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Profit From Predictably Irrational Companies

|About:The Coca-Cola Company (KO), Inc. (AMZN), BBW, DENN, DIN, GMCR, HD, LOW, SBUX

Investing Time in Reading

In The Warren Buffett Way, Robert Hagstrom notes Buffett's voracious reading and notes that long time Geico investment manager Louis Simpson (now retired from Geico but with a record heralded by Buffett in this Bloomberg piece) believed the "most important job of an investment manager is to keep reading and reading until an idea materializes" (123).

Some of the richest reading for investing ideas may be behavioral economics and psychology. Investors need not peruse jargon laden, technical articles in obscure journals to get started. Professor Dan Ariely's book on this topic, Predictably Irrational: The Hidden Forces That Shape Our Decisions, was a readable best seller (the pages cited are to the 2009 revised, expanded version).

The book provides insights into an array of topics: social policy, public health, education, etc.; however, many topics can be applied directly to business and, in particular, investing. Through careful reading, investors may find concepts and strategies companies can use to profit from some irrational (but predictable) behaviors of consumers.

Predicting the Irrational?

A dual PhD (cognitive psychology and business administration), Dr. Ariely is a creative researcher with a practical bent. Much of his work points to a "coherent arbitrariness" in our choices. Simply put, people may not always make completely rational choices (in their purchases, tastes, and even dating), but the irrationality is also often predictable, as his data from simple experiments reveals.

Questioning the conventional wisdom with empirical research is a personal affair for Ariely. As an 18 year old Israeli, an explosion left him with 70% of his body burned and covered in bandages for 3 years.(xii-xiii). His experience in the way bandages were removed to minimize pain gave him a tremendous insight into the "conventional wisdom" versus the results of empirical studies and what was really going on in the mind and experience of the patient (NASDAQ:XIV).

Ariely began his academic career in Israel and in the United States asking questions that challenged basic assumptions. For example, he thoroughly questions the underlying assumption that consumers in marketplace are always "rational" in their choices, an assumption often relied on in fields like economics.

Through his simple but well designed experiments--think selling chocolates at various prices on a table-- Ariely offers numerous core ideas investors might use and apply. His books and research are compiled on his website. Such studies might be used by investors, in tandem with studying conventional investment information, and many possible applications emerge.

Applying The Predictably Irrational

Ambiance and A Cup of Joe

Ariely's experiment with coffee satisfaction should have anyone who has read about the history of Starbucks (NASDAQ:SBUX) on the edge of their seat. Ariely's predictably irrational experiment may hint at the root of Starbucks' and other firm's success.

Would you pay more or like coffee more served with a silver spoon or a broken white Styrofoam cup? Ariely found people gave the same coffee higher ratings and expressed a willingness to pay more for it when he added silver spoons and high end condiment containers versus white Styrofoam cups with handwritten red letters on them (204). The same coffee but with slightly changed ambiance made all the difference. Irrational perhaps--but predictably so.

Starbucks' meticulous attention to the surfaces, sounds, smells, and high-end finishes are a tangible expression of this finding about the coffee experience and consumer preference. However, most investors know Starbucks has taken this ambiance premium global already and it may be priced into the stock. So the more interesting play for investors looking for opportunities in the "ambiance premium" would be to look at a firm selling lots of coffee but without the careful attention to ambiance that can lead to enhanced satisfaction and willingness to pay more.

Denny's (NASDAQ:DENN), for example (at least in my experience in stores across the West) has not fully tapped the ambiance link. However, in the transcript of the Q3 Earnings Call, the Denny's leadership acknowledges this in placing their 2014 focus and resources solidly behind remodeling of locations, a move that could lead to the ambiance premium (and pave the way for price increases) that Arielly has shown is part of the experience and psychology of the transaction.

Armed with this research based insight, that consumers will pay more for the same coffee with simple/minor ambiance enhancements, investors can even do some of their own independent research by stopping by ambiance laggards in the food and drink industry or checking up on ambiance leaders, ground level research as important as reading the details in the annual report.

Anchoring and Decoys

Another possible link between consumer psychology and a real investment opportunity might emerge when investors study some of the research in Predictably Irrational about pricing and especially anchoring and decoys; these concepts apply to a wide range of products and services. But to continue the restaurant theme, price anchoring can be useful in a menu or other food/drink promotions.

