Traits of the Successful Investor, and the Changing Nature of Brand Loyalty
(Guest Commentary by Rick Konrad – March 4, 2010)
Note: I haven't taken a weekend off in a long time (since New Year's). Since there isn't much new happening in the markets recently, I have decided to take this weekend off from writing. Don't worry, though – MarketThoughts is still here! Instead, David Korn, who have written for us in the past, will be penning our guest commentary this weekend. Thank you so much for your patience!
Dear Subscribers and Readers,
For those who had want learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in our regular guest commentator, Mr. Rick Konrad for a guest commentary. Rick has been a regular guest commentator for a few years now and offers his unique insights to us in his twice-a-month mid-week commentaries. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick discusses the concept of brand loyalty and the changing landscape of how brands are now being perceived – as well as what the investment implications may be (Rick also asks why Warren Buffett has been deviating from investing in brands recently). Rick begins the commentary discussing what the successful investor's edge may be, which I am sure you will appreciate as well. Without further ado, following is Rick's biography:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see "A Shaky Start Does Not a Year Make" for his last guest commentary). Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years. You can view a more complete profile of Rick on his blog. You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
Transatlantic flights for those of us who have a tough time sleeping on planes provide a great opportunity to think about investing. Roughly seven hours of uninterrupted time at a sitting is precious for those of us who manage investment businesses. This post is a result of some of those reflections, mostly about the traits of successful investors but also about the importance of brands to value investors.
As we said in our last post here, a shaky start does not a year make. The subsequent rally that has transpired since that time has caught many people flat-footed, but that is the price of erratic trading. Most of us are bombarded with an onslaught of noise portraying itself as information. We are encouraged to make massive shifts from sector to sector, from stock to stock, even from currency to currency. Our exposure to information and communication technology in real time has advanced well beyond the advancement in our human judgment for most of us.
I think successful investors accept the rapid pace of trading with a great deal of humility. Many of our worst problems in investing stem from the hubris of imagining, if not actually believing that we are that super-brain that can predict short term fluctuations in the market. Most successful investors approach the market with a great deal of humility and a fundamental understanding that the short term is incredibly random. How many six sigma events do we need to endure in a decade to understand that the market can fluctuate completely unexpectedly?
Cheapness, in and of itself is not a sufficient condition for investing. Think of the disastrous results of many value investors in the last couple of years who bought book value “bargains” in the financial services sector. I think great investors are extremely conscious of the quality of balance sheets, both from the quality of the asset side as well as the nature of the liabilities and especially the off-balance sheet liabilities. How often have I been approached by a young analyst who insisted that some retailer was debt-free without regard for its heavy schedule of operating leases? How often do we forget the impact of assumptions in the pension plan liability or the retirement health care benefits? How little attention or regard did some analysts have for the obligations of banks as issuers of securitized assets?
Great investors have a strange capacity to suffer. And the best returns develop from those times when you suffer the most. There is rarely a bell-ringing moment that tells you are looking at a bottom. Fight the complacency that we succumb to in bear markets, that feeling of why bothering to do anything, because next month the price will probably be cheaper.
In strong markets, stay disciplined and don't try to be too creative. Unusual takeover activity in a sector should encourage you to sell investments in that sector rather than seek “the next target.” We were fortunate to have a position in Pall Corp (PLL) which reacted strongly to the announcement of the Millipore (MIL) takeover. Pall hit our target price and in our determination was fully valued unless some strategic buyer chose to pay the same sort of multiple as Millipore enjoyed. Possible but I choose not to roll the dice and play a game of hope. Pall is sold and gone from our portfolios. Maybe I'll look stupid next week, a chance I am willing to take. It's my version of risk control.
What is the source of a successful investor's edge? Can this apply to the average “home-gamer” as Cramer refers to the retail investor? I divide edges into four types:
Informational Edge- Do you have information that nobody else has? As a rule of thumb, having insider information and acting on it will get you into prison. Rule FD leveled the playing field so that analysts with long standing relationships (but not ethics abiding CFAs) could not receive special insight. Information had to be disseminated democratically.
Analytical Edge- I view this as coming to a different conclusion than the consensus viewpoint based on the information that is there. For example, John A. Paulson made a fortune in betting against residential real estate and the mortgage markets based on his understanding of the sub-prime markets and the exposure of various banks to this market. Sometimes an analytical edge can be garnered by using the same inputs everyone else has but weighting them differently. For example, a great business run by capable managers may extend its franchise to other geographies where markets are under-penetrated. This incremental growth might not be priced into the current price of the stock. A problem subdivision which represents a sideshow or a distraction, at worst a short term problem can become an overwhelming distraction for Wall Street and hence, most investors.
Behavioral Edge- As Buffett described it, be fearful when others are greedy and greedy when others are fearful. This is an incredibly difficult attribute to develop because for most of us, we are falsely comforted by a consensus viewpoint. We often ask for advice from people who will affirm our own views. The frenetic investment in bond funds last year seemed to be more of a movement to avoid the pain of stocks rather than an endorsement of the fixed income markets. Another example, Administaff (ASF) announced a dreadful fourth quarter on February 11 which clocked the stock from $23 to $16 and change in the next two days. It appears at least superficially to be based on a non-recurring one-time issue. In decent times this has been a mid 20's return on invested capital, but in two days, almost 30% of the company's shares outstanding traded hands, dismissing the past entirely. An important part of the behavioral edge is the ability to actually execute, not merely to theorize and wait. If it ain't on the tape, it ain't in the portfolio.
