The Power of Brand Investing

by: Jiang Zhang

In my article on TAL Education Group (XRS), I pointed out that one of TAL Education’s competitive advantages lies in its brand equity and how the company can leverage its brand to create a virtuous cycle that attracts top teachers and students, which translate to the company’s above average industry growth. About two weeks after the publication of the article, XRS reported a solid 1Q12, in which revenue jumped 63% y/y and earnings climbed 67% y/y. EPS came in at $0.09 compared to $0.05 consensus. Total enrollment grew 23% y/y compared to 18% in the previous quarter. Its average selling price expanded 32%, driven by higher sales on its 1-on-1 classes. Finally, the company guided 42-47% revenue increase for 2Q11, and raised full year sales growth to 40-45%, which is 10ppts higher than previously announced. Following the earnings announcement, the stock jumped about 20%.

In my critique of IBD's article on Chinese ADR investing, I further emphasized that investing in Chinese brand name companies that are recognized by people who are familiar with China is often a better first step than investing in U.S.-listed Chinese issuers that have just a good growth story.

In this article, I will present readers with a unique approach of brand investing.

Brand is often an overlooked attribute of a company when it comes to investing because, unlike the financial numbers and ratios, it is difficult to quantify. Brand can also be difficult to grasp because it is different from a company’s other competitive advantages such as economy of scale, proprietary technology, patent, and monopolies. However, brand could be just as important as the other factors when making informed investment decision.

According to Walter Landor, founder of brand and marketing consultancy firm Landor Associates, “products are made in the factory, but brands are created in the mind,” meaning that brand is an unintended consequence of many little things the product has on the opinions of consumers, and that it cannot be easily manipulated. While marketing and product positioning can play a short term role in manipulating consumers’ brand perception, poor product experience cannot be compensated by clever advertising in the long term. Therefore, brand is not a strategy or a tactic that can be devised in the conference rooms, but the result of consistent behavior and execution by the company and its product, and their value to the consumers. Michael Eisner, former CEO of Walt Disney, explained that “brand is a living entity, ant it is enriched or undermined cumulatively over time, the product of a thousand small gestures.”

There are three ways a company can strive to create a brand: aspiration, innovation, and scale.

A company that focuses on innovation to build its brand has an edge on product development or business processes. For example, Intel (NASDAQ:INTC) introduces a new chip every two years rather than traditional four years, and L’Oreal’s (OTCPK:LRLCF) investment in R&D is twice as much as Revlon (NYSE:REV) as a percentage of sales.

While creating innovative products can establish a strong brand image, connecting with consumers’ emotions, association, or personalities can be equally effective. Louis Vuitton (OTCPK:MAGOF) is associated with luxury, creativity, and craftsmanship, whereas Budweiser (NYSE:BUD) is associated with casual, sports, and American. In addition, corporations leverage aspiration to attract and retain talents, as we see in Google’s (NASDAQ:GOOG) non-traditional workplace environment.

Finally, by leveraging power over suppliers and distributors and the company’s network effect through scale can also generate strong brand positioning and competitive advantage. For example, Coca Cola (NYSE:KO) controls the bottlers that package and distributes its products. Facebook leverages its massive user base to create a network effect that ultimately results in a brand in social networking.

When capitalized effectively, each attribute is sufficient to create a great brand. However, companies can also effectively combine two or more of these attributes, such as in BMW (aspiration and innovation) and Budweiser (aspiration and scale). Rarely do we see companies with all three attributes. But for those that can combine all the attributes, the companies usually exhibit brand authenticity, quality products, a strong core market, and brand-focused corporate culture. In addition, strong brand companies can also exhibit innovation, long-term thinking, global reach, and effective marketing, though these characteristics are not completely necessary for success. Some of the companies that are well-known among us and that feature all the attributes are McDonalds (NYSE:MCD), Apple (NASDAQ:AAPL), Disney (NYSE:DIS), and Nike (NYSE:NKE).