Firms like IHOP (NYSE:DIN) have found the art of the menu "up sell" is a lucrative crucible mixing psychology and consumer preference as mentioned in businessweek. While this piece on the IHOP menu calls it a "Jedi mind trick", an effective pricing strategy and increased sales may also relate to how people often "anchor" on a initial price and then react to relative prices (38).

Looking closely at a firm's pricing strategy could be fertile grounds for investment research. For example, Ariely, notes consumers rarely choose the highest priced option but frequently choose the second highest option (4). A food chain adding a high-end item on a menu may simply be using it as a "decoy" to get consumers to buy other upper-priced items.

In the same vein on pricing, the notion of "free" is one of the most powerful pricing incentives (even when it turns out to be not so free). It consumes an entire chapter (Chapter 5) in Ariely's book. Whether it is a free FICO score on a Discover credit card (NYSE:DFS), Amazon's free shipping (NASDAQ:AMZN) or a common "kids eat free" in the restaurant industry, the "free" offer may drive consumers into higher margin products or to buy something when they otherwise might not. Investors should try to see how a firm's pricing (along with its products and promotion) in the marketing mix actually melds with current research on consumer psychology.

More Recent Research: The IKEA Effect

Another intriguing concept for investors from Ariely (and co-authors Norton and Mochon) is from a more recent 2012 article that reveals people place a higher value on items they assemble themselves. Hence the aptly titled name for this article and finding: The IKEA Effect. The phenomenon applies to both practical things like an IKEA storage box and decorative items like origami. And the implications extend well beyond the unique furniture store.

Just add an egg--The DIY trend

This IKEA Effect article begins by explaining how corporate America simplified the cake baking process in the 1950's to "just add water" and mix; however, housewives found it "too easy", so the solution was to add an egg (453). This is the general theme of the IKEA Effect--infusing labor can lead to the higher valuation of a product by consumers.

This is not news to anyone who favors a homemade meal. And it is nothing new to anyone who has watched the amazing trajectory of DIY (Do It Yourself) in the US home improvement context. From one prominent show and guru in the 70's and 80's (Bob Villa on public television) to multiple networks, countless shows, and entire industries built on people working on their own homes (HD, LOW). The DIY trend tapped a rich vein of consumer preferences. But is it the money savings, the customization, or something else at work?

IKEA Effect

The Ikea Effect study bore out the notion that simply "adding labor" enhanced something about the product or experience. The results indicate adding labor enhances their value up to 63% over an identical item they did not assemble and people even prefer their item over a expert made item(455). With this finding, producers of all types of product should take notice--especially in a world of pressured margins and tough competition.

There are some theories and ideas behind this concept. Of course, there is a customization approach--that you can add your own color, style variation or preference on DIY products--but this was not a factor in these experiments. And assembly can save money in some cases but this was also not a factor here. The labor and power to make things, alone, appears to trigger a higher valuation and/or ownership bias.

Firms that recognize people are willing to pay more for something they have a role in producing could find ways to boost margins and differentiate products. Moreover, there could even be reduced labor costs (by shifting assembly to consumers). But the IKEA Effect is not without risks. That is, "some assembly required" can go wrong if people cannot complete a task (i.e., tab a does not fit into slot b). The result is frustration and the added valuation dissipates according to the article.

Investors can be on the look out for new or existing companies that may be able to harness the IKEA Effect in a variety of areas beyond home improvement. Be it putting together your own furniture , a home improvement product, or building your own teddy bear (NYSE:BBW), successful business models can be built on the concept.

DIY Coke?

Maybe the interesting question is whether the Ikea Effect can apply to products consumed daily--like soft drinks. There is already arguably a "look what I made" aspect to the Keurig coffee of Green Mountain ( GMCR); while light on labor, it does seek to bring the foamy, aromatic coffeehouse to your home. But what about DIY Coke (NYSE:KO)? Isn't it easier and cheaper to just open the can (rationally, yes).

Interestingly, a Yahoo Finance piece on the possibilitiess of Keurig and Coke notes DIY Coke would cost much more, but armed with IKEA Effect research--investors may be able to ponder if the enterprise may mesh with consumer psychology. This may be especially so if the price is more comparable and if Coke and Green Mountain can perfect the experience. While it may be irrational to pay more for a Coke you make at home--it may be predictably so.

Disclosure: I am long DENN, SBUX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own all of these stocks as top holdings in ETF's or in index or mutual funds.