Time Horizon Edge- Having the ability to take a longer term perspective, having the comfort of waiting for the fat pitch, having the ability to avoid the misinformation is another important edge that some value investors enjoy. Great ideas deserve a disproportionate part of your capital, but make sure you are safe. Too short a time horizon and you're in danger of not letting your thesis unfold. But look at and stress test your portfolio all the time. Being married to too big a view can be dangerous however. Being too dogmatic and inflexible can be dangerous. For example, one of my former partners was married to a view that the S&P 500 could not possibly trade at more than twice book value because historically this represented dangerous ground. Needless to say, as share buybacks became prevalent, and write-downs eroded the value of equity, his dogma became nonsensical.
Though it is difficult for the average retail investor to develop an informational edge, I believe that it is certainly feasible for this person to develop and utilize any of the others. It is vital to develop this edge in my view. If you approach the markets without a model or a philosophy, your odds of being doomed are very high. If you don't have a framework anchored on objective measurements (in other words not just a gut feel) you will be ground down by the uncertainty of markets. As individuals, it is tough but not impossible…we are neurologically not wired to make rational decisions, with emotional decisions anchored in animalistic “fight or flight” wiring. If you think like an owner, you will remember that the investment is locked up in the business rather than the stock price.
Someone once said that successful portfolio management was a little like taking friends and family out on a fishing boat. The paramount responsibility is everyone's safety. Cluttering and overloading the boat is a dangerous practice in boating just as it is in portfolio management. Heading out into an oncoming storm can be disastrous for the boater and investor alike but storms pass and smooth sailing will follow.
I will put together some commentary on the Buffett's annual letter soon but taking his recent investments into perspective, especially the regulated utilities and Burlington Northern, it seems that Buffett is showing less and less interest in brands. I sense some changes in brand loyalty are occurring. Why is this?
It seems that a number of factors have proliferated which have governed brand loyalty are getting more difficult to attain. These new, and developing, challenges include:
- Consumer expectations of their branded products have risen: be it in the quality or value they expect, the ethicality or transparency of the practices of the brands they consume or the number of “solutions” these products provide to the everyday problems they face. All these factors mean that it is easier for a brand not to deliver against consumer expectations. So standards are higher and brands which do not continually improve their standards will be dropped. Consequently, brand lives may be shortening and the spending to support a brand may be increasing.
- There seems to be a general trend toward experimentation which tends to lower the intensity of loyalty and encourages switching between brands. Some people refer to this as brand promiscuity.
- The recession has caused a significant and perhaps more than a temporary change in shoppers' behavior. Brand choices are now made using different criteria than in the past. The need to cope with less discretionary spending is putting many brands through an ongoing review, scrutiny and re-evaluation.
- Private labels are starting to emerge as brands in their own right, and offer a strong incentive to switch to a retailer's products. As retailer controlled brands (especially with Wal-Mart and Target) the strategy for competing against them is different from competing against other national brands.
- Social media is changing the brand management landscape.
One of the best demonstrations, in my view of the changing role of brands is Apple (AAPL). Before the iPhone, it could be argued that brand loyalty in mobile phone markets was low for both handset manufacturers and for network providers. Networks have generally been regarded negatively. In the past, consumers often switched handsets repeatedly, and often tried handsets from a variety of different manufacturers as a result. Before the iPhone, cell phones were very much commodity items, competing on price for the number of functions and reliability they offered. Nokia (NOK) had some loyalty but largely because of functionality considerations, not because Nokia was a “lifestyle brand” which helped consumers have more fun from their phones.
The tons of apps that are offered for the iPhone have changed everything. Consumers now are able to use a service which is both fun, allowing them to use the products in new ways and also helping them to lead their lives in different and unique practical and not so practical ways. This is a powerful proposition.
Apple has also managed to increase its input into the consumers' view of its brand by increasing its interaction with that consumer. This means that not only at purchase but also after it, interaction is not limited to the retailer, the manufacturer can still build an ongoing relationship with the customer for more than simply providing information (or doing recalls!).
So it seems that brand loyalty in the future will be derived largely by the post-purchase interaction. Over time effective engagement of consumers will allow the “loop” to be closed between initial product strategy development and consumers' actual views and experiences of using or consuming a brand. With the consumers' need to experiment with other brands, hopefully in a fairly limited way, engagement does not mean that the consumer will always be purchasing your brand, but it does mean that they should continue to have positive views about it.
Online transparency will force brands to ensure that their credentials stand up to scrutiny. While online sites, and offline post-purchase engagement media (such as Facebook or Twitter) have at least a proportion of the content controlled by the brand owners, ultimately post-purchase engagement opens up a two-way relationship with a customer. If a consumer sees something they don't like and can't do anything about it on the brand's own site, it won't take long before they post comments about it somewhere else, for anyone to see in what may be a largely uncontrolled environment. This means that transparency is a key watchword for brands when developing post-consumer engagement – by inviting consumers to be more involved with your brand they are likely to take a longer, deeper scrutiny of what the brand is doing.
Brand loyalty, both capturing it and maintaining it has become a new discipline. However, many brands with a long heritage and consumer trust have survived the recession better than middle brands, and have invested to ensure that they come out of this period in a stronger position to continue growing.
We plan to address this issue in subsequent posts both here and in Value Discipline.
Disclaimer: I, my family and clients may have long positions in some of the securities that have been mentioned in this post.