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Customer Concentration Is Not Necessarily Bad

November 20, 2012 | About:
Value investors are all hard-wired in a certain way. Most of the time, this is called discipline and it works well. In other situations, it can work against you. One example I wrote about previously was on net gearing or net cash. Many investors take a net cash position as a sign of balance sheet strength without digging deeper. Management may not able to use the available cash to pay off large amounts of debt on the balance sheet because the cash is earmarked for working capital or capital expenditures.

This time, I am going to focus on one of the most common business risks that investors zoom in on — customer concentration risk. If you view business in the same way you view value investing in a portfolio of stocks, you will understand that there are good and valid arguments for and against a concentrated portfolio. This is the same for businesses; customer concentration can cut both ways.

First, a long-time customer with recurring business is better than 10 new customers. In marketing, students and practitioners are taught that it takes less to retain an old customer than to win a new customer. A company with strong long-term concentrated customer relationships should be viewed more favorably than another company with more than 1,000 customers and high customer churn every quarter.

Second, we can view customer concentration from a borrower-lender perspective. From a portfolio perspective, one may argue that it is better to lend to more people to diversify the credit risk. However, the credit strength of borrowers and customers varies. A company with a few big customers in the public sector may be exposed to less credit risk than another company which sells to a variety of small-medium enterprises or start-ups.

Last, people tend to equate choice with bargaining power. Bargaining power may also be affected by stickiness. By sticking to a few customers for a long period of time, both the company and its customers are intertwined in more ways than you can imagine. Certain company functions and product lines may be designed or structured in a manner to suit each others' characteristics. Customers' switching costs can be significant in relationships like this.

About the author:

Mark Lin
Mark is a private value investor and runs the Cheapskate Investing website which borrows from the wisdom of value investing giants, using a systematic quantitative screening approach to filter the global stock markets for cheap deep-value cigar-butts and wide-moat compounders. He is also a regular contributor to various value investing communities.

Visit Mark Lin's Website


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