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The Investor's Podcast (We Study Billionaires) - The Investor’s Podcast Network
TIP744: Hidden Monopolies w/ Kyle Grieve
01:01:00
Kyle Grieve reframes competitive advantage through customer loyalty and introduces the Moat Strength Index (MSI) to help investors assess and track business quality.
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- [00:01]
Unknown Host
You're listening to tip.
- [00:03]
Kyle Grieve
Have you ever owned a company that looked great on paper? You know, the type that has strong financials, a big chunk of market share, and even a recognizable brand, only to watch those advantages slowly melt away? Well, you're not alone. Even legends like Warren Buffett and Peter lynch have spent years focusing on traditional competitive advantages such as economies of scale and cost efficiencies. But there are plenty of cases where those advantages just weren't enough. The issue with viewing businesses solely through that lens is that you can miss one of the most potent value creating forces out there, customer loyalty. Today, I'm going to walk you through a fresh approach to identifying enduring competitive advantages. This framework flips the script, shifting the focus away from how a business stacks up against its competitors and toward the strength of its relationship with its customers. We'll dive into the five types of customer loyalty modes, all built around increasing switching costs. And we'll look at how to score a business's customer loyalty in a more objective and structured way. Now, one of the biggest traps investors fall into is thinking about moats in black and white terms. Either a business has one or it doesn't. But in reality, moats exist on a spectrum. Some are getting stronger, some are eroding, and that distinction really matters. This episode will give you a simple scoring system to help assess the strength and more importantly, the direction of a company's moat. It's a practical tool that can sharpen your thinking, increase conviction, and help you avoid costly analytical errors. If you're a long term investor who wants to understand why some companies keep customers coming back for years while others fade into irrelevance, this episode is for you. Now let's get into this week's episode on customer loyalty.
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Unknown Host
Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self made billionaires the most, we keep you informed and prepared for the unexpected. Now for your host, Kyle Grieve.
- [02:07]
Kyle Grieve
Welcome to the Investors Podcast. I'm your host, Kyle Grieve and today we're going to discuss a book with a pretty novel idea. It's pretty tough to find investing books that aren't just, you know, rehashing the core concepts of value investing. Now, while it's good to be reminded of value investing's core concepts and its history, it's also great to see new, important ideas that could be added to a framework to make us a better investor. Today I'm going to discuss one such book, which is called Investing in Hidden monopolies by Patrick W.E. rick the book's premise is simple why customer loyalty creates superior moats and how you can profit from it. Let's start with how most investors look at a business's competitive advantage. This is achieved through the classic aspect of investing, such as examining a company through the lens of its advantages over its competitors. Now the author has a few concerns with viewing moats in this manner. Let's start with a great case study that he gave on Nokia. Now Nokia was one of the first major businesses that created the cell phone. I even actually had one as a kid. I had the Nokia 3310. Now that one product sold 125 million units globally. Nokia had a 30% market share, double that of its closest competitor. Because of this position, it was pretty evident that their massive scale advantage allowed them to do things that businesses with a lot of revenue can just do. So there's three main things they could do here. Number one was that they could spend more money on research and development compared to competitors to continue making innovative products. Number two was that they could spend more money on advertising than competitors do to stay on the top of mind of their customers. And number three, they could charge less for their products or generate higher profit margins than competitors due to scale advantages. Now in 2007 Nokia was the fifth largest brand globally. But as the saying goes, capitalism is brutal. While it was clear that Nokia had a competitive advantage for a time, the problem, as Patrick puts it, is that these advantages tend to weaken over time. A significant contributing factor to this weakening is the technological advancements made by competitors. These advancements do things such as lower production costs, enhanced features and and create platforms and ecosystems. Now in the case of Nokia, Apple was coming to eat their lunch. Apple made one tweak to their system that I think helped them just crush the competition and that was to create third party app developer communities around the iPhone. This strategy would further enhance the ability of others outside of Apple to improve Apple's devices by creating their own innovative apps. I remember around this time in 2007 I was actually a full time BlackBerry addict and I really stuck to my gun simply because I liked the BlackBerry product. There are many people I knew who were still using BlackBerry messenger to communicate which gave BlackBerry some sort of network effects. Unfortunately for BlackBerry that was pretty short lived. After I was consistently discouraged by their new product features and the lack of good apps, I eventually made the switch to Apple and have never looked back. These Same deficiencies that BlackBerry had were also a problem for Nokia. For instance by about 2010 or so, Apple had 150,000 apps compared to Nokia's 6,000. All this to say that despite all the competitive advantages that Nokia had, its inability to excite customers similar to BlackBerry, led to its eventual demise. One part of the book that I highlighted was as the success of Apple's iPhone demonstrates, low cost advantages don't provide companies with a viable defense against innovative products. Let's now look at a business that took obsession with customer loyalty to a whole new level. Amazon. So in the 2017 annual report, Bezos himself wrote, we are guided by customer obsession rather than competitive focus. To Bezos, what mattered most was delighting customers, even if that meant harming Amazon in the short term. There's just not that many businesses or CEOs that think like this. Now, since Amazon was so successful at beating competitors, not by purely focusing on competitive advantage, it's worth explaining why Amazon achieved such success. And Patrick's best guess is that they just focused on customer loyalty. In my episode on Scuttlebutt Investing on tip 694, I discussed at length how important it was to sleuth customers of a customer's product. I think this is why hidden monopolies resonates with me so much, because similar to that aspect of Scuttlebutt, it focuses heavily on the customers of a business rather than its competitive positioning against competitors. And at the end of the day, it's the company's customers who are signing those checks which determine how attractive that investment can be. So why is customer loyalty so important? Because if you have loyal customers, your benefits are significantly higher compared to businesses that just don't have loyal customers. This means that a company with loyal customers will have more repeat customers. The book notes that more than 80% of Apple's customers own multiple Apple products, and 30% own four or more products from Apple. Now, it all comes down to numbers, though. So let's explore the importance of customer loyalty in that context. Let's say we have two companies. For simplicity's sake, we'll call them A and B. They each have 100 customers. Company A has a customer loyalty rate of 80%, meaning expects to lose 20% of its customers by the end of the year. Now, company B has a customer loyalty rate of 95%, meaning it expects to lose 5% of its customers after the year. Now, let's assume both these businesses want to grow at about 10%. So company A will need to attract 30 customers, and company B will only need to attract 15 customers. This means that company B can have similar customer acquisition costs to customer A, but the total spend will be 50% lower. Patrick writes, investors should forget about a company's market share or revenue growth as a measure of its success. The true measure of its strength lies in its abilities