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By Jeremy Glaser and R.J. Hottovy, CFA | 05-08-2014 11:00 AM

Brands Key to Consumer Moats

Brand power can create strong competitive advantages in the consumer sector, but cost advantages and network effects also can play big roles.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. In our new book, Why Moats Matter, we delve into the importance of finding companies with strong competitive advantages. I'm here with R.J. Hottovy, our consumer equity strategist, to look at that consumer space.

R.J., thanks for joining me.

R.J. Hottovy: Thanks for having me.

Glaser: Let's talk about what makes a moat for these consumer companies. Is it just a matter of having a brand that a lot of people know?

Hottovy: Yes, I think that's the cornerstone of economic moats in the consumer space. It's clearly the brand intangible asset. I think that's the thing that most consumers recognize; it's the reason why a lot of times they're willing to pay up for a product that's in a commodity industry. Having a superior brand is the primary source that we find in the consumer space.

Of approximately 90% of the companies that we award an economic moat to, the source is actually an intangible asset.

Glaser: But are brands alone enough? Are there examples of great brands or well-known brands that don't turn into a moat?

Hottovy: I think it is enough. What we do find is that a lot of times in the luxury categories or other premium consumer products categories, having a brand--a Tiffany or a Louis Vuitton--those are the type of brands that alone will give you an economic moat. These are brands that have withstood fashion cycles and changes in any consumer preferences. At the end of the day, consumers have paid up for these brands and paid premiums for several decades, if not centuries, and so those are the type of brands that alone will give you an economic moat.

But at the same time, brand isn't necessarily enough, and I think it boils down a lot of times to distribution. If you are the manufacturer of these products, usually the brand is enough. But if you're a retailer where you've got a well-known brand, and you're dependent on other manufacturer's products, that oftentimes doesn't give you an economic moat.

In the retail space we don't award moats to well-known brands like Target and Best Buy because ultimately they're at the mercy of their manufacturers, and that can make it a very, very difficult proposition.

Glaser: Outside of those intangible assets, are there other factors that contribute to a moat in the consumer space?

Hottovy: The other factors that we do see really are twofold. One is that a lot of times in the consumer defensive side--the consumer staple products, such as beverages, household products, packaged food--those companies when you get to a certain size, you do see economies of scale, whether it be in the production, whether it be supply chain, whether it be marketing--those are powerful. They do lead to cost advantages. Ultimately, that's probably a weaker moat source than the intangible asset that goes behind it. But if you look at a company like Coke, it certainly has an advantage over some of the smaller beverage companies, or we see it a lot of times in tobacco or household products with Procter & Gamble. So, I think that's one thing.

The other one is actually if you look at online retail where you start to see network effects come into play, where the number of people that are on the platforms attracts a wider audience of third-party sellers. I think that's another important moat source that we're starting to see, particularly as we're starting to see a channel shift where more and more consumers are shopping online.

Glaser: You mentioned online and people moving there, what impact has that had on competitive advantages across the sector?

Hottovy: It's been completely disruptive, particularly in the consumer cyclical side among our retail names. What has happened is now all of a sudden consumer packaged goods companies have the ability to take that product directly to consumers. They can sell their product on Amazon; they can sell their product directly off their own websites. And so they've become much, much less dependent on retailers to sell their products. As that's happened, bargaining power that retailers have with those consumer packaged goods companies or just any kind of original manufacturer, that power is dwindling and has made it much more difficult.

As a result, when we see a massive change in the channel of distribution, it has a dilutive impact on the bargaining power those companies have had. It's been very interesting to see the change in the moat profile of the consumer space that has emerged coming out of the rise of e-commerce and more recently mobile commerce.

Glaser: R.J., thanks for your analysis on this diverse sector.

Hottovy: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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