While having the right attribute or a combination of attributes can allow the company to establish a solid brand, the industry in which the company operates should also be brand friendly in order for the company to build its brand. Brand friendly industries are often characterized by close proximity to end-users, product differentiation from competitors, and the level of importance end-users place on brand in decision criteria. These attributes are prevalent in consumer-driven sectors, such as fashion (Ralph Lauren), personal electronics (Apple), and autos (Mercedes-Benz). Without these attributes, the industry would lack the attractiveness for a company to establish a formidable brand. For example, brands are almost non-existent within the waste management, oil and gas, utilities, and precious metals industries because they all lack the three criteria mentioned above.

Identifying a company that has one or more sources of brand and that operates in a brand friendly industry is just the first step the process. The next step is to determine when to invest in a brand name company.

Similar to the product life cycle, which characterizes a product by its introduction, growth, maturity, and decline stages, brand has its own cycle that is characterized by introduction, transformation, domination, and decline.

A brand can emerge through innovation or capitalizing on market inefficiency. For example, Starbucks (NASDAQ:SBUX) was able to create and scale a coffee shop concept that encompasses both high-end product and convenience. On the other hand, Nike’s founder Phil Knight capitalized on the cheap labor in Asia to gain an advantage over Adidas (OTCQX:ADDDF) and Puma (OTCPK:PMMAF) on operating cost structure. During the introduction phase, investors are generally excited by the emerging new brand because they generate the most absolute return compare to the other brand phases.

After a brand has emerged, the company needs to transition itself from a product company to a brand company so it can eventually leverage its brand to expand into new channels, countries, and products. This phase is usually characterized by strong and consistent revenue growth and healthy margin expansion, and it is also considered the best time to own the stock because the company can generate higher market value due to increasing visibility of its industry standing, revenue growth, and brand awareness. For example, Microsoft (NASDAQ:MSFT) transformed itself from a pure software maker to a brand by creating network externalities for Windows OS with products such as Office and Internet Explorer to become the standard OS for PCs around the world.

Once the company has transformed into a brand company, its brand becomes iconic and globally recognized by consumers. However, at the same time the shareholder return tends to diminish during this phase. For example, Wal-Mart (NYSE:WMT) was a great growth story with strong brand awareness but has reached to the point of domestic saturation and is facing difficulty of replicating its success overseas. Sony (NYSE:SNE) is another example of a company that has been associated with innovation but is facing difficulty to outthink the smaller emerging players. Because of the diminishing shareholder return, this phase is usually, though not always, a good time to sell the stock.

From its introduction to domination phase, company with successful brand could generate spectacular shareholder returns. However, it ultimately depends on the management’s execution on innovation, project management, acquisition, and investment. Management’s poor judgment could result painful shareholder return. For example, Croc (NASDAQ:CROX) made the error of over expansion in manufacturing and distribution that resulted in a massive inventory issue that almost brought the company to the brink of bankruptcy. Research-In-Motion (RIMM) failed to grasp the emerging acceptance of smart phones in the consumer segment and is now struggling to hold its ground from the Apple and Google juggernauts. Blockbuster built its brand in the movie rental business but ignored the emergence of high speed Internet that can deliver movies to viewers even more conveniently than a 15-minute drive to its nearest branch, which resulted in its defeat to Netflix (NASDAQ:NFLX).

While a fallen company could face insurmountable challenges in maintaining its business and brand, a combination of the right leadership and a focused strategy can eventually reinvent the brand that ultimately results in attractive shareholder returns. Of the famous brand reinvention stories, Apple Computer stood out to be the classic example of an ailing company with a fallen brand that was turned around by its innovative CEO Steve Jobs who transformed the computer maker to a consumer electronic company that is also known for its iPod, iPhone and iTune online music services. There are other companies such as Nintendo, which brought a more interactive gaming experience through Wii after its unpopular Nintendo Cube system, and Coach (COH), which suffered from old-fashioned design, revitalized itself after combining fun and modern attributes with quality and affordability, while lowering operating cost by moving manufacturing overseas so the company can invest in brand building.

So how do brand-name companies perform compare to the broader market? According to a study done by Credit Suisse, companies that focus on brand building by spending at least 2% of sales on marketing outperform the S&P 500 by more than 4% annually since 1997. The top 20% of the companies featured in the research outperformed the market by 17% annually over the same period.

While brand is usually not a factor when making an investment decision, understanding its significance could supplement the traditional metrics and approaches when identifying the next great investment or the next fallen brand.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.