to keep its customers coming back. A clear understanding of the behavior of a company's customers, the primary source of its cash flow, enables investors to more accurately gauge the durability of those cash flows and the company's value. This is an incredibly bold statement, and when I first highlighted it I was very skeptical and you might be as well. So let's keep diving in. Warren Buffett has said that he wants businesses that not only have a moat, but are growing one that they already have for him. This might be evident in the numbers such as an increased return on invested capital, return on equity, pre tax margins, or cash flow. And while I think that's a fantastic way to measure the direction of a company's moat, there are other ways to do it as well. The book notes that customer loyalty can be used to gauge whether a business is improving, stagnating, or deteriorating. Customer loyalty has two significant advantages over the traditional way of looking at competitors, so the first one here is that it helps investors maintain conviction. While the measures above are valid, businesses can run into all sorts of headwinds. If you see a business's cash flow decreasing, you may incorrectly believe that your thesis is wrong. If you utilize customer loyalty and can see that that's improving, you'll have no reason to sell, as it's likely that the business will have a rebound in its cash flow after a period of time. Second, businesses with high customer loyalty are very hard to replicate. If a company acquires a good piece of machinery that increases its efficiency, then all the firms in the industry will likely copy that advantage, making it a very short lived one. Look at the Berkshire Hathaway textile mill. They couldn't get a competitive advantage for precisely this reason. When a new piece of equipment was released and one participant in the industry acquired it, the entire industry was compelled to upgrade just to keep pace. Therefore, no actual competitive advantage was occurring, despite the fact that they were spending more on Capex. Now, for a business with customer loyalty advantages, Patrick says, competing becomes much more difficult. Let's now imagine a company where the cost of failure is very high. So if a business has built up, you know, just years of trust in its products and services, it's very, very doubtful that the customer will switch. If they feel the cost of failure increases by switching to a competitor's Product. This means competitors end up having to spend even more money trying to get customers to switch, with very little success. So now that we have a better understanding of why customer loyalty is so important, let's have a look at some of the customer loyalty moats that are explained in the book. There are five. So the first one is the sticky product, the second one is complementary product, third is information asymmetry, fourth is ecosystems, and fifth is platforms. So in this chapter, WeWorks breaks down each of these moats, examines how these barriers help retain customers, provides examples of companies that possess these moats, and discusses how they enhance customer value. Let's start by looking at sticky product moats. So a sticky product moat occurs when the product is enticing, and that's whether it's because it's an exceptional product or maybe it's addictive. A business like Topicus is an excellent example of a company with a sticky product. So Topicus develops vertical market software that is mission critical for a variety of different industries, specifically in Europe. Let's take education as an example. So one of Topicus subsidiaries, called SOM today develops software that alleviates administrative burdens on teachers, enabling them to devote more time to the teaching of their students. Now this is sticky because the product offers several customer loyalty benefits, including a long product lifespan, reduced variety seeking, and a small fraction of total costs. So the need for that software even during economic hardship, extensive setup and learning costs, and a large extent of customization. So Patrick refers to this type of sticky product mode as a subscription based model. There's also a consumption based model which is more common than the subscription based model. So these models have customers who engage in transactions at regular intervals which vary in size and frequency. So notable examples might include Altria group, Heineken, Kellogg's, McDonald's and Starbucks. It's a consumables based model where the product has a very limited lifespan. So, you know, things like cigarettes, beer, breakfast cereal, hamburgers and coffee are all products that are consumed very, very quickly. So if customers are loyal to the brand they want, they're just going to keep coming back for more. And since feedback on these items is nearly instantaneous, a company like McDonald's can test out new products and observe whether they deserve to be rolled out permanently, such as, you know, the McRib. Now, the value of sticky product modes is the ability to upsell. Whether you are considering subscription based or consumption based models, the ability to upsell is a very powerful tool for something like a software business. They can develop additional features or modules that enhance the value of their product. For a company like Starbucks, you know, it started with coffee and now it offers a variety of different beverages and even food. Next up is the complementary product mode. So this occurs when a business sells a low margin product in one segment, but then can complement it with a higher margin product in a separate part of the business. So the book is a superb example of Otis, and I find it hard to think of a better example. So Otis is a very boring business. They build and they service elevators. A good friend of mine actually works in the elevator industry, so we often discuss Otis, even though he doesn't sell Otis products. So Otis sells low margin equipment, but makes up for it with very high margin maintenance contracts. Since elevator maintenance is just vital to ensuring the safety of elevators, and it is regulated by governing bodies, the maintenance aspects of their business model is highly lucrative and shielded from competitors. So even though Otis margins on the equipment are nothing special, at about 6% operating margins, according to Fiskel AI, they more than make up for it in the maintenance operating margins, which are about 30%. Now, one of the advantages of elevators is that they typically last for a very long time before needing to be fully replaced. And during that period they need to be maintained. So buyers of Otis elevators will buy multi year service contracts. Part of Otis's moat is that if a different service company is hired to maintain their elevators, then the warranty becomes void. The moat has two subtypes as well. So there's a maintenance model which I just discussed with Otis, where additional customer transactions are relatively fixed and charged on a regular basis. And then the second subtype is the Razer razor blade model. So the Razer razor blade model involves irregular customer transactions. One great example that comes to mind is HP printers. So HP sells printers and you know, they're not very expensive. I went and looked it up. You can easily get one for 150 bucks. Where they end up getting customers is on the ink cartridges. So I can buy a printer for $150. That'll last for multiple years. But the refillable ink cartridges are going to cost me additional, you know, 40 to $70 per cartridge. Now one of the problems that I see here with complementary product moats is that third party businesses often offer consumables at a significantly lower price than the oem. For instance, on printers there was actually a time when you could take your ink cartridges into a third party place to get them refilled. And HP found a way around this. And here's what someone on Reddit said. They lock down their printers to only accept genuine HP cartridges, which are sold at absurdly inflated prices. And if you try to use a third party cartridge or refilled ones, HP's firmware updates, which you might not even realize are happening, will block them entirely, rendering your printer useless until you fork over more cash for their overpriced ink. It's like buying a car and then being told you can fill up at a specific gas station for five times the normal price. And if you don't, then the car won't even start. From this friend of mine who works in the elevator industry, he said that Otis will charge exorbitant amounts, like literally $15,000 for tiny replacement parts, which can be purchased from a third party for a tiny fraction of that price. But like I said, a lot of these