When buying value stocks—that is, stocks that are undervalued due to market underperformance—look for stocks that have
a strong product franchise. Market leaders have pricing power and purchasing power
Pricing power + Purchasing power = Strong margins and Flexibility
With good management (the next factor) this combination should generate superior earnings growth over time. A stock may be undervalued due to a problem with its products or its profitability, but at the end of the day the chances are much better that the company will be able to fix the problem if it is dealing from a position of strength. This factor emphasizes the importance of leadership and the resulting “mind share”
accorded to leaders in the marketplace. Industry dominance does not ensure a company won’t stumble, but it does increase the odds that a company can right itself.
Nike (NKE), for example, is the franchise leader in shoes, producing a franchise that is recognized worldwide.
NKE started to build its brand recognition with famed American distance runner Steve Prefontaine and the run- ning shoe. However, Michael Jordan’s affiliation with NKE in 1985 revolutionized industry marketing practices. NKE’s development of Brand Jordan and the overflow of that brand into other sports categories is responsible for a sig- nificant portion of the athletic footwear sales growth throughout the decade. Jordan and Brand Jordan really put the NKE swoosh on the map. Moreover, rather than resting on its laurels with Jordan, NKE attached other unique per- sonalities to the swoosh. Nike Town stores and Tiger Woods have helped continue the strong franchise value of NKE in the 1990s. The power of that brand’s dominance and the NKE swoosh drives fashion cycles. NKE is well positioned to respond or adapt to changes as the market leader. The same thing can be said for Gillette in personal care prod- ucts. Gillette “owns” shaving in a way that no other com- pany can.
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Owning a brand can be a critical component of franchise value, particularly in the consumer nondurable sector.
Strong evidence of this fact can be found in a 1994 study done by London-based Interbrand Corp. in which the strongest brands in England in 1933 were shown to still be the market leaders in 1994, more than sixty years later.
Hoover was still number one in vacuum cleaners; in fact, Britons don’t vacuum their carpets and floors, they
“hoover” them. Colgate was still number one in toothpaste, Gillette was still number one in razors, and Cadbury’s was still number one in chocolates. If you look at the U.S. market, this same branding trend holds true. Few competitors have ever been able to displace a company that gains mindshare through brand dominance.
Questions to consider in looking at franchise or niche value include:
1. Is the company profitably maintaining/gaining market share?Finding growing companies is critical to any investment strategy. It is best to avoid firms that are struggling to maintain position. Chrysler is a good example. The company, although it had a strong brand, was plagued by poor product quality and declining per- ception in the market. Additionally, it did not hold a leadership position as the number three player in auto sales in the United States. Without a dominant market share and with a product plagued by quality concerns, Chrysler did not meet the criteria of this factor. Once it’s established that a company has a strong product offering, the question is whether that product line is being effectively used to spur profitable growth.
2. Can the company leverage its franchise to enter new markets profitably over time? As markets become saturated and mature, a company has to be able to extend its franchise in order to continue to grow. In the 1990s, companies began to successfully portray
their brands as “lifestyle” choices. Nike was able to jump from shoes into athletic wear with strong approval from consumers. IBM, which made desktop computers, became a major supplier of Internet serv- ices, using the computer as the starting point of entry into the World Wide Web. Mercedes-Benz became a dominant player in the burgeoning sport utility vehicle market by building a rugged, stylish SUV that was priced reasonably, but had all the amenities and cachet of a Mercedes. When a company can leverage its brand into new areas that make sense given its business model, and can therefore extend the franchise, the company has a better chance of holding its dominance within its respective industry.
3. Has franchise value (the earnings driver of the company) increased over time? This is really a combination of the first and second questions. It is not enough to maintain or gain market share, and it is not enough to enter new markets. A company has to be recognized for its efforts in the marketplace, and be rewarded for it by investors. The critical factors for com- panies successfully passing this test are their ability to deliver quality offerings and, on an ongoing basis, their ability to develop new products and get them to market in a cost effective/profitable manner. Intel is a good example of a company that has a strong history of sustained increases in franchise value. Intel’s earnings have grown from just over $1 billion in 1992 to $10.5 billion in 2000, (well ahead of the average company in the S&P 500) while at the same time it has built a repu- tation based on continuous innovation and delivery of a high-quality product. Pricing power goes to the market leaders; for a company like Intel, this means it can set a competitive market price and maintain profit margins while investing in future product innovations to main- tain its dominant position.
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