Happy customers likely to improve level and stability of net cash flows. Researchers at the University of Michigan’s Ross School of Business think they may have stumbled into a formula for stock investing that beats the market and lowers risk: put your money in companies that go out of their way to treat customers well.

The Ross School team, led by professor Claes Fornell, set out to challenge the notion that companies please shareholders when they reduce costs by lowering customer-service standards. Using the American Customer Satisfaction Index (ACSI) – a Ross School-run gauge of quality of economic output, as measured by household consumption experience – Fornell and his colleagues found a positive correlation between companies with high levels of customer satisfaction and excess returns, and it found that investment in such companies actually lowers market risk.

Sweet carrot, big stick

The phenomenon of high returns without high risk hinges on the connection between buyer utility and capital allocation, according to Fornell and his colleagues Sunil Mithas, Forrest Morgeson and M.S. Krishnan, whose research paper “Customer Satisfaction and Stock Prices: High Returns, Low Risk” appears in the January 2006 Issue of the Journal of Marketing. “[The] efficient allocation of resources in the overall economy and consumer sovereignty depend on the joint ability of product and capital markets to reward and punish companies such that firms that fail to satisfy customers are doubly punished by both customer defection and capital withdrawal,” they write. “Similarly, firms that do well by their customers would be doubly rewarded by more business from customers and more capital from investors.”

In other words, efficient resource allocation is a function of the ability of consumers and capital to reward and punish companies. Companies that fail to satisfy their customers are punished by customer defection and capital withdrawal. Companies that do well by their customers are rewarded with more business from customers and more capital from investors. Because satisfied customers tend to generate higher levels of net cash flow in addition to more stable cash flows, returns are positively affected and risk is allayed.

The proof of that, say Fornell and his collaborators, is in the pudding. Their Journal of Marketing article describes two ACSI-based stock portfolios: one hypothetical “back-tested” portfolio and an actual hedge fund. Both outperform the market by considerable margins and both have low beta values.

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The hypothetical portfolio generated a return of 40% – not counting dividends and transaction costs – between 18 February 1997 and 21 May 2003, compared with a 13% return for the S&P 500 in that period. The hedge fund produced a 75% return from its inception in 2000 through 2003, compared with a 19% drop in the S&P 500. The ACSI portfolio also outperformed most other hedge funds, which had an average return of 28% for the same period.

The hedge fund in question is limited to qualified investors and it “relies on some fairly complicated and proprietary estimates of the extent to which capital and customer satisfaction move together,” according to Fornell. Still, he and his colleagues suggest that individual investors would be well advised to incorporate ACSI information when they buy and sell stocks.

The ACSI, which has been around for about 12 years, tracks trends in customer satisfaction and provides benchmarking insights for companies, industry trade associations, and government agencies. Its data, based on more than 70,000 household customer surveys each year, are subjected to something called “econometric parameter estimation” using proprietary software developed by Fornell. Each company included in the survey is measured annually. –FWR

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