customers are forced to work with Otis. Therefore, it's essential to understand the relationship between the supplier and the customer. Captive customers aren't always beneficial when a competitor can exploit a poor relationship. But enough of that. Let's return to the next customer loyalty moat, which is the information asymmetry moat. So an information asymmetry moat requires three parties. So you got the supplier, which is the company, you got the intermediary, and then you got the end user. So an information asymmetry mode arises when expert intermediaries make product decisions on behalf of customers who lack the necessary knowledge and expertise. This gives the supplier pricing power and customer loyalty as buyers rely on the expert's recommendation rather than evaluating alternatives on their own. The key success factor for this moat are the strength of switching barriers, the customer's degree of risk aversion, the expertise gap, and the average remaining lifespan of individual professional experts. Picture yourself looking for a new lock to keep your home safe. You may not know what's the best lock, but your locksmith probably will. You'll tell the locksmith you want the best lock possible to keep your household secure. They may say just a lock by some company such as Assa Abloy. You don't understand why their locks are good, but you've heard of them before and your locksmith insists that they are the best. The locksmith behind the scenes has undergone extensive training by Assa Abloy to ensure that they know how to properly install and service these locks. Now, because of that gap in expertise, the customer puts their trust into the intermediary. And since the intermediary has invested time, effort and money in educating themselves on a specific supplier, they tend to use more of that supplier's products. Now we get to a customer loyalty mode that I think everyone's going to be familiar with. The Ecosystem Moat I often think about investing in terms of ecosystems, but never in terms of a moat. So I resonated with this section of the book. So the ecosystem creates a seamless, integrated experience that keeps customers engaged across multiple products or services. But building this moat requires companies to gain a strong foothold with customers through a flagship product that serves as the entry point to the ecosystem. Now, we've already discussed Apple here, and the book uses Apple as an example, so let's just continue with that. There are two connections required in an ecosystem moat. First, the company must integrate multiple ecosystem products and they must create links between those products and the customer. Apple is obviously the ultimate ecosystem. So the flagship product is the iPhone. This gets the user into the ecosystem to start with. Once they realize how much they enjoy the iPhone, they start looking at other products that integrate with it. In my case, that's my MacBook Pro. Everything works seamlessly between these two. You know, my photos, notes, reminders, calendar, email, music, podcasts, imessages and contacts are the ones that I use on a very regular basis. Now, I've owned a PC in the past and the lack of integration was what always kept me inside of the Apple ecosystem. A few keys to the success of this market are the lifespan of products and the breadth of product portfolio. If products need to be constantly replaced, customers may look elsewhere. But Apple's products have a great reliability and excellent customer service, so the breadth also matters. If all Apple has was the ability to, you know, sync music between my phone and my computer, I'd be a lot less likely to stay loyal. However, since they integrate many of my most frequently used apps, it's just simpler to stay within the Apple ecosystem. The final moat discussed in the book is the platform mode, so you may recognize this one as basically network effects. Platform moats are built by connecting two distinct groups of users and facilitating a transaction or interactions between them. So this dual sided structure allows companies to extract value from both groups through things such as fees, data or other form of exchange, creating very, very powerful network effects and high switching cost. One great example of this is booking.com, a business that my co host Clay and I discussed on detail on tip 722, which I'll link in the show notes. So booking.com has a platform that serves two groups of users simultaneously. First is the hotels or hosts of alternative accommodations. These parties pay a fee to booking.com when customers use the booking.com website or app to book accommodations with them. In turn, the end user booking the accommodations receives competitive pricing, detailed descriptions and Trust from the Booking.com brand. Both parties strengthen each other, which is why platform oats are so strong. As more hotels list their rooms on booking.com, the platform becomes even more valuable because of its assortment of products expanse and because they offer a larger number of possible products. It then attracts more customers and because more customers flock to the platform. This further incentivizes more hotels to have a room available on booking.com and the flywheel continues. Let's take a quick break and hear from today's sponsors.
- [20:03]
Unknown Sponsor
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- [23:53]
Kyle Grieve
Limited time alright, back to the show. Now it's time to transition to the meat of the episode, which is how we can use the knowledge of a business's relationship with its customer to help us measure the strength of a company's moat. Measuring moats can be very hard because it's a lot simpler to just look at a business and conclude it either has a moat or it doesn't. However, if we examine moats in this manner, we obtain an incomplete picture. So two firms might have a similar moat, but one may be well entrenched while the other business is just developing their moat. How do you compare the two in that scenario? Another problem with moats is the way that most investors evaluate them. So Michael Porter wrote his Five Forces, which examines Obviously five different forces, which are the threat of new entrants, the bargaining power of suppliers, the bargaining power of buyers, the threat of a substitute product or services, and finally the rivalry among existing companies. In other words, it focuses on the specific dynamics of a particular industry, but it completely ignores the relationship between a customer and a business. I don't think there's anything wrong with Porter's five forties, but Patrick argues that the customer loyalty is a better lens through which to evaluate moats. When you think about a moat, there are really two things that a moat does. One, it protects a business from competitors, and two, it keeps customers from leaving. When examining how a business can protect itself against competitors, consider the competitive advantage period, a time which a business enjoys an advantage over its competitors. Capitalism will show that this period is relatively short for the majority of companies. Things like technological disruptions and improved efficiencies act as a razor, just reducing the competitive advantage period that most businesses have, if they even have one in the first place. You can also look at an advantage period in terms of customer loyalty, though. The book refers to this as the customer loyalty period, which states that the longer a customer stays loyal to a business, the longer the time which the supplier's cash flows are going to be protected. If customers aren't leaving and continue spending money on a monthly or annual basis, you're looking at an excellent business and it's easy to see why this is the case. So the book gives a really good example of two companies. So let's say company A loses 20 customers per year and company B loses about 5 customers per year. This means the customer loyalty period is 5 years for company A and 20 years for company B. Now, in reality, obviously, companies don't lose customers linearly, as shown in the example above. They might lose customers at a given rate. Maybe it's 10% per year or 50% per year. The most interesting aspect of a customer's relationship with its suppliers is the cash flows that are expected to result from that relationship. There's a great example of a customer buying, you know, a hundred dollar product with, let's say, 20% margins. So in one year the customer is worth $20. However, if you consider the net present value of that customer spending $100 per year, for the next 10 years, the net present value increases to $145 with an 8% discount rate. Therefore, the longer you can retain customers, the more value they hold. The