Very few Americans have experienced an economic downturn as severe as the current recession. Although it is very possible that GDP will show a positive reading for the third quarter, hardly anyone expects the employment situation to improve significantly until 2011. It is very possible that unemployment will soon exceed the worst levels of the 1981-82 recession. In most economic downturns, consumers attempt to substitute cheaper private label “store brands” for brand name goods. The key question is whether the current “great recession” will produce more lasting effects in consumer behavior.
The Rise of Private Labels
According to The Economist, private label sales have grown by 9% in the United States and 5% in Europe over the past year and have seen gains from branded goods in many categories. This has been driven by consumers seeking to save money but also by large retailers attracted by higher margins on their own private label merchandise. For example, the estimated share of private label goods is now 20% at Wal-Mart (NYSE:WMT) and 35% at Kroger (NYSE:KR). In many cases, it is easy to trim a shopping bill by 20 to 30% simply by substituting private label brands without suffering any discernible impact when it comes to quality.
Owners of Economic Moats Beware …
The presence of an economic moat can often translate to the bulk of market capitalization for consumer product firms. Such moats are often built over a period of many decades and investors are normally willing to assign much higher valuations to companies demonstrating the presence of durable economic moats.
This is entirely logical in cases where such a moat can produce high returns on equity over time and are considered durable. However, if the moat is impaired, much of the goodwill embedded in the market value of a company can quickly disappear. Therefore, it is critical for investors to carefully evaluate the implied presence of a moat when considering whether a company is fairly valued.
Visible vs. Invisible Consumption
One quick test that is useful to apply to any consumer product company where the market valuation implies the presence of a moat is to consider whether the branded product represents an item that brings status to the consumer. Most individuals care deeply about how they are viewed by family, neighbors, and co-workers and wish to appear successful. Items that are consumed in a visible manner, such as soft drinks, beer, or packaged food tend to be items that enjoy a durable economic moat compared to items such as laundry detergent or paper towels which are consumed in private.
For example, consider the decision-making process of a consumer who is at his local supermarket for a weekly shopping trip and needs to purchase items for a dinner party or barbecue over the coming weekend. Will this consumer want to purchase generic soda and discounted beer for the party? Probably not. Assuming that the consumer does not perceive a major quality difference in the private label paper towels or detergent, he may choose to purchase those items in order to pay more for the branded soda and beer.
An investor who pays a significant premium for a business based on the presence of an economic moat needs to carefully examine the durability of the moat. This must go beyond whether the moat has worked well in the past and consider the scarring impact of the current economic recession on many consumers who have never experienced anything like it in the past. Such consumers may adopt a more thrifty attitude toward spending even when the economy improves. In general, since consumers care deeply about the opinion of their peers, branded consumer products that represent “visible consumption” should logically be more durable than products that are mainly consumed in private.
Clearly there will be major exceptions to this generalization and many brands of “invisible consumption” products will survive this recession fully intact. However, the combination of large retailers with an economic interest in pushing private labels with the lingering psychological impact of a major recession on consumers must force investors to critically examine each moat for durability and refuse to pay for moats that appear vulnerable to impairment in the future.