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In a Wal-Mart era, it's innovate . . . or else
Some companies understand the changing nature of the brand in a post-Wal-Mart world. Some don't. Look for those that know how to innovate and survive.
By Jim Jubak
The traditional brand is dead. Dump the shares of long-term, buy-and-hold blue-chip companies that don't understand that change.
Long live the post-Wal-Mart brand. Buy the undervalued shares of long-term buy-and-hold blue-chip companies that 'get it.'
I can't think of any change in the economy over the last decade that's more important for long-term investors.
Let me show you what I mean.
Over the last five years it has been much more profitable to own shares of Wendy's International (WEN, news, msgs) than McDonald's (MCD, news, msgs). The average annual return for Wendy's in that time has been a tasty 15.4%. McDonald's shares have lost an average of 3.6% annually.
What best explains the difference? Certainly not the value of the company's brand. McDonald's has one of the most recognized consumer brands in the world. Wendy's is a strong No. 3 in the U.S. fast-food burger market, but is just about unknown outside North America. Only 11% of the company's revenues from its Wendy's unit in the most recent quarter came from international operations, and more than half of that came from Canada. In that country, moreover, the best-known Wendy's business, the Tim Horton chain, doesn't even carry the company's name.
A baked potato with toppings
It's innovation within the brand that has resulted in the huge difference in stock performances in the last five years. Wendy's was first off the block in adding side salads and full-meal salads to its menu. It has led the fast-food burger chains in menu variety with offerings like chili and baked potatoes (with toppings). It was way ahead of the competition in developing and promoting special limited-time sandwiches. And even in areas where McDonald's and Burger King have belatedly moved to catch up, Wendy's has kept pushing the envelope: Customers can now substitute a side salad or baked potato for French fries with any Wendy's combo meal.
Wendy's is an example of a company built around a brand that understands the changing nature of the brand in the world after Wal-Mart Stores (WMT, news, msgs). The traditional brand is dead, I argued in my recent column "A brand-name survivor in a Wal-Mart world." But the savviest brand managers at companies such as Procter & Gamble (PG, news, msgs) have figured out how to increase the value of traditional brands by turning themselves into innovation factories. In a Wal-Mart world, a company that can push its brands to the top of the heap by keeping customers buying through constant product innovation that adds real value for the customer can charge a premium price and win an expanded share of the available distribution space at the expense of second-tier brands.
In my Wal-Mart world column, I used the P&G example to argue that this brand reinvention is important for investors. But this change in the nature of the brand isn't limited to just one company, or even the consumer-products sector. This change is at work among technology companies, and in the health care and financial sectors. It's so powerful that it has swept over consumer icons such as Coca-Cola (KO, news, msgs) and Walt Disney (DIS, news, msgs), changing their marketplace power. And this change may now even be taking a bite out of Wal-Mart, the company that's probably most responsible for the creation of this shift in the economy.
Counting on the brand
Long-term buy-and-hold investors are the group that most needs to take this change into account when building a portfolio. That's because these investors count on brand as one key element in the long-term competitive advantage that enables a company to survive the bad spots.
Long-term investors count on the Coke or McDonald's brands to get them through those years when a company's execution stumbles. Incompetent management can hurt a company's results in the short run. But a global brand's power guarantees that in the long run, the company (and shareholders) will survive the idiots temporarily in charge. In fact, because of the long-term value of these global brands, a short-term stumble is widely seen as the time to buy because better management at some point will be able to unleash the brand's full power.
But that investment strategy and the assumptions behind it are being challenged by the change in the nature of the brand. Now, long-term investors need to carefully examine their portfolios to separate the companies that 'get' the post-Wal-Mart brand from those that don't.
Let me use my 50 Best Stocks in the World portfolio to show you how I'd go about this kind of portfolio review. This list is especially well-suited to this effort to separate the sheep from the goats because I built the portfolio by identifying 50 companies with long-term competitive advantages, and that certainly included a global brand.
To do this review, you can start at either end of the scale, either with companies that get the world of post-Wal-Mart branding or those that don't. I'm going to start with the companies that clearly don't get it because a) it's a shorter list and b) it's easier to demonstrate that a company doesn't get it than to prove that it does.
The poster boy
On the 50 Best Stocks in the World, Charles Schwab (SCH, news, msgs) is a poster boy for companies that don't get it. You don't have to look much further than the company's current ad campaign, which uses a "Call Chuck" tag line.
I certainly understand why a company that's reeling as a result of a complete collapse of the strategy of its last CEO would bring back Charles Schwab, the founder, as an icon. But the other steps that the company has taken as part of its turnaround are just more of the same game of catch-up that has been a major part of the long-term problem.
Yes, Schwab has cut trading fees -- but not as low as the lowest-cost competition. It also has a fee structure that's still far too difficult to understand. And it doesn't match up very favorably with that of the company's toughest competitor, Fidelity Investments.
