In Warren Buffett’s 2007 letter to Berkshire Hathaway shareholders, he highlighted the importance of an enduring ‘moat’ for a truly great business. A powerful worldwide brand, such as Coca-Cola, Gillette, or American Express, is a formidable barrier to protecting a company’s excellent returns on invested capital. But do these valuable brands always translate to high-returning investments?
Investors often perceive the ‘moat’ attributes of highly valued brands and strong reputations as indicators of excellent investments. Consequently, the demand for companies with these characteristics drives up their valuations, which could potentially lead to lower future returns. This suggests a significant difference between great companies and high-returning investments. However, leading brands may be undervalued due to accounting rules that treat investments in branding as operating expenses, resulting in lower accounting earnings and the book value of equity.
The Efficient Pricing of Intangible Assets in the Market
Researchers Hamid Boustanifar and Young Dae Kang investigated whether the market has efficiently priced the intangible asset value of brands. They found that an equal-weighted portfolio of Best Brands (BBs) in the U.S. yielded an excess return of 25 to 35 basis points per month from 2000 to 2020. This result is remarkably robust across various factor models and is not driven by exposure to common (risk) factors. Furthermore, the excess returns of the BB portfolio are not attributable to firm characteristics, industry composition, or small-cap stocks.
Expensing vs. Capitalizing Brand Investments
The researchers provide evidence suggesting that expensing investments in brands (instead of capitalizing them) and underestimating the impact of brand names on future earnings contribute to the excess returns. Brand capital constitutes a significant portion of firm value, with prior studies estimating its average contribution to be between 10-23 percent. For companies producing and selling consumer-brand products, this ratio can be as high as 60 percent.
A strong link exists between a more recognized brand name and higher firm value. Top brands command higher prices, enjoy more loyal customers, possess durable advantages over competitors, face lower threats from entrants, have fewer financial constraints and greater cash flow stability, and can more easily attract and retain employees. Additionally, they generate increased customer interest in trying, adopting, and promoting new branded products.
In conclusion, while valuable brands do not guarantee high investment returns, their intangible value contributes to a company’s success and should not be underestimated. Investors should consider both the brand value and market dynamics when evaluating potential investments.