By Claes Fornell, Ross School of Business, University of Michigan Business School

You've no doubt encountered many barometers of stock performance. So why not customer service?

Many companies are not convinced that investments in customer satisfaction actually pay off, for their investors. In fact, few top executives have really thought about it Most are cutting costs and reducing customer service in order to try and satisfy shareholders interested in profits. Along with a team of researchers at the University of Michigan's Ross School of Business, I set out to prove that this philosophy is not only unwise, but misguided from a business perspective.

Using the methodology of the University of Michigan's American Customer Satisfaction Index (ACSI), we may also have discovered the investor's Holy Grail: beating the market and reducing risk at the same time. The lead article in the January 2006 issue of Journal of Marketing found that investments in firms with high customer satisfaction ratings (as measured by the ACSI) lead to excess returns with lower stock market risk.

The challenge is how you can best extract customer satisfaction intelligence and use it in your investment strategy. As the robust and complex ACSI methodology attests, understanding customer satisfaction is not simply a matter of asking customers what they think.

How to Beat the Market

By investing in firms that treat their customers well, the research clearly shows that it is not only possible to consistently beat the market, but to lower risk at the same time. The explanation behind the discovery that assets with high returns don't have to carry high risks lies in one of the most basic principles governing capitalistic free markets: the connection between buyer utility and capital allocation.

Efficient allocation of resources in the economy depends on the joint ability of consumers and capital to reward and punish companies. Firms that fail in satisfying their customers are doubly punished - both by customer defection and capital withdrawal. Firms that do well by their customers are doubly rewarded - by more business from customers and more capital from investors. Because satisfied customers tend to generate higher levels of net cash flow in addition to stability of cash flow, both returns and risk are affected in positive ways.

Comparing Stock Portfolios

The 2006 Journal of Marketing article describes two ACSI-based stock portfolios - one hypothetical back-tested portfolio and another which is an actual investment portfolio. Both outperform the market by considerable margins. Both have low beta values (an indication of low systematic risk).

The back tested portfolio generated a return of 40% (dividends and transaction costs excluded) between February 18, 1997 and May 21, 2003, compared with 13% for the S&P 500. The actual investment portfolio fund produced a return of 75% since inception (from 2000 to 2004), compared with -19% for the S&P 500. It also outperformed the vast majority of hedge funds, which had an average return of 28% over the same time period and included up-markets as well as down-markets.

Since the Journal of Marketing article was published, the actual ACSI-based investment portfolio has shown returns that make an even more compelling case for investing in firms with high ACSI scores for their industry, or firms that are seeing their ACSI scores rise.

As of January, 2007, the actual ACSI-based stock portfolio had beat the S&P for seven straight years. The gap between the ACSI portfolio's cumulative return and the S&P's is 133% over that time frame. Investing in firms with higher ACSI scores clearly provides proven returns. Although the investment portfolio described here relies on some fairly complicated and proprietary estimates of the extent to which capital and customer satisfaction move together, it is important to note that you should consider incorporating ACSI information when buying and selling stocks.

When looking at individual companies who have recently done very well or very poorly in the ACSI recently, the impact of customer satisfaction on stock prices is clear. For example Kohl's, Google, J.C. Penney, DirecTV, and Toyota all had high scores and increased levels of customer satisfaction over the last 18 months. Their stocks have outperformed the market by a wide margin (about 50% over the last 18 months).

The same can be said for the companies that had drops in customer satisfaction, like Sprint and Dell, who saw both big drops in satisfaction and in stock prices.

Investor Advice

Investors should consider investing in companies that treat them well. If your phone company keeps you on hold too long, hang up the phone and call your broker to sell their stock. Given this clear link between ACSI and stock prices, individual investors should be looking at a company's ACSI scores as one of several factors they use to determine an overall investment strategy.

Second, this research should encourage corporate boards and investors to demand a better measurement of customer satisfaction and more information about the status of firms' customer relationships.

About the ACSI (www.theacsi.org)

Established in 1994, the ACSI is a national indicator of quality of economic output, as measured by household consumption experience. It is produced by the Stephen M. Ross School of Business, University of Michigan, in partnership with the American Society for Quality (ASQ) and CFI Group. The ACSI tracks trends in customer satisfaction and provides benchmarking insights for companies, industry trade associations, and government agencies. The overall ACSI score for a given quarter factors in scores from about 200 companies in 40 industries and from government agencies over the previous four quarters.