What Mistake Are Smart Investors Making These Days?

Warren Buffett did the investor community a great favor by introducing the concept of an “economic moat” when explaining what types of businesses are so superior that they can be purchased and held passively for long periods of time and riches will subsequently abound. In his annual letters, Buffett has defined a moat as “the ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.”

Often times, a strong brand name is the source of what gives a corporation an economic moat. But a laziness, or at least a false equivalency, has arisen in recent years in which the terms “commonly known brand name” has become interchangeable with the concept of an “economic moat.” An economic moat only exists when a business has a competitive advantage over it competitors which is usually either pricing power or an economy of scale that creates lower distribution costs.

For instance, we have all heard of Adidas shoes. That brand has general name recognition. Now, let me ask you this: How many of you would be willing to pay 15% more for a pair of Adidas shoes than a similar pair of Nike or Under Armour shoes? Judging by the company’s recent reports, the answer isn’t many. Adidas is a well-known brand, but it doesn’t have superior pricing power. The returns it earns for shareholders will have to come from its wide distribution network channels, or the extent to which it can charge a premium to no-brand shoes that is less than Nike and Under Armour’s price to offer a compelling value buy.

So how do you identify a brand name that gives rise to pricing power?

On the qualitative side, you need to perform your analysis without ego of your own preferences. I can’t tell you how many analyses I’ve read from men who say: “Why would I buy Starbuck’s stock? I don’t want to blow my money on overpriced coffee when I can just make it at home for twenty cents a serving. This is stupid millennial culture run amok.”

Well, guess what. Of men and women between the age of 20 and 50 that live in urban areas, 72% of them report getting a beverage at Starbuck’s within the past twelve months. They have gone from selling $3 billion worth of beverages to $16 billion worth of beverages in the past thirteen years. As an investor, it’s job to understand why.

There are 327 million people in the United States. A whole lot of money gets made satisfying the needs of a small fraction of them. It is in the best interests of your family to recognize when a fraction of the population is being served well even if that happens to exclude you. Being a customer of a product and being an investor that recognizes the success of a product are not overlapping Venn diagram circles. You can belong to the latter without the former.

On the numerical side, you want to pay attention to what happens to sales after price hikes. Do they stagnate, decrease, or do they increase? How do the profit margins compare to competitors in the industry?

However, I want to stress that profit margins are not a perfect substitute that lets you understand how a brand name leads to pricing power that is proof of a successful economic moat.

Just look at what has happened to Kellogg’s cereal over the past fifteen years. The net profit margins have remained in the 9-10% range every year since 2001. The catch is that the company has spent the past seven years slashing employees and wringing out every possible cost from its distribution network. In other words, the profit margins that appear to remain steady are not doing so because Famous Amos cookies can sustain high single digit price increases. Instead, it is because the truck driver delivering the cookies to Wal-Mart hasn’t gotten a raise. If Kellogg’s wasn’t cutting costs, you would see that profit margins would go down from 9.5% to 7.0%, and you could point to this number to support a qualitative observation that General Mills and even generic brands are successfully limiting Kellogg’s pricing power these days.

It doesn’t mean that you should refrain from owning Kellogg stock. It just means that you should recognize that brand name recognition doesn’t mean wide economic moat, and you should discount the stock appropriately. This is why I criticized Kellogg stock in June when it was trading at $77 per share and I wrote the following in my article “Kellogg Stock: Investor Expectations 2016-2021”:

“This means that earnings of $3.60 per share will grow to around $4.60 per share by around 2021. If the P/E ratio comes down from 21x earnings to 17x earnings, for a nearly 20% expected headwind, then this stock ought to trade at $78 per share five years from now. Right now, the price is trading at $77.50. That means you could be treading water for five years, earning no capital gains and only collecting dividend income while you wait for the valuation to adjust.”

On the flip side, you should not assume that a company needs to be big in order to have a wide economic moat. WD-40 stock is only valued at $1.5 billion, much smaller than the typical company that I cover on the site. Yet it earns 13% profit margins and completely dominates its niche in the petroleum-spray lubricant market. It raises its price 3-5% each year, and then it sells 3-5% more sprays each year. People are willing to pay a premium for this brand they know. And meanwhile WD-40 is big enough to take advantage of economies of scale.

You think I’ve been writing a lot about Nike lately? If WD-40 came down to my price, I’d have no shame discussing it five times per month from all angles because it is a great lifetime holding. But the valuation right now is crazy for a business that only makes $52 million in annual profits. If it was valued in the $700 million range, I’d become so enamored by it that I wouldn’t shut up about it. But that’s not the case right now with the $1.5 billion valuation that puts the stock in the 30x earnings range. It is trading at $114 right now–I would wager you will see the stock trade at a lower price than that sometime in the 2020s.

If you keep Post-It notes (3M’s moat!) around your desk, you should write on one of them: “Brand name recognition is not pricing power.” It is a good place to look for pricing power, but it does not logically follow that general awareness of a product leads to premium pricing. That is a separate inquiry that you must perform. There is a trend right now in which investment commentators are suggesting that the mere fact that you’ve heard of a company’s product is proof that it has long-term investment potential due to a wide economic moat, and that chain of logic is unsupportable in reality.

Originally posted 2016-12-22 15:30:42.

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