Loyalty is a sticky business. Here are 3 companies mastering it

Joe Magyer

Lakehouse Capital

Livewire readers may be familiar with our 'fascinations'-driven approach to investing. Rather than ease into traditional investing frameworks, such as sector or geography, we kicked off with a very basic question: what is the best way to identify outstanding businesses to buy and hold for the long-term?

Today I'd like to focus on one of our three investing pillars: Loyalty

Think enterprise software, payment processors, subscriptions, or any other form of business with an intense focus on customer loyalty and retention. Importantly, we view loyalty as not just switching costs, which make it difficult for customers to move on, but also the delivery of value and delight to customers that makes them want to stay.

Businesses with extremely loyal customers are often underestimated by the market because of their staying power, pricing power and ability to cross- and up-sell. In our experience, many investors lump recurring revenue businesses into one big pile, which creates an opportunity for discerning buyers to separate the coal from the gems.

3 businesses delivering value and creating loyalty effects

Charles Schwab is not a household name in Australia, but it is in the US where it is the largest discount broker with more than 32 million brokerage accounts, 2 million corporate retirement plans, and total client assets of US$7.4 trillion. Schwab’s shares performed extremely well during the year thanks to a confluence of factors including a strong stock market, which saw the S&P 500 gain 39% year-on-year, the company’s recent merger with industry heavyweight TD Ameritrade, and expectations that interest rate income would grow as the US economy gathered momentum. 

Two other important contributors to Schwab’s year, a mix of cyclical and structural, were an increase in net new accounts and increased trading activity. We view these as cyclical in the sense that markets are performing very well and that retail investors have been bored and emboldened during the American lockdowns. But they are also structural because Schwab’s shift to $0 commissions on equity trades has permanently reduced a barrier to trading for investors with smaller accounts. We also note that, while brokerage activity is cyclical, the average brokerage account itself is very sticky, with normalised annual retention rates of more than 93% for accounts. Additionally, the average client assets per account grow over time thanks to asset growth and clients collectively being net savers. 

Schwab is an excellent natural hedge because the stock tends to perform well when interest rates increase, which is generally negative for the rest of the companies in our portfolio. And the position did its job for us by increasing during a rising interest rate environment, enabling us to harvest much of our gains from Schwab and redeploy them to shares of other growth companies that had sold off in response to higher rates. We’re mindful of the run in the shares and the cyclical nature of the business but are comfortable keeping a small position for now due to Schwab’s:

  • natural hedging dynamics, 
  • extremely loyal customers, 
  • and industry-leading position in a growing market.

Like Schwab, Amsterdam-based enterprise payments processor Adyen is not a household name. But its reputation within the investment community is growing, thanks to a string of expectations beats, impressive clients such as eBay and McDonalds, 99% annual client retention rates, and Adyen recently boosting its long-term EBITDA margin guidance from 55% to 65%. 

The company has thrived despite rolling lockdowns - second-half net revenue grew by 28% year-on-year - as growth with online retailers and digital goods clients overshadowed the slowdowns with its travel and offline clients. In the meantime, Adyen continues to win new clients thanks to its:

  • flexible solutions, competitive rates, 
  • cross-border capabilities, 
  • high payment authorisation rates, and 
  • long menu of integrations and customer payment options. 

Investors are fond of toll road analogies, so we’ll make one here before moving on. Imagine a toll road that keeps 99% of its drivers from one year to the next, the average revenue per driver goes up north of 20% each year, and that it takes years of costly, compliance-heavy development work for a driver to change to using another toll road. That’s basically Adyen in a nutshell. Not surprisingly, even though the shares have done quite well for investors, we are happy to retain a material position in the company.

PayPal had a tremendous year as it was a significant beneficiary in the pull-forward in ecommerce. Total payment volume increased by 50% year-on-year through the first quarter of 2021 thanks to significant growth in users and merchants. The company now has 392 million active users, up 20.6% from March 2020, who use PayPal an average of 42 times a year. The significant growth in users and activity both look structural to us, not cyclical, and we doubt the six-million-plus merchants who began accepting PayPal in the past year will suddenly stop accepting one of the internet’s most widely used forms of payment. 

PayPal is a prime example of how a widely followed business can still be chronically misunderstood. FactSet tracks 48 analysts who publish price targets on the stock, suggesting PayPal’s shares should be efficiently priced, and yet PayPal has beaten analysts’ average sales and earnings estimates in 18 of the 21 quarters since it was spun off from eBay. We suspect the market tends to underestimate the business’ inherent operating leverage and that the lifetime values of incremental new users continue to rise over time thanks to improving functionality and a growing merchant base that allows new users to spend PayPal more widely than did their predecessors. 

We continue to think that PayPal has a considerable growth runway not only from gaining share of a large, growing market via its core platform but also from new tools and functionality including an enhanced instore experience, crypto offerings, Pay with Venmo, and buy now, pay later. The business isn’t sitting still despite its strong position and we look forward to what the future holds.

The Lakehouse Global Growth Fund holds positions in Charles Schwab, Adyen and Paypal. Explore more in the below link:

Managed Fund
Lakehouse Global Growth Fund
Global Shares
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Joe Magyer
Former Co-Founder
Lakehouse Capital

Joe is the former co-founder. Please visit and follow Donny Buchanan and Nick Thomson for the latest insights around Lakehouses’s unique concentrated investment approach that focuses on the key themes of Intellectual Property, Network and Loyalty...

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