book then examines several different KPIs that analysts can use to assess a company's ability to retain customers it's fascinating to see all the various numbers and KPIs that are floating around, but the problem with all these numbers are that they're not going to be publicly known and obtaining them from the company might be very unlikely as they may regard these numbers as trade secrets and they don't really want to share those with their competitors. Now the book covers several failures with customer loyalty metrics. So we got nine here. So the first one customers who are loyal out of captivity are not as valuable as those who are loyal out of satisfaction. Second, a temporary improvement in retention rates may be a symptom of short term strategies rather than a secular trend. So you can look at this, for instance, maybe there's management that are incentivized to increase short term ARR to gain an incentive. So if they're doing things that work in the short term to maybe improve that ARR, it could actually be detrimental in the long term. So the third one here is the failure to identify the effects of different time frames. Annual retention rates cannot be extrapolated from just monthly numbers. For instance, Netflix has a monthly subscriber retention rate of 96.5%. But you can't extrapolate this number to annual retention rates. The actual annual retention rate is actually only 65%. Fourth is customer data can be distorted by the definition that the company provides for its data. For instance, do paused subscriptions count as customers or not? The fifth is a failure to take customer concentration into account. It's definitely more challenging to extrapolate valid data when there is a high concentration of customers. 6 is a failure to analyze a customer base. If a customer requires a customer base in a new geography, you cannot assume that customers in a new area will act the exact same as customers in another area. Seventh is the failure to consider the customer's trial phase. So trial periods can really distort customer loyalty. A business such as HelloFresh actually loses 70% of its customers after the trial period, but the customers that it does retain are very, very loyal after the fact. Eighth is that there's a misunderstanding of a customer's lifecycle. So if your entire customer base has changing needs regarding your product and you can't service those changing needs, your ability to retain customers is going to be significantly impaired. And then the ninth one here is a failure to address the nature of customer advantages. So customer loyalty typically strengthens or weakens over time. If you overlook this, you may attribute unrealistic retention numbers to a business into the future. Now, due to the potential failures in using customer Loyalty metrics. This book proposes a straightforward three step framework that Patrick calls the Customer Advantage Framework. The framework consists of three distinct steps, all based on switching costs. So the first one is called base barriers. Base barriers discourage customers from replacing their current products and keep them loyal to the business. This might be a cheap recurring income service the company offers. It could be something simply like an auto renewal process, and it could be from a few other processes which we'll cover in depth in a few minutes here. The second one is called exit barriers. So once a customer is contemplating replacing their existing products, these suppliers face new challenges. Is it difficult or easy to replace existing products with an alternative supplier? And then finally comes entry barriers, which you might think would come first. But this situation arises if a customer wants to exit a company's product. If a customer was to switch, is there a challenge to them making that switch? Is there a learning curve involved with switching? Do you require formal training to make a switch? Will it take significant amount of time to learn how to use a new product? The part I like about the Moat Score Index, which I'm going to be referring to as the msi, is that it's efficient and straightforward to get through compared to a competitive perspective. If you're knowledgeable about a company's relationship with customers, you may not have any need to spend hours or days trying to learn more about industry dynamics. I personally find industry dynamics very interesting, but if there's time that can be saved, I'm all ears. Now, before we delve into the details of the base, exit and entry barriers, let's review how MSI can be measured. It's simple because all you have to do is really measure the number for each of the barriers. So a reputable business like SAP, which specializes in on premise enterprise resource planning, has an MSI score of 53, which is very high. Alcon, the manufacturer of contact lenses, has an MSI score of 25. But inside of each of these scores there are three parts, base, exit and entry. You just add them all up, come up with an average, and that's your msi. I'm going to be going over this in some more detail on some of the businesses that I own later in the episode. Now, the cool part about it is that you can see where a company is strongest inside each of the customer loyalty metrics. I've run the numbers on a few of the businesses in my portfolio and it was very interesting to see the results. Now the other big use case for MSI is to determine which direction a business's moat is heading. And once we understand the scores for the base exit and entry barriers, we can observe where the business is improving or deteriorating to see if a company is widening or narrowing its customer loyalty. For instance, the book uses Netflix as an example where its best barrier is the base barrier at a number of 39. But that barrier is expected to erode significantly over time, which could diminish Netflix's future cash flows. Perhaps other investors might think the opposite. In that case, you may be looking at a business that could be undervalued. We'll explore further how we can utilize the MSI for potential companies later in this episode. Let's now examine each of the barriers in some detail. So we're going to start here with base barriers. Base barriers are the barrier that occur when a customer has already purchased products or services from a supplier. The book breaks down how these barriers work in three ways. So the first one is System one thinking, the second is System two thinking, and the third is risk aversion. So base barriers are most substantial when they rely on System 1 thinking. For those unfamiliar with System 1 and System 2 thinking, I'll briefly describe it for you here. So System one thinking is lazy and intuitive, but it gets us to make a decision pretty fast. It's kind of that fight or flight response. If we're in danger, we know what to do immediately and we can do what we need to do to reduce any type of threat. But in terms of decision making, it's pretty subpar. That's where System two comes in. System two is more slow and deliberate. It requires more energy, but the quality of the decision is much higher. Now, Patrick makes an excellent point that base barriers that rely on System one are potent because customers will make snap judgments to buy the product. Three factors impede customers from activating System two. That's satisficing behavior, the stability of their financial situation, and the use of products that represent a small proportion of their total expenditures. Now, risk aversion here is also a very critical factor. Aircraft manufacturers must have safe equipment. If they don't, nobody's going to buy it, or regular authorities will forcefully remove it off of aircraft. And if there are significant risk factors associated with switching suppliers, then the supplier can lower the probability of a customer switching. The three factors that are included in risk aversion are the degree to which a product carries a high cost of failure, customer's previous switching experiences, and domain expertise. Now let's go over each of these factors in more detail. So the first factor here is satisficing a Nobel Prize winning economist said, decision makers can satisfy either by finding optimum solutions for a simplified world or by finding satisfactory solutions for a more realistic world. So what satisficing means is whether the product is good enough to discourage a customer from switching to an alternative. Apple does a good job on satisficing behavior. So each year they are releasing a new iPhone with new features and new benefits. They are reducing their customers satisfaction levels, but because they tend to keep users inside of their ecosystem, users are more likely to upgrade their existing phones rather than