In September 2016, Wells Fargo (WFC 0.59%) paid $185 million to Los Angeles city and federal regulators after admitting to the creation of fake customers accounts. The company hoped that this would put the issue behind them. After all, big banks pay big fines for messing up all the time. However, that wasn't the case.
What followed was the uncovering of one of the biggest corporate scandals in living memory. Management had claimed at the time that it was a few bad employees who had tried to cheat the system to get results. But as we learned, the company's 'Eight is Great' mantra — which meant that every customer should be sold at least 8 Wells Fargo products — had rotted away the very culture of the company.
Under intense pressure from management to perform, Wells Fargo employees had set up millions of accounts for customers without their knowledge or consent. Those employees who refused to do so or spoke up against the system were quickly fired.
Not only had these bogus accounts racked up millions of dollars in fines, but they had also affected customer credit ratings. This meant that they could have been charged many more millions of dollars in higher interest rates. The true cost of the scandal is likely never to be fully calculated. Understandably, there was public uproar.
CEO John Stumpf was summoned to a hearing in front of the Senate Banking Committee, at which Senator Elizabeth Warren — now a presidential hopeful — called him "gutless." "You should resign," Warren said. "You should be criminally investigated by the Justice Department and the Securities and Exchange Commission."
Stumpf did eventually step down, but at this stage, the bank's reputation was in tatters. Surely, given this evidence of wanton malpractice, customers left Wells Fargo in droves?
In the immediate aftermath of the scandal, consultancy firm cg42 surveyed existing Wells Fargo customers. They reported that the bank would likely lose 14% of its customers, with a further 30% stating that they would be shopping around for alternatives. Overall, cg42 estimated that the company would lose about $99 billion in deposits and $4 billion in revenue in the subsequent 18 months.
It should have been a death blow for the company — the kind of thing that sends a stock plummeting. But in reality, nothing much happened.
From peak to trough, Wells Fargo stock dropped about 12%. The following month, it had recovered. In January 2018, it was at all-time highs. In the first quarter of 2017, rather than lose deposits, the company actually gained an additional $80 billion.
So what happened?
What protected Wells Fargo was something Wall Street knows well: People don't switch banks.
Despite all the public anger, most of the bank's customers didn't leave. They might have thought about it and even told people they would, but when it came down to it, there was just too much hassle involved.
It makes perfect sense when you think about. Changing a bank account means moving funds around, getting new credit cards, getting new PIN numbers, and updating direct debits. It's an organizational mess that most people would simply rather avoid, particularly when just one mistake could mean missing an important payment that could cause further pain down the line. That ability to keep customers (even in the most severe circumstances) is an incredibly powerful asset for a business.
Back in 2007/2008, rating agencies not only failed in their primary function but became a major part of the systematic failure that caused the financial crisis. Yet Moody's (MCO -1.33%) stock is today hovering around all-time highs. Comcast (CMCSA -2.47%) regularly takes the title of "America's Most Hated Company", but over the last 10 years, the stock has grown close to 500%. And after the Equifax (EFX -0.08%) hack in 2017 — one of the most invasive in recent memory — the stock is currently not far off pre-hack levels.
The fundamental ability to retain customers (also known as stickiness) is something we should always be on the lookout for as investors. Not only does it provide a great source of recurring revenue for businesses, but it allows them to survive some serious setbacks. Of course, if we can find this 'stickiness' in a great business rather than some of the bad eggs listed above, all the better.
Switching costs are a particularly compelling form of leverage for a business to build a truly sustainable competitive advantage. These costs can be created in more ways than you think, too.
Think about coffee chains, for example. There's no financial penalty for choosing to go to Dunkin' Donuts over Starbucks (SBUX -0.68%), but if you're already part of the Starbucks loyalty program, making a permanent switch to Dunkin' means you'll lose your points.
Intuit (INTU -1.10%) has an amazing business model. There are plenty of companies out there flogging tax software, but Intuit got in the game first. If you're a small business owner, you may be tempted by a cheaper competitor., but moving all your old accounts to another platform is going to be hugely disruptive to your business. So most people don't bother, which means that Intuit can keep increasing prices.
Companies like Shopify (SHOP -2.40%) manage to do this very well too. If someone's entire e-commerce business is built on Shopify's platform, it's going to take a lot of time and money for them to change to another provider.
Even companies like Facebook (META -3.31%) do this but in a different way. There's no financial cost to switching to another social network, but we'd lose all those connections we've made over the years. We'd even have to reupload all our photos!
It might seem small and insignificant, but it's something that most people just won't bother with.
Far too often when we think about investing, we focus on how companies are going to expand — how they're going to attract new business. Just as important as this is finding companies that have an intrinsic ability to hold onto current customers, though.
Those businesses can then reinvest in themselves, expand to new markets, and develop new products... all the while relatively assured of this recurring revenue stream.
MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in Facebook, Intuit, Shopify, and Starbucks.