Warren Buffett has spoken much of moats, or characteristics that allow a business to enjoy above average profits over a long time period despite the constant threat of competition. As investors, we can sleep better if assured that our companies have characteristics that give them immense sticking power with customers even in the worst of times. Pat Dorsey’s 2008 publication, “The Little Book That Builds Wealth”, is an excellent piece of work on moats – and accessible to the layman. Dorsey expands on four key moats:
The Challenge: Identifying Switching Costs
Most companies do not have moats, and are thus likely to generate mediocre returns over the long haul. Without barriers to entry, competitors are free to copy or improve on the product and then lower prices to gain share. There is no systematic method I’m aware of to screen for moats, but their presence can be detected by finding companies with a consistently high ROIC, or Return on Invested Capital. ROIC is simply annual profit as a percentage of the money invested in a business – it’s a crude gauge of how efficient each dollar of cash is at generating profit. The logic here is that if a business can earn an attractive return on its capital for a long period, it must possess something that is keeping competition at bay.
Unless you are a customer of a product or service that is tough to change out of, it can be difficult to identify switching costs from the outside.
I think it is correct to generalize that most “strong moat” businesses tend to be large companies. However, switching costs is the one moat that does not seem to discriminate on the size of the business. The beauty of switching costs is that they can be created through ingenuity, and perhaps that is why they are more abundant (in my view) across a wide spectrum of businesses relative to the other moat types. Most of the Starvine strategy is invested in small/mid size (i.e. less than $5 billion market cap) and switching costs have a strong presence in more than half of the portfolio.
Unless you are a customer of a product or service that is tough to change out of, it can be difficult to identify switching costs from the outside. That’s because the essence of this moat is psychological. For example, have you ever thought about changing your cable subscription to another provider? Your first thoughts about doing so will probably be the time and financial burden. The process will likely involve a good 30-45 minutes on the phone while being transferred from rep to rep, and the company will put up a fight by offering concessions. There is also the prospect of financial penalties attached to leaving a bundling package previously entered by agreeing to certain discounts on condition of purchasing broadband, wireless and cable services in one. Suffice it to say if these mechanisms weren’t in place to discourage you, the cable business would be less profitable.
BTB Companies: A Breeding Ground for Switching Costs
Where switching costs carry even more power is in certain business-to-business (BTB) situations. A great example from Dorsey’s book that would resonate with business owners is Quickbooks, which is software that small businesses widely use for bookkeeping. Speaking from personal experience, once accustomed to using Quickbooks, the bonds are hard to break. By encouraging the automatic feeding of transaction data from business bank accounts into the software, the accounting of a small business becomes almost seamless. Little manual intervention is needed to balance the books and generate financial statements. Over time, a continuous record of all a business’s transactions is formed in one place.
What does all this amount to? Pricing power. If I were to switch to another program, an investment of time would be required to learn how to use the new software. Also, my accounting system is mission critical, so why would I take the risk of changing providers unless absolutely necessary? The risk that something could go awry dampens the incentive to go with a cheaper offering. To top it off, the monthly subscription cost is a small percentage of my total overhead. Hence if Intuit (the owner of Quickbooks) were to raise the fee by 10% or 20%, there’s a good chance I will stay a customer without too much thought. Intuit’s ROIC is approximately 30%.
Another example is CRH Medical Corporation (a current Starvine holding), a provider of anesthesia services to ambulatory surgical centers (ASC) in the U.S. ASCs are typically owned by doctors, and the anesthesia practice within each ASC is also owned by the same individuals. By selling a partial or entire interest in the anesthesia practice to CRH, the doctors are able to monetize a part of their business. Moreover, having CRH administer the anesthesia practice translates into increased staffing and billing efficiency. Provided CRH performs well in its function, the ASC has no reason to switch providers. In fact, doing so poses operational risk given the high level of integration of CRH into the doctor’s business. Furthering the difficulty of switching providers is the fact that CRH’s anesthetists are bound by non-compete and non-solicitation agreements; the ASC would therefore need to swap out the entire team in order to change providers. In this scenario, the doctors would need to spend the time integrating the new personnel into the ASC’s operations, which would be daunting especially if the current services are already satisfactory. CRH’s adjusted ROIC is 20%
The businesses of the two above examples couldn’t be more different in both products and size; Intuit is $29 billion in market capitalization, versus $245 million for CRH. However, what they share in common is a deep integration into their customers’ businesses. The integration equates to being entrenched, which means not having to offer the lowest price possible at all times. In turn, having pricing power is conducive to high returns on capital.
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