Innovation still seems an afterthought, from trading tools to its new product offerings, which don't match Fidelity's, E*Trade Financial's (ET, news, msgs) or Ameritrade Holding's (AMTD, news, msgs). A company that built its brand on bringing innovative new products to market that increased the value of its brand seems locked into a me-too approach.
The other company on this list that I'd put in the "doesn't get it" category is Home Depot (HD, news, msgs). This icon of innovation that created the big box do-it-yourself segment is bogged down worrying about execution and line extensions.
So which companies on my list get it? I come up with 10: American Express (AXP, news, msgs), Avon Products (AVP, news, msgs), Dell (DELL, news, msgs), FedEx (FDX, news, msgs), General Electric (GE, news, msgs), IBM (IBM, news, msgs), Johnson & Johnson (JNJ, news, msgs), PepsiCo (PEP, news, msgs), P&G and Toyota Motor (TM, news, msgs).
Key traits
I don't have the room here to go through each of these companies. But common traits include the willingness to risk cannibalizing the core brand in order to reach new customers with a new value proposition (American Express), a dedication to pushing and pushing again to add new value in the core trait identified with the brand (Toyota and Dell), a dedication to driving technological innovation in ways that matter to consumers (IBM) and a willingness to drive costs to the consumer lower and lower in existing and new market segments (Dell).
That leaves most of the companies on my list of 50 in a middle category between "don't get it" and "get it." Some of these companies are remarkable innovators, such as Intel (INTC, news, msgs) and Nokia (NOK, news, msgs) that are struggling to find ways to produce a steady stream of innovations that are valuable to customers/consumers of their core brands. Others are companies such as Coca-Cola and Disney that are searching for the next innovation that will bring new energy to a brand. Others such as Microsoft (MSFT, news, msgs) and Cisco Systems (CSCO, news, msgs) have promising innovations in the pipeline but haven't yet figured out how to produce a steady stream of innovations that are valuable to consumers. (Microsoft publishes MSN Money.)
I'd call this in-between category "companies with cyclical brands." They have a strong traditional brand and a pattern of the intermittent addition of value to consumers through brand innovation. Investors can, of course, buy and hold these stocks as they ride the cycle between periods of fruitful innovation and periods of slow innovation. But a better strategy might be to buy these stocks when innovation is slow or where recent efforts have missed the mark and then hold until the innovation turnaround.
Cyclical brands to consider buying now because these companies are at brand-innovation troughs include Cisco, Coca-Cola and Microsoft.
Three more
To that buy list, I'd add these three stocks from the "gets it" category: PepsiCo, P&G and Toyota. Investors haven't fully valued the ability of these companies to innovate within their established global brands, so I'd recommend them as buys at current prices for long-term investors.
One final word about Wal-Mart, the company that more than any other represents the new economy and the changed nature of a brand. The recent struggles of Wal-Mart's stock are usually attributed to things like tough earnings comparisons, the squeeze that higher oil prices puts on the lower end of the Wal-Mart market, or a slowing economy.
I look at Wal-Mart's current problems rather differently: After innovating an entirely new distribution structure, the company has hit a creative slump. The Sam's Clubs membership stores don't stand out from those of Costco Wholesale (COST, news, msgs), and in fact Costco continues to innovate far more effectively than Wal-Mart. Target (TGT, news, msgs) has gone after a higher-income but still price-conscious consumer by creating new products with cachet. Wal-Mart hasn't matched those innovations. Wal-Mart continues to do what it has done and to do it superbly, but at the moment, I'd put it squarely in the cyclical-brand category.
For those new to the 50 Best Stocks in the World format, membership in the list is updated only once a year on the anniversary of the portfolio in September. Although this portfolio is designed for long-term investors who trade infrequently, I do indicate with buy ratings up to 10 stocks that are, at the moment, undervalued. So for example, at the date of this column, I have "buy" ratings on PepsiCo, P&G, Toyota, Cisco, Coca-Cola and Microsoft.
Changes to Jubak's Picks
Sell Performance Food Group
I'm glad that Performance Food Group (PFGC, news, msgs) got a higher-than-expected $855 million from Chiquita Brands International (CQB, news, msgs) for its troubled Fresh Express unit. The company has said that it will use the $600 million or so left after taxes to pay off all its debt, buy back shares and pay a dividend to shareholders. That's all to the good, but Performance Food Group will also have to replace a fast-growing, if only sporadically profitable, business that produced $1 billion in revenue. And since the potential in the Fresh Express business was one of the major reasons that I bought these shares, I'm going to use the bounce that has resulted from the deal as an opportunity to sell the shares. Fresh Express has a 40% share of the bagged-salad market. Performance Food Group hasn't been able to make the business consistently profitable despite customers such as McDonald's (MCD, news, msgs), Taco Bell and KFC