look at a different supplier. The absolute and relative price of a product make a difference to customer loyalty. If someone is going to pay, let's say $500,000 for a home renovation project, they're probably not going to bother arguing over ways to save $5. However, if they're considering a product that costs $15, then saving $5 becomes highly relevant. This base barrier is significant for suppliers that are offering lower priced products. If a competitor wants to try and steal customers, they can simply discount their product, which would increase the customer's ability to seek variety in that product line. Fast fashion comes to mind here. The clothes you know are very easy to replicate and cheap to produce. So even if you get some customers, there's a good chance they will shop around to find very similar products that might be a few dollars cheaper. Now let's discuss how a customer's financial situation influences their decision making. This is a very simple concept. When a customer experiences minimal changes in their economic conditions, they are less likely to switch as they are very satisfied with the satisficing heuristic. However, if they have significant change in financial circumstances, and that's whether it's positive or negative, it can increase the chances that customers will reevaluate their purchasing decisions. I've been researching a business that services the E and P industry. And while the E and P industry can be very volatile depending on the price of oil, the service companies that utilize the products of the business that I'm examining tend to be relatively stable since they have a wider variety of business lines. Even if one part of the business isn't performing well, it doesn't make a significant impact on the finance of the entire business. And because of this stability, they're less likely to switch to a competitor's products. Now let's look at three factors that affect risk aversion, starting with the price of expertise. I'm very familiar with this, especially when I go to get my oil changed. I will freely admit that I don't know much about Cars. It's just not something that interested me when I was younger and still doesn't interest me as I get older either. So whenever I go to get my gas changed and the service guy tells me that I have 10 different things that are wrong with my car, I have a massive gap in expertise. The guy servicing my car could theoretically make up whatever they wanted. Because I have no desire to really learn about it. I would be at their mercy if they tried to abuse that power. This expertise gap offers the service provider additional negotiating power towards their customer, making people like me more susceptible to price gouging or unnecessary services. The interesting part about this example is that the knowledge gap isn't that big. You know, if I really wanted to, I could spend some more time on the Internet learning about cars through something like ChatGPT or YouTube. But other industries that constantly innovate ensure that that knowledge gap actually stays wide. So even if I were to close the gap on understanding maybe their first generation products, once they release the second generation, I would be in the dark again. However, if that innovation closes the expertise gap by making things simpler, then the product actually runs the risk of becoming a commodity with no competitive advantage. So suppliers have to kind of toe this line between being innovative and keeping the knowledge gap sufficiently broad to avoid customers from switching. The expertise gap is interesting for some businesses, but unnecessary for others. For instance, some suppliers have a product that is just so vital that the customer will not even consider another supplier's product. That is what a high cost of failure looks like. Remember that business I was speaking about that services, the E and P industry? If their product were to fail on, let's say, an offshore rig, the cost would be very high. These rigs are often rented and can cost up to, you know, $800,000 per day. So if something were to happen that would cause a delay to that rig, that's an awful lot of money to stay idle. So if these EMP service companies could find another product trading for a discount, but just had no experience with that product, they may not be swayed to switch, even if the discount is substantial. If there was even a chance that switching would cause a delay on the rig, then the discount would turn into a liability very, very quickly. So this barrier exists on products that are vital to a customer's operations. The last barrier we'll discuss here is a customer's previous switching experiences. So when evaluating a customer's experience with a product, you must ask, have they switched before? And what was the customer's experience like when they switched as a business owner, you would prefer to have customers who haven't switched before because that alone denotes that you have loyal customers. Now. Generally speaking, this base barrier works hand in hand with the risk averse nature of a customer. If the customer is highly risk averse, they're unlikely to test out competing products. However, if they have no risk aversion, then you'll need to consider other base barriers to achieve customer loyalty, as it's likely the customer will have tried alternative products. The podcast that you're listening to right now is a great example. So in podcasting, there obviously is no risk aversion. You could follow bad advice from a podcast, but it's unlikely to cause you a massive loss. As a result, many podcast listeners tend to listen to multiple podcasts rather than being loyal to just one. When I look at my own podcast app, I have around 13 podcasts in my feed that I'm subscribed to. So when you're evaluating a business's base barriers, I think it's smart to go through a checklist, examine these barriers that keep customers on system one thinking, and then consider the avenues that relate to risk aversion. If a business doesn't have substantial base barriers, that's okay as it can make up for it on the next barrier, which is exit barriers. So exit barriers keep customers captivated by the product. As we've already discussed, captive customers aren't always satisfied with the product, so we prefer them to be loyal due to satisfaction with the product. Some companies make it difficult for customers to exit because their products become so embedded in them in various ways. So the different ways here are monetary loss costs, benefit loss costs, the sunk cost fallacy, breadth of use, extent of modification, brand relationship costs, personal relationship cost, and addiction. So let's examine each of these facets individually, beginning with monetary loss costs. So the book has a great example of the relationship between Pinterest, a digital pinboard company, and Amazon Web Services. So in its 2022 annual report, Pinterest disclosed that it had to spend at least $3.25 billion on AWS cloud services between 2021 and 2029. But let's say Pinterest finds another service provider, such as Microsoft Azure or Google Cloud. If they thought the services were better or they could maybe get a better rate, they could theoretically switch, but they would actually be penalized for switching. So for Pinterest to break its contract with aws, it would need to pay the difference between what they'd already paid and $3.25 billion. So this benefit is often seen in subscription based businesses and is also known as things like a breakup fee, exit fee or early termination fee. Therefore, for a provider like Azure or Google Cloud to take Pinterest business away from aws, they may need to pay that breakup fee, which as high as it is, seems very unlikely. Monetary loss costs deal with the customer's finances, but another way that a supplier can keep you interested in their product is by offering benefits that would be lost if you decide to take your business elsewhere. A great example this is Amex. So I have an Amex card that is partnered with aeroplan. So I earn points that I can use on travel whenever I use the card. If I want to cancel that card, I would no longer be able to collect those aeroplan points. And if there's no activity on my aeroplan account such as earning new points, redeeming points, donating or transferring for 18 consecutive months, my points will expire completely worthless. So this is a benefit loss cost. Since I've accrued a fair amount of points over the years and I would prefer not to lose them, it keeps me in the Aeroplan ecosystem. And from what I found, Amex is the best way for me to collect aeroplan points. So I just stick with them and pay my yearly fees to Amex. Let's take a quick break and hear from today's sponsors.
