Most of the products that were popular in your youth have faded into obscurity.

But you still remember them. You might even have fond memories of shopping at Sam Goody music stores, firing up your first Gateway 2000 computer, or developing photos on Kodak film.

You remember these products because they were at one time relevant to you. They provided some utility, some enjoyment that positively impacted your life and you were happy to spend money on them. 

But once those products lost their relevance and utility, they naturally became less valuable to you. Recognizability isn’t enough to get you to open your wallet.

Relevance drives attention, attention drives demand, demand drives pricing power. 

Unless products adapt to meet changing customer needs, they will become less relevant. And as they become less relevant, their companies’ moats begin to erode, even if the products remain highly recognizable.

Investors often confuse recognizability with relevance and by doing so overestimate the company’s pricing power and moat. This is a classic Quality Trap.

We find that quality traps are particularly common with blue chip companies and those with household name brands. Recognizability can obscure relevance decay.

To illustrate, a recent Wall Street Journal article discussed how big food brands are struggling to maintain shelf space despite having better brand recognition.

General Mills’ sales of baking mixes and ingredients have declined over the past five years. The company’s Betty Crocker, Bisquick and Gold Medal flour brands are losing shoppers to smaller rivals and store brands. For example, Kodiak Cakes LLC, a family-run maker of high-protein pancake mix, has taken market share from Bisquick and other competitors, according to market-research firm Spins. Even though Kodiak’s annual revenue is less than one-tenth of General Mills’ baking sales, Kodiak is gaining shelf space. (My emphasis)

It might be comforting to own the more recognizable General Mills’ brands, but ultimately, it’s not whether you recognize the brand or product. What matters is the product’s relevance to customers over time.

Relevance can diminish for one or all the following reasons:

• Technological change: Massive and rapid technology change, such as music going from physical media to digital and streaming, can impair an established company’s strategy. Few successful businesses are willing to destroy their cash flow machines to chase what at first may seem to be a fad.
• Customer preference shift: Similarly, companies that have built their brand or reputation on a certain image that was once treasured by its customers can find it difficult to pivot once that image is no longer in fashion.
• Increased/new competition: Incumbents are often dismissive when a competitor launches a highly-relevant product that has yet to hit critical mass. Until the upstart impacts their profitability, incumbents are unlikely to adjust their strategy. And by then, it’s often too late.

Whatever the cause, as an investor, you don’t want to be on the wrong side of declining relevance.

Here’s why. If you’re doing a discounted cash flow valuation, between 70-75% of your fair value estimate is driven by your terminal value. Conflating recognizable with relevant products will lead you to overestimate the company’s moat and its returns on invested capital (ROIC) in its terminal year, which will in turn lead you to dramatically overvalue the business.

On the other hand, what you want to see is a company with products that can remain relevant to its customers over a long period of time.

Indeed, the popular products of our youth that maintained their relevance are the ones that we kick ourselves over not buying years ago. Companies like McDonalds, Disney, and Nike – all well-known brands and businesses for 30-plus years – have found a way, despite bumps along the road, to remain relevant and valuable to their customers.

If you could know nothing else about a business over a 10-year period, you’d want to know whether its products still mattered as much as they do today. As such, one of the questions we ask before investing in a company is whether we believe its products and services will be at least as valuable to its customers a decade from now.

Admittedly, it’s a tough question to answer. After all, a lot can happen in ten years. Consider RIM’s (Blackberry’s) global market share swing from 2007 to 2016. 

It would have been easy to think in 2009 that Blackberry would remain highly relevant for the next decade. The trends were positive at that point. But with hindsight, that would have been a terrible conclusion.

On the other hand, Starbucks has become increasingly relevant to global consumers over the last decade. Consider the Google Trends global search results for “Starbucks” since 2004.

Starbucks’ consistent relevance drives traffic and allows it to steadily raise prices on your favorite drinks.

You might be saying to yourself, “Great, but how might we be able to tell the difference ahead of time?”

We think a good starting point for evaluating future relevance includes asking:

• Is the company led by good brand stewards?
• Is the company culturally agile to adjust to new challenges and trends?
• Is there an underlying motivation that drives customers to buy the company’s products?
• Is there a weakness in the company’s offering that exposes them to upstart competition?

Though uncertainty will remain, we believe answering these questions helps paint a better picture of the company’s relevance.

We are certain of one thing: a company will face multiple challenges over the course of a decade. As such, extrapolating the status quo is folly. What we want to find are companies that can survive and thrive in various environments and remain relevant. 

To be sure, these companies are rare. But those that maintain relevance maintain pricing power and therefore maintain their moats. Moat sustainability leads to persistently high ROIC, which usually surprises markets and leads to strong stock performance. 

 

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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