The value of a brand

It’s been a tough year for consumer and technology companies this year. Rising inflation and the cost-of-living crisis have put many consumer companies under severe pressure while rising interest rates have led to a significant decline in corporate valuations particularly in technology and other growth sectors.

One key to success in 2022 was to focus on companies with “pricing power” and the ability to defend profit margins in a world of fast rising costs. The problem with this approach, though, is that it is incredibly difficult to measure pricing power. One shortcut to identifying companies with pricing power is to look at businesses that have a well-recognised brand. Warren Buffet famously likes to invest in brands like Coca-Cola because of their enduring profitability.

If we look at the below list of the 20 most valuable brands in the world, we see that Coca-Cola is once again in the Top 10, just like every year for as long as I can remember. But can this investing in brands strategy work on a broader basis?

The 20 most valuable brands

Source: Interbrand

Hamid Boustanifar and Young Dae Kang tested a simple investment strategy that invested in the 100 most valuable brands after they were announced each year. They compared the performance of this portfolio of 100 brands with a portfolio of US companies matched by characteristics like valuation, size, profitability, etc., and another portfolio of companies matched by industry. The chart below shows the performance of the best brands portfolio in comparison to these benchmarks. On average, the best brands portfolio outperformed the benchmarks by some 3% to 4% per year between 2000 and 2020.

Outperformance of best brands

Source: Boustanifar and Kang (2022).

This may not be too surprising since good brand recognition is linked to higher and more stable profit margins and more stable sales both in boom times and in a recession. But what is surprising is that the analysis of Boustanifar and Kang indicates that the outperformance of the best brands is driven by a systematic underestimation of how good these brands are.

Analysts covering the companies that own these brands systematically underestimate the pricing power and future earnings growth associated with these brands. This leads to a systematic underpricing of these shares and as a result a constant stream of positive surprises. The effect seems to be particularly large for companies that have developed their brands in-house and thus have no value associated with it on their balance sheet. It seems this ability to constantly surpass expectations is what drives the outperformance of the best brands.

As we head into another recession in the US, Europe and the UK (at least in my view we are) investing in these brands can once again be a way to insulate a portfolio from the worst fallout that is inevitably going to hit corporate earnings.