Investment Checklist III - From the customer's perspective

This chapter in Shearn's book goes to the heart of the scuttlebutt approach that is so popular. Not all investors use this approach. But viewing the business through the customer's perspective can be very useful. It can expose some biases that we're falling prey to. Often we like to hear good news about the business under consideration. This positive feedback loop can actually be hugely detrimental to a sound investment thesis. The scuttlebutt approach finds answers from stakeholders who actually drive the demand for a business i.e. the customers.

This post also begins to focus on concepts for competitive advantage that were missing in the previous post. Okay onto Shearn's checklist then -

1. Who are the core customers of the company? - Sometimes a major share of the revenues can come from a small percentage of customers. Understanding why these customers will stick around at times of distress can be the differentiating factor for a company's success.
2. Is the customer base concentrated or diversified? - Without product differentiation, a company is better off with a diversified customer base.
   
   Unfortunately unlike US companies, Indian companies are not obligated to mention the names of customers that contribute the most to their revenues. But with a little search should generally reveal names.
3. Is it difficult to convince customers to buy the company's products? - A company having an aggressive sales strategies without other merits will not have a sustainable advantage.
   
   
4. What is the customer retention rate? - Brand loyalty can be the make/break thing for a company. It pays to hear from the horse's mouth why it will/will not drink the water.
   
   Companies which have subscription services might be susceptible to disruption. Tracking customer retention is crucial here. Even if there are newer customers, without returning customers a business cannot grow e.g. Why should Mahindra Holidays/Wonderla/Speciality Restaurants continue to increase profits if they don't have returning customers?
   
   It is informative to speak to sales people and see whether they receive commissions for customer retention. e.g. the insurance business is completely based on this.
   
   If a company is selective about its customers, it's usually a good thing. This shows that the company wants to work with long-term clients who'll provide sustainable business.
5. Is the company customer friendly? - A customer friendly business, especially where customer-company interaction is very frequent is likely to do better.
6. What pain does the company alleviate for the customer? - This is important to determine for service oriented companies.
7. To what extent are customers dependent on the company's product/service? - Discretionary customer spending is likely to drop in times of financial hardship. Products which are more "need to have" are unlikely to face pressure.
8. If the company disappeared tomorrow, what would its customers do? - This reinforces the need-to-have v/s nice-to-have thinking. e.g. most fixed income managers would be completely lost without ratings companies.