increase over time: network effects. Oracle has a strong virtuous flywheel of more data, more users, more value.

Here we see two characteristics of switching costs that go up over time: the ability to see how customers can easily invest more time and money into the product, and network effects.

Product quality alone is not sustainable

So does a high product quality-to-cost switching cost strategy do that?

Often not.

In Dorsey’s example, a superior lubricant is not going to get used in more places over time. It’s possible the superior lubricating technology can be used in related products that could find new applications in a customer’s business. Really, though, as soon as a better product comes along, any and all could be switched out.

There’s also clearly no network effect inherent in using a better product like this.

So is a product quality-based switching cost's moat worse than an integration- and network effects-based one?

Not necessarily. It certainly makes sense that to maintain and even increase a product quality advantage over time is easier if you have patents or can develop other complementary moats (e.g., a strong brand). These are real assets that can be bought and sold, so it’s easier to wrap our heads around them.

There’s a whole other category of capabilities and competencies, however, that can lead to a sustainable competitive advantage.

Competence-based special capabilities

Organizations that can develop a distinctive continuous innovation process can offer differentiated products over time. I think it’s possible for this to be unique enough that it’s a real moat.

Combine that with more scale and spend than the competition, and it could be very difficult to compete away a quality advantage even over long periods.

Having just one high-quality product is not enough for long-term investors, however. You need a way to replicate and continuously deliver on that.

Whether that’s through patents, brands or internal customer service and research and development processes, I’m not sure it matters.

Certainly, from the outside it’s harder to assess the sustainability of the internal stuff. This makes it a more difficult investment to make, but one that can still make sense.

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About the author:

Jae Jun
Old School Value is a stock grader, value screener and valuation tool for busy value investors.

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