The Case for a Brand Bubble
Pricing power for branded consumer staples is weak. Many consumers have traded down to cheaper consumer staples products and private label brands. Businesses are being forced to offer discounts to lure customers back to branded products and should input costs continue to rise, margins will be squeezed on both ends. Customers have stopped believing that brands are special. At the same time, financial markets keep raising brand valuations. Result: a brand bubble.
Intangibles assets include the estimated value of brands, market position, business systems, and knowledge. Estimates show intangibles have become a bigger part the market's value every decade. Ocean Tomo estimates that intangible assets account for 81% of the S&P 500. Any write-down in the perception of brand equity would result in significant mark-to-market losses.
Markets have pushed the valuations of many brands to historic highs at just a time when the quality gap between generics and branded products is reaching all time lows.
The Opposing View
Despite fears of rising input costs and erosion of pricing power in the face of increasing competition from private label brands, shares of businesses that sell small ticket item consumer brands consistently outperform the market over time.
Consistent, Predictable Profit Growth
Brand loyalty protects market share and pricing power and encourages trial of innovative new products. These products benefit from infinite demand, as they are consumed and replaced on an ongoing basis. They are both price and income inelastic, because these products are viewed as necessities and represent only a small percentage of a household budget. Furthermore, these products have global appeal as the necessities of life are consistent across time and culture.
Consumer staples companies benefit from slow, but consistent, margin expansion. This is a result of economies of scale and increased operations efficiency. If revenues can grow 4%-6%, but SG&A growth is limited to 2%-4%, the companies can deliver steady margin expansion.
Brand loyalty, pricing power, global product appeal, stable demand and focus on costs are among the factors that enable consumer staples companies to generate cash flow. This money can then be used to invest in R&D, make strategic acquisitions, pay a dividend, or buyback shares.
It is at least plausible for the broad markets to be involved in a brand equity bubble while at the same time find attractive value propositions in specific consumer staples companies. Time is the friend of superior businesses. When it comes to consumer products, the industry leaders tend to run away from the pack due to the quality of brands and economies of scale. Fortunately, you don't need an MBA in Finance to identify the likeliest winners.
Companies like Coca-Cola (KO), Procter & Gamble (PG), PepsiCo (PEP), Nestle (OTCPK:NSRGY) and Philip Morris International (PM) are committed to continuous innovation. Because they have the top market share position, they can afford to invest more into R&D, marketing and brand support. Successful innovation protects and expands market share, and frequently serves as a mechanism for pricing power.
Consumer trends matter, and many brands will lose their appeal in favor of the lowest cost provider. The threat of generic competition is greatest where consumers don't perceive differentiation in technology (like generic pharmaceuticals) or taste (like bulk food products). However, private label penetration is less of a threat in technology products and aspiration brands.
In many cases, the perception of technological superiority is greater than the real difference. This is what allows Colgate (CL) to charge more for toothpaste than generic brands. Perceptions of taste also matter. The marginal cost between a can of RC Cola and Coca-Cola is so slight that consumers have little incentive to trade down. The same may not be true of Heinz (HNZ) baked beans.
The value of intangible assets is at historic highs. The quality gap between branded products and generics is shrinking. Will consumers continue to pay up for brand name products? Or are we already in a "Brand Bubble"?