- [42:11]
Unknown Sponsor
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- [45:32]
Kyle Grieve
All right, back to the show. So next we encounter sunk costs. Sunk costs occur when we have invested a significant amount of time or effort into a product. I remember speaking to a TIP mastermind community member in Omaha in 2024 about why I like Topicus so much. All of Topicus subsidiaries are mission critical software companies. For instance, one of their services is the Force Product Suite. So this UNIFI platform streamlines the entire mortgage lifespan for lenders by serving as a shared workspace where all stakeholders can update and access information in real time. It also offers things such as a customer portal, which allows buyers to track the status of their mortgages directly. Now, users of this suite undergo training on it and many hours are spent learning how to effectively use that software. While yes, there are competitors out there, you'd have to retrain your entire staff on new software, and that can be a significant challenge as it means diverting time from actual work to learning a new software platform. So the next one here is breadth of use, which is another exit barrier that prevents customers from looking elsewhere. I've noticed this barrier in my son's love for monster trucks. So he has these Hot Wheel monster trucks littered all over the house and he never says no to getting a new one. The breadth of use means that once a customer enters an ecosystem and enjoys a product, they're more likely to stay within that ecosystem. So regarding my son, there are numerous contact points that Hot Wheels has with him. They have this Netflix show called Hot Wheels Let's Race that is constantly on and that he loves and it showcases all of their products. I haven't even gotten him one of these racetracks yet, but I'm sure he's going to love that once I get it for him. And Hot Wheels is also always coming out with new cars or trucks that my son finds absolutely fascinating. So as long as he enjoys cars and monster trucks, I assume he's going to stay inside of that Hot Wheels ecosystem. Some products that are custom built for a customer require so much modification that switching becomes an afterthought. The book mentions enterprise resource planning, and I think that's probably the best example available. So a friend of mine who works in the fashion industry told me that his company created its ERP system using Microsoft Azure. It was completely customized, and he said it took about two years to be built out and for employees to learn it. So the amount of modification needed to fit his exact business was immense. Now let's imagine his company then wants to add additional features to improve their ERP system. Are they going to go through another two years of building it out with someone else who can match the customization that they already have? Or will they just simply pay Azure more money to add more features? It's pretty obvious that it's probably just going to be the latter. The next exit barrier is more challenging to identify from an investor standpoint in business, and that's personal relationship costs. So business is a highly personal endeavor, but as an investor you aren't Boots on the ground enough to really understand some of the more subtle relationships that are built between a business and its customers. However, it matters, and it matters a great deal. So a trust manufacturer I own depends on many of these types of relationships. From my research on the business, I've always wondered why they don't operate in Vancouver, where I live and where I know that their buildings being constructed at a very, very swift pace. The reason is that builders here lack loyalty to their suppliers. All they care about is getting the cheapest price possible. So where my business excels is actually in these smaller communities where personal relationships with contractors is vital. The business definitely does not offer the lowest price, but the product is superior. And contractors are aware of that. Since they have these long standing relationships with the company, they're willing to pay a little more extra to maintain their good standing. If a contractor in these more rural areas were to take their business elsewhere, it would actually alter the relationship for future deals. So they often do business with the same person to ensure the relationship stays strong and to maintain favorable bargaining power. When you think of businesses like McDonald's, Coca Cola or Starbucks, you're looking at companies that have built up very, very powerful brands. Now, a brand's strength lies in a strong loyalty that it is cultivated with its customer base. This loyalty is founded on principles such as integrity and trust. This trust builds strong behavioral and emotional connections that customers can't really find elsewhere. This is why McDonald's has been flipping burgers since 1940 and still does today. Another strength of brands is their consistency. Customers prefer to do business with companies where they know they will consistently have a positive experience. This is why having a McDonald's hamburger in Vancouver, BC will be the same as having one in New York. If I have a bad experience in one location, it would make me question the credibility of that Entire brand. And McDonald's knows this, which is why they have incredibly high quality control standards. Lastly, here we get to addiction. While I think addiction has a negative stigma attached to it, it's not always bad. I've been addicted to many different things throughout my life and I don't regret some of them. For instance, I've been addicted to many different sports in my life and I don't regret any of it and I don't think it caused any long term harmful side effects. But in business, the key to gaining addiction benefits is to reinforce customer habits frequently. Which means the products that are consumed quickly are more likely to be addictive than those that are consumed over a extended period of time. So social Media, I think, is the perfect example of, unfortunately, an unhealthy addiction, but it serves as a great example of1. So ByteDance, the developer of TikTok, is a prime example. Now, I've never opened an account because I feel I can spend my time better, but I know that there's so many people, kids and adults alike, that are just glued to using that app. The videos are short, they're consumed quickly, and the algorithm is very good at finding your next dopamine hit. Now, the app is just excellent at keeping you engaged and preventing boredom. Other examples include things like soft drinks, alcoholic beverages, and cigarettes. Now we reach the final layer of customer loyalty, which is entry barriers. So entry barriers create additional friction for potential customers who are considering switching to them. These entry barriers are exclusivity, search costs, evaluation costs, setup costs, and learning costs. Now, exclusivity can be a very robust barrier. Since I've been speaking so much about McDonald's and Coca Cola, we'll use those two as an example. Let's say you're a fan of Pepsi. In that case, you're not going to step foot inside of a McDonald's. And that's because McDonald's has an exclusive supplier agreement with Coca Cola. This is an example of a territorial exclusivity. Unless you're authorized to sell inside that territory, you're excluded. Another type of exclusivity is content exclusivity. For streaming businesses such as, you know, HBO Max, it can be challenging to really retain customers, as that product is seen as a bit of a commodity. One strategy to improve retention is to partner with other businesses, as HBO max did with AT&T. AT&T offers specific customers free subscriptions to HBO Max, which helps to reduce HBO Max's churn rate and provides value to ATT's customers. My favorite type of exclusivity is actually regulatory exclusivity. This occurs in types of businesses where patents protect products. Yes, competitors can eventually try to figure out how to compete with a product by maybe reverse engineering it, but that can be very expensive and time consuming. This is part of why I like microcaps. Many of them have solved problems which larger companies just don't want to bother trying to solve because the market is so much smaller. Another entry barrier is search costs, which can create problems with finding competing