One of the best investing books I think you can read is Pat Dorsey's The Little Book That Builds Wealth. The book is an excellent guide to identifying businesses with robust economic moats or competitive advantages.
One of the most powerful moats described in Dorsey's book is switching costs. These are barriers that make it hard for customers to jump to another competitor.
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The incredible power of switching costs
When was the last time you changed banks?
Most of my banking is through the same bank I've been with for the last 30 years! It has become a hub for my money: managing all sorts of arrivals and departures automatically, receiving cash, paying bills and allocating savings. To switch banks would be a huge hassle.
This is great news for my bank! Businesses that can retain customers with switching costs can charge these customers higher fees and earn higher returns without fear of losing customers.
The 3 companies with strong switching cost moats
Accounting platform Xero Limited (ASX: XRO) is a perfect example of a product with high switching costs. Once set up, Xero's software becomes deeply embedded into the daily operations of the businesses it serves. It becomes a daunting task to consider shifting to a competitor.
This helps to explain why Xero has such good customer retention rates. The number of customers that leave Xero is known as 'churn' and in the 12 months to 31 March, 2020 Xero had an average monthly churn of just 1.13%. This strong customer retention gives Xero a pricing power that it can deploy to counter-cost inflation.
A similar example is digital church payment service Pushpay Holdings Ltd (ASX: PPH). Once Pushpay's church customers are set up with the software, and the congregation has downloaded the app, it is a time-consuming and disruptive process to change to a competing product. PushPay has been growing strongly and has a revenue retention rate of 97.5%.
A different kind of switching cost is possessed by Transurban Group (ASX: TCL), one of the world's largest toll road operators. In many places that Transurban operates, transport projects' switching costs come in the form of time and convenience. Sure, you could get to Melbourne airport by avoiding the Citilink M2 toll road. But for many people, the extra 25 minutes of driving is just not worth it to avoid the $5–$10 toll.
Foolish takeaway
Keep an eye out for companies that have high switching costs, hinting that they have strong economic moats. If we can pick up these companies at a reasonable price and add them to our portfolios, the powerful returns they produce offer us a good chance of compounding our wealth handsomely over time.
