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What Customer Satisfaction Is Telling You About The Future Performance Of These Stocks

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POST WRITTEN BY
Phil Bak
This article is more than 6 years old.

Phil Bak: At ACSI Funds, we believe that investing should be simple and not complicated. When I say simple, I don't mean that we proceed without research and without quantitative and investment merit, but that we need to take a step back from financial models and understand that behind every company is a tangible product or a set of customers that are doing business with that company -- any company in any sector. Taking out correlations to the market and the global economy, stocks tend to move on earnings surprises. It is the biggest driver of stock movements.

When you look at earnings surprises and companies that hit or miss, there is plenty of forward looking analysis, but there seems to be an astonishingly small amount of retrospection going on in the market where people say, "This stock hit or missed in a big way, but did we do anything to try to understand what drove that?" -- not from the financial statements, but from the customers who actually put up their money, who are the personification of those earnings. Did we do anything to understand or to foresee that they were going to miss or hit those earnings?

At ACSI Funds, we've got about 25 years of academic research and data that shows that there's a very high correlation between customer satisfaction and earnings surprises in both directions. It is based on the work of Dr. Claes Fornell from the University of Michigan, who pioneered the idea of quantifying customer satisfaction and figured out how to do that. He's written countless white papers showing that customer satisfaction is a leading indicator for stock performance. So what we do at ACSI Funds is we manage a hedge fund and an ETF. They use the customer satisfaction data as a leading indicator for security selection. The ETF is entirely rules-based. We have a portfolio that has 160 stocks in it. We are diversified by sector and we're trying to match the general risk parameters of the broad market.

With every sector, we weight the companies by their relative customer satisfaction scores. What we end up with is a portfolio that looks, in terms of diversification, generally similar to what most investors are typically used to seeing in their large-cap mutual funds or ETFs -- but we tilt it toward companies that are the most loved and that we think have the best chance for having earnings surprises in a positive way that are going to drive the stock price higher.

Wally Forbes: A very different approach. Can you get into a few that you like or you don't like at this point?

Bak: When you look at customer satisfaction, each sector has a very different elasticity. And there are some very tangible examples of that recently.

Take a look at Chipotle (NYSE: CMG). Out of millions and millions of customers that love Chipotle, only a few dozen got sick with food poisoning. But that story had a drastic impact on all of their customers internationally -- in every location -- because the fast food and the restaurant sectors are highly elastic when it comes to customer satisfaction.

Then you take a look at what happened with Wells Fargo (NYSE: WFC). When they had their issues, it affected many more people than were affected by Chipotle, and they were affected in a much bigger way. But the elasticity was significantly less. And that had to do with the hassle and the work that's involved in switching your bank. With people who were not directly affected, it might have left a bad taste in their mouth, but not to the point where they were going to take two days off of work in order to switch all their banking and all their auto-pays and everything else that is involved in making a retail banking change.

So it's paramount that you take a look at the customer satisfaction on a sector by sector basis so that you get the elasticities right and understand a move in customer satisfaction in one sector is very different than a move in another sector. What we're seeing in the airline industry is also quite interesting because the United Airlines (NYSE: UAL) issue captured the attention and imagination of the world.

These things have happened for as long as I can remember. There have always been different customer service snafus at the airlines -- and some really horrendous ones. But the forceful removal of a United passenger hit home to a lot of people because of its culmination. It's the straw that broke the camel's back. People were already so dissatisfied with the airline experience and so fed up with the way that they were being treated that when they saw those videos, it was a point at which they have had enough, and what we're finally starting to see is that even though there has been a huge divergence in customer satisfaction scores from the top tier companies such as JetBlue Airways (NASDAQ: JBLU), Southwest Airlines (NYSE: LUV), and Alaska Air (NYSE: ALK) and the bottom tier where you have companies like United and Spirit Airlines (NASDAQ: SAVE), at the end of the day, customers oftentimes would pull up their flight search and buy the cheapest airline regardless of the customer sentiment and the customer satisfaction levels.

Now, we're finally starting to see, after this United fiasco, that customers are making decisions based on not only what the cheapest flight is but also what their customer experience and their customer satisfaction levels are.

Forbes: How about some more stocks you like or don't like?

Bak: In addition to those leaders on the airline side like Jet Blue, Alaska, and Southwest, we think that Costco (NASDAQ: COST) is a great company. Now, they raised their membership by $5, and the stock took a big hit. We said all along -- because we could see it in the data -- we thought that it was not going to have a material impact on their subscriber base.

The customer satisfaction levels at Costco, relative to the other big box stores like Wal-Mart (NYSE: WMT) and Sam's Club, are significantly higher. Costco has almost a cult-like following, and their customers are very, very happy with their experience. We think it's a very inelastic customer base. And it even affords Costco some pricing power which they haven’t tapped into yet. We're very bullish on Costco.

If you look at the restaurant space, a lot of the big names such as McDonald's (NYSE: MCD) and some of the Yum! Brands (NYSE: YUM) have very low scores. But some of these upstart companies, like Shake Shack (NYSE: SHAK), have very high scores. And we're able to catch that very early on as that is a high growth story -- based not just on the revenues and balance sheet, but based on the customer experience.

Forbes: An interesting approach to how you select investments, Phil. I appreciate your taking the time to share your approach and your selections with our readers.

Bak: Well, Wally, I very much appreciated being able to do this with you.