products. If I want something such as a bag of chips, you know, I can go to Safeway down the street and have an entire aisle of competing brands. So potato chips would have obviously very low search costs. If on the other Hand, I'm looking for a product that can maybe, you know, hide heat signatures from enemy drones. I'm probably going to have a lot of trouble finding a product like that unless I'm deeply involved in the military. Unfortunately, with the increasing popularity of the Internet, it's pretty challenging for a business to maintain high search costs. Now, speaking of low search costs, it's also pretty easy to find reviews on competing products. This is what is basically evaluation costs. Let's say I have a product that I'm completely ambivalent about and I might look for alternatives. Let's say I go onto Amazon and I see that they have competing products, but the cost is half the price and the product has four and a half star reviews from literally thousands of people. There's probably a pretty good chance that I'm going to switch. Search costs and evaluation costs fits very well with the satisficing behavior, which we've already covered. Remember, we're very lazy by default. If it requires too much energy to find alternatives and evaluate their quality, we will simply stick with what we already have and remain loyal. The two final entry barriers I'll lump together because I think they are pretty similar. They are setup costs and learning costs. So setup costs require the customer to have significant costs just to get the product ready for use. If you need to hire a specialist to set up equipment, and it's a lengthy product process, you probably won't be in any rush to switch to a competitor and repeat that process. But if it's easy for you to install on your own, you might not have any problem switching. Learning costs are another great entry barrier. Many businesses require users or intermediaries to complete lengthy courses that can last 100 hours or even more. Once people have gone through that training, they're likely to stick with that product as they will have the advantage of the training that not everyone else has, and they will have the sunk costs of having invested money and effort into training in the first place. Now, the final chapter of the book discusses several ways that customer advantages can be disrupted. So the first one is regulations. Some companies have monopolies that aren't necessarily hidden. Alphabet, I think, is a great example. It owns 92% of the search market worldwide. So if they want to increase prices, they could do so and there wouldn't be that much that their customers could do about it. And because of that, Alphabet is in constant litigation due to its monopolistic powers. And there have been rumblings that it may even spin off some of its segments, such as YouTube, just to appease regulators. Second is sanctions. So when Russia invaded Ukraine, it was incredibly disruptive due to the sanctions that were placed on Russia. Since many countries around the world did business inside of Russia, it was a painful lesson for these companies. One great example is Netflix. So they had to cancel 700,000 subscriptions in Russia due to the sanctions. And while that actually represented a very small percentage of their overall subscriber base of 222 million, it was a shock to the company's perception as the share price tumbled 75%. This serves as a timely reminder that perception is often stronger than reality. The third one here is change in ownership. So when another company acquires a supplier, key personnel may be let go as part of that restructuring process. If the business has high customer relationship costs, then letting key personnel go could lead to customer switching. Snapple is actually a really good example of this. Snapple was a brand of juice that was incredibly popular for a time. So Snapple was acquired by Quaker Oats in 1994. Quaker fired many of Snapple's independent distributors who had great relationships with many smaller retailers and delis. They did this to take advantage of their distribution channel, which they felt was more efficient. However, sales absolutely plummeted and Quaker Oats ultimately sold snapple at a $1.4 billion loss. And then the last one here is Weak Customer Advantages so companies with high customer loyalty will have an easier time maintaining their customer base compared to a business with low customer loyalty. The book features a valuable table that illustrates the various ways competitors can target specific customer advantages to attract customers away from them. So Charlie Munger once said, when you find a truly great idea, take it seriously. And I think this concept of customer advantages is a great idea. When I first read the book, I felt like it was primarily aimed at software businesses. It mentioned several great customer retention metrics, but when I considered how I could apply them to the companies that I already own, I realized it would probably be useless because many of the businesses that I own don't disclose any of these numbers. However, Patrick was aware of this, which was part of the reason he developed his Customer Advantage Framework that works on all sorts of businesses. So I didn't speak very extensively about numbers on this episode, but I will do so here briefly, just to illustrate how any investor can apply the Moat Strength Index to a business that they already own or are maybe researching. So I'm going to use a business that I own as an example here, and we'll use Topicus. So Topicus is a European serial acquirer of vertical market Software businesses. When I ran the numbers for base, exit and entry barriers, it scored very high compared to some of the other businesses that I own. The scoring system here is quite simple. So you rank the strength of each advantage as either low, medium or high. So low gets a score of 0, Medium gets a score of 1 and High gets a 3. Topicus got a base score of 78, an exit score of 30, and an entry of 47. Its total MSI score was about 52, which is very high even compared to many examples in the book. So to get each score, you have to do the following. The first is that you add them up for each advantage. For instance, the base, the total score was 14 for topicus. You then divide that by the number of scoring criteria. In the base case, there's six and you multiply that by the three different types. Then you multiply that by 100. So since the number of scoring criteria varies for each customer advantage, you must use correct numbers. So the base is 6, the exit is 9, and the entry is 5. To get the total score, you just average the sum of all three of these scores and then you'll get your moat strength index number. Here's how I plan on using this framework in my own investing. So first I'm going to review the MSI scores of all the businesses that I currently have in my portfolio. A company like Topicus has an insanely high MSI score, which is excellent. My guess is another constellation spin off, Lumine, that I own will have a similar score. But when I ran this on a business like Aritzia, the score is actually only 12. And it makes sense. You know, Aritzia is a fashion business. Nearly anyone can visit a mall and see a variety of competitors. The question then becomes, will I use these MSI scores to help with decision making? And the answer to that is yes, but not necessarily by culling businesses with low scores. So I think specific industries such as retail will generally have low customer loyalty on average. However, if you can find a company that has even a nominal advantage, that can be a significant edge over competitors. And I think Aritzia has that slight edge. An alternative perspective is to examine each of the three customer loyalty moat scores and envision the direction each is heading in. So you can use some destination analysis here. Where do you think they are gaining an edge? And where do you think they won't be able to make any improvements? And what do you think competitors can do to detract from customer loyalty? Let's conduct a destination analysis here for Topicus. In the context of customer advantages. So its most significant customer advantage were rooted in its base barriers. Its weakest area was in exit barriers. There are certain areas of Topicus business where they will never score more than a zero, for instance in the benefit loss costs. Since topicus