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Will Consumer Brands Survive the “Great Recession”?

August 27, 2009
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 and 35% at Kroger. 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.

Buyer Beware

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.

Ravi Nagarajan

http://www.rationalwalk.com/

About the author:

Ravi Nagarajan
Ravi Nagarajan is a private investor and Editor of The Rational Walk website. Ravi focuses on applying value investing techniques to find securities trading well below intrinsic business value. Ravi has over 15 years of experience in the financial markets and started investing on a full time basis in 2009. From 1996 to 2009, Ravi held a number of technical and executive level positions in the commercial software industry. Ravi graduated Summa Cum Laude from Santa Clara University with a degree in finance. Visit his website The Rational Walk

Visit Ravi Nagarajan's Website


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Comments

kfh227
Kfh227 premium member - 5 years ago
Regarding those barbeques,

People probably could care less about hte meat. Once cookd you can not see the diference.

Beer is funny. To aot of people, Budweiser and Coors are what you serve for beer. That is the cheapest swill one can drink when it comes to beer. Interesting to note that there is a moat there.

And of course, Coke. I know that is what I serve because generic soda just does not cut it.

AS an aside, it was interesting that during the ice storm in the north east about 12 years ago that alot of liquor stores sold out of all their goods where I attending university..
rnagarajan
Rnagarajan - 5 years ago
Budweiser and Coors are actually in the premium beer category - you can get a whole lot cheaper than that! Natural light, Miller High Life, etc, etc ,etc ....
buffetteer17
Buffetteer17 premium member - 5 years ago
I accepted the "trade down" thesis and sold out my Whole Foods stake at around $23 for a loss. It subsequently ran up to around $30. Earnings and revenue beat analysts' estimates by a mile and even exceeded my tougher expectations.

This is a case where I should probably have paid more attention to the evidence in front of me rather than conventional wisdom. I shop at a couple of local Whole Foods stores on occasion and whenever I travel around the country, I like to drop in at Whole Food stores to see how they are doing. What I observed is that at the height of the panic, the stores were crowded. The store in Chapel Hill near where I live expanded their floorspace by 50%.

I think a lot of people continued to shop there for the same reasons that I did. I say organic schmorganic, but the quality of the meats and fresh vegetables beats the local Safeway by a large margin. Sure they're more expensive, but they taste so much better. I go to Safeway and Harris Teeter for most staples. Another couple of reasons to visit Whole Foods: they have a large selection of cheeses, chocolates, and wines. They have a variety of prepared food. I can't find grade A maple syrup at the local stores but Whole Foods has it. The Whole Foods sushi is pretty good, but that from Safeway tastes like cardboard. So what if the price at Whole Foods is 50% higher. I wouldn't take the Safeway sushi if they gave it away free.

Bottom line, there are a lot of people who continue to pay up for quality. Don't discount this too much.

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