When fat margins combine with dubious business practices, investors always suffer!
Psychologists estimate that, roughly speaking, two-thirds of any relationship is built on trust. In other words, when trust fails, so too does the bond.
Scaring off customers
Thus, we use the expression 'Vote with your feet' to describe the situation when customers walk away from providers or suppliers who cheat them. Indeed, rip-off pricing and/or sub-standard customer service are no recipe for corporate success.
In short, corporations can only fleece and fiddle customers for so long before these consumers depart for more ethically minded, dependable organisations. Thus, any business that relies on ripping-off customers for its business model will eventually be found wanting.
Three bad business models
To illustrate my argument, here are three consumer scandals that ultimately cost investors billions of pounds:
1. Payment protection insurance (PPI)
For almost a decade, The Motley Fool fought a long, hard battle against rip-off PPI. Indeed, as an ex-insider in this field, I personally slated this 'protection racket' more than 500 times in print.
Way back in 2003, we exposed multiple problems with this accident, sickness and unemployment cover, including sky-high premiums, huge commissions, anti-competitive behaviour, widespread mis-selling, and policies riddled with exclusions and get-out clauses.
After more than a decade of mis-selling, the PPI industry's chickens came home to roost as the Financial Services Authority, Office of Fair Trading and Competition Commission finally cracked down on its dreadful business practices. This year, Britain's biggest banks have set aside more than £9 billion to pay compensation for PPI mis-selling, hitting their already weak share prices yet further.
2. Card protection plans
Card protection plans are another over-priced add-on that I've campaigned against throughout the Noughties. This market is dominated by two players: CPP Group (LSE: CPP) and Sentinel. For an annual fee of, say, £25, these schemes provide emergency support and protection against fraud if your plastic cards are lost or stolen. Both companies also sell identity-theft insurance of limited value.
However, consumer law restricts your liability for card fraud to just £50, which makes the value of these policies highly dubious. What's more, a former marketing manager at one of these firms once admitted to me that they enjoyed "the highest margins in retail financial services".
However, following news in March that CPP faced an FSA investigation into allegations of mis-selling, its shares halved in a single day. Having floated at 235p in March 2010, CPP's shares now trade at 117p, down 50% and at an all-time low. Again, when the regulatory heat was turned up, CPP's investors suffered burnt fingers.
3. HomeServe
HomeServe (LSE: HSV) is the UK's leading home-emergency insurance cover and domestic-repair provider. With three million contracts in force, it flatteringly describes itself as "Britain's fifth emergency service". Once again, I have long argued that the boiler cover and home-emergency plans provided by HomeServe and the like are over-priced and provide poor value to policyholders.
On Hallowe'en, HomeServe investors received a shock when the firm suspended all outbound sales and marketing activity, following a highly critical internal review of its business practices by auditors Deloitte.
As a result, HomeServe shares plummeted by 28% in a single day. Having peaked at 535p earlier this year, they now stand at 240p, having dived as low as 205p on Tuesday, following the latest interim results. Personally, I would no more buy HomeServe shares than I would purchase one of its over-priced policies, so they get the firm thumbs-down from me.
More scandal-hit shares
Of course, consumer rip-offs don't stop with the three names listed above. All too many companies have come a cropper when, sooner or later, regulators started tackling rip-offs.
Another example in this category is debt-management advice and insolvency solutions, including IVAs (Individual Voluntary Arrangements) at, say, £9,000 plus VAT a time. Eventually, this industry's rip-off fees and misleading adverts finished off its London-listed members.
Likewise, I've long been wary of shares in Dixons Retail (LSE: DXNS), because of its over-reliance on profits generated from the sale of high-priced, low-value extended warranties. In a similar vein, I would not buy shares in doorstep lenders such as Provident Financial (LSE: PFG), which charge their low-income borrowers extortionate interest rates often exceeding 2,000% APR.
Red-flag warning
In summary, businesses that use high-pressure selling to flog products of limited consumer value can (and do) enjoy booming growth and profits. However, dubious marketing practices and unsustainable business models do not create long-lasting value for owners. Eventually, such businesses and their shares will come down to Earth.
Thus, when adding a share to your watch list, always check to see whether a company's chunky margins are the result of exceptional business practices, or from ripping off consumers. In addition, bear in mind that directors and managers happy to mis-sell to customers could do the same to shareholders!
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