SaaS businesses don't offer benefits such as points, they will never be able to build on their score of zero in that area, and that's perfectly fine. So I gave them a medium score on breadth of use and personal credibility costs. This is an area where they could probably improve or may be susceptible to competitors entering the market and helping customers switch. How might a competing business do this? So a competitor might do things such as lobby for interoperability of software, making it open use, which would open the floodgates to competitors. They may hire key people from a Topicus subsidiary who have strong relationships with customers, and these individuals would then bring their customers with them if they were to join a competitor. I plan to highlight specific areas of Topicus where they are vulnerable to competitors or where they can improve their customer advantages. Additionally, conducting this analysis may reveal some places that I could maybe spend some more time researching. For instance, I gave Topicus a medium score on breadth of use. I could be a little off here, though, perhaps it deserves a higher score. I need to examine some of the subsidiaries more closely to determine the number of modifications the software has. Many software programs offer a variety of different features, and since Topicus is mission critical, they may provide a wide breadth of different service options. Now, the wider the better, because it means customers are more likely to be satisfied with their current services and less likely to shop elsewhere for a competitor to meet those changing needs. The next area that I'll be using this framework on is my checklist when evaluating a new business. So you can examine each of the customer advantages individually and assess their strength in each area. Now, while you're doing this, you'll notice which barriers are strongest and which they're weakest in. If you want to go the extra mile, you can run this analysis on competitors as well. I have about three other ideas that I've thought about in regards to how I can use this framework. So the first one is as a filter. So if a business doesn't have an MSI score, let's say above a benchmark, you just don't buy it. While this is interesting in theory, it will probably lead you to overweight specific sectors or just completely ignore sectors that might offer some very, very, very good opportunities. And even though some companies might have hidden monopolies, the Market is very efficient at sussing these things out. It's no coincidence that a business like Topicus is going to have very high customer advantages and the shares trade at a high price. The second one is as a monitoring tool, so I'll be using it to track the direction of customer advantages and businesses that I own, ensuring that I see where they are moving towards. If it's evident that a company I own is going through a weakening of its customer advantages, that doesn't bode very well for the future of the company. Capitalism is obviously brutal and I'd prefer to exit a business that is on the losing side of that fact as early as possible. But on the opposite end, I'd love to own businesses that are widening their moats, and if they're improving customer advantages, they're doing precisely that. If I have a company that is either maintaining a high MSI score or showing gradual improvement in the MSI score, I can use that as a signal to hold on to a good idea. As Buffett and Munger have said, good ideas are rare. And if I have another way of identifying a good company, I want to make sure I leverage that so it stays in my portfolio for as long as possible. And the third one here I had was just as a waitlist tool. So if you get the MSI score of a business that's on your wait list, there's probably a reason that you don't own it. Perhaps it's because it's too expensive, has too much debt, or, you know, using this framework, maybe it's MSI score falls short of your benchmarks. Now, the beauty of entrepreneurship is that business owners are continuously striving to improve their business. So just because a company has an MSI score, maybe of 20 today, doesn't mean it'll stay there into the future. If the business truly wants to create customer advantages, it should monitor what it is doing to improve in areas where it can improve. And if they do things right, they may enhance that score even past your benchmark. Or suppose you have very high conviction that what they're doing is going to help that score over, you know, a multi year time period. In that case, you might get into that investment a little earlier and just reap the benefits of improved customer loyalty a few years in advance. Now, I want to close this episode out by discussing a subtopic that Patrick writes about in his book titled what is Buffett's critical lessons to CEOs? Buffett said, on a daily basis, the effects of our actions are imperceptible Cumulatively, though, their consequences are enormous when our long term competitive position improves as a result of these almost unnoticeable actions. We describe the phenomenon as widening the moat. Our managers focus on moat widening and they are brilliant at it. Now you don't have to be Warren Buffett to take advantage of this. If you own a portfolio of businesses, you can clone his framework here on an individual basis. Evaluate all your management teams which ones are improving the width of their moats and which ones are allowing their most to get smaller. I think Patrick Weirich's framework here is a great start, but it can be combined with other frameworks to further enhance its effectiveness. For instance, I really like Hamilton Helmer's seven Powers Now Whether you use competitive advantages or customer advantages, the goal for a business should be to make it more challenging for competitors to steal market share. The goal for a business should be to make it more challenging for customers to switch Another interesting thought on customer advantages is how they can have a kind of lollapalooza effect. For instance, strengthening one customer advantage can have an outsized impact on the overall strength of a customer advantage. One example from the book is when the cost of a product represents only a fraction of a customer's total expenditure and the product holds critical importance, the mutual reinforcement of customer advantage significantly reduces the likelihood that customers will change suppliers. This is an example where, you know, one plus one equals three. If you can find these lollapalooza effects in business, you'll get some incredibly high quality companies in your portfolio. Customer advantages are very tough to build, though. You know, entry barriers, for instance, are complex for a company to build on its own, but are actually sometimes actually gifted to them by their competitors. For example, if competitors are making it more challenging to buy, install, or use their product, it can actually strengthen the loyalty to other companies. Smart home technology is a very good example where you may need 10 different apps to control all your smart home technology. If you have 10 different brands now for this reason, if a customer already has a brand, they're likely to add products from that same brand if they want to upgrade or expand their selection of products. That way they don't have to use, you know, 10, 20 different apps. Exit barriers, on the other hand, can be a little bit easier to establish. Benefit loss costs such as warranties, certifications, or points present hurdles for customers to switch. And if products require customization, that further increases customer loyalty. This is why companies with highly specialized products can have more success widening their moat compared to companies with standardized products. Another benefit of specialized products is that they often have a longer lifespan, but certain parts have shorter lifespan. This can offer suppliers additional recurring revenue streams by supplying spare parts. And that's all I have for you today. On customer advantages. Want to keep the conversation going? Follow me on Twitter at rational mrkts or connect with me on LinkedIn. Just search for Kyle Grief. I'm always open to feedback, so feel free to share how I can make the podcast even better for you. Thanks for listening and see you next time.
- [67:08]
Unknown Host
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