The Importance Of Brand Strength

The Importance Of Brand Strength

Morning folks,

Let’s take some time off from the COVID-19 pandemic and go back to some investing basics.

When analyzing any business, the first thing you want to look for is a good product. That’s pretty straightforward. Most great investments begin with discovering a product or service that you like and deciding to do some research. If that product is owned by a publicly-traded company, you have the opportunity to invest.

On a quick side note, make sure that the product or service you like represents a significant portion of the company's revenue. It’s no good investing in a large conglomerate like Procter & Gamble because you happen to like one of their hundreds of brands. That brand will probably account for only a small percentage of the overall business and its success alone won’t be enough to move the stock price. More research will be required in this scenario.

Let’s imagine though that you find a product you love and that it is the primary product of a publicly-traded company. You’re still not ready to invest. You need to start thinking about how that product or service is protected from competitors. It’s far too easy these days for companies to replicate products, or even improve on them. Before you invest, you need to figure out if the company has a sustainable competitive advantage — an economic moat.

Two weeks ago we discussed switching costs as a strong economic moat, particularly in the business-to-business space. Today let’s talk about brands.

Every business in the world likes to talk about their brand and every business likes to believe they have a strong one. If you were to look down the income statement of a hundred public companies, my guess is that about 90 of them would list sales and marketing as their biggest operating expense, spending hundreds of millions of dollars every quarter to generate demand for their products and build their brand profile. However, few businesses can claim to really have a strong brand.

Pat Dorsey, formerly of Morningstar, argues that a strong brand has to have one of two characteristics. It has to either command a premium price tag or it has to lower search costs. 

The first one is pretty self-explanatory, but what does lowering search costs mean? Put simply, it means that consumers are willing to pick that product rather than try out its competitors. Take Heinz Ketchup as a good example. Most people don’t really want the hassle of trying out every brand of ketchup. They know Heinz is the world’s most-loved ketchup brand, so when they’re shopping they don’t even consider any others. The same could go for sodas or laundry detergents — or really any small ticket items that people purchase frequently. For larger ticket items, say a vehicle or laptop, search costs are not as powerful, as consumers will generally do some research before making a purchasing decision. 

Consider Tiffany & Co.

Does a Tiffany engagement ring command a premium price? Absolutely. Tiffany has some of the highest gross margins in the industry — about 60%. Competitors like Blue Nile and Signet struggle to get 20%. Tiffany’s brand is so strong that there’s even a black market for its signature blue boxes.

Now consider Sony.

Twenty years ago Sony had a strong brand. They were one of the top names in consumer electronics. Today, though the company name is well-known, I would argue they don’t have a strong brand. They still compete at the high-end of the market, but companies like LG and Samsung have competing products that mean Sony doesn’t have pricing power, nor do they lower search costs.

What about IKEA?

You wouldn’t spend more money on an IKEA product. However, if you need an office desk because you’ll be working from home for the foreseeable future, IKEA will probably be the first place you check. You’re pretty certain to find something that meets your needs at a reasonable price point. That’s lowering your search costs.

Like IKEA, Amazon’s brand is not associated with premium pricing. Amazon Basics range is supposed to be cheap. However, around 66% of online shoppers begin their search for a product on Amazon (compared to just 20% for Google). Amazon has become the primary shopping catalog of the internet. And when shoppers find what they’re looking for on Amazon, they typically go straight to purchasing. 89% of consumers say they’ll buy from Amazon over other e-commerce sites. That’s because Amazon has spent decades building trust with consumers through quick delivery and unmatched customer service. 

Compare that to eBay, which was the original online auction site. Over the last decade, eBay has failed to establish itself as a proper competitor to Amazon. It tried to make the transition to full-priced goods but didn’t have the same consumer trust. I would say eBay is a weak brand — unsure of itself and not given any premium consideration with consumers.

You can see in this small handful of examples of how being well-known does not equate to a strong brand that’s going to be able to fend off competitors over the long-term. When companies say they have a strong brand, your first action should be to question that. Does this company command premium pricing? Does it lower search costs? If the answer to both those questions is “no”, then management is mistaken.

There’s plenty of other forms of economic moat besides a strong brand, so don’t dismiss an investment purely on that basis. However, it’s one of the most frequently touted competitive advantages, and one that can easily be dismissed with a bit of research.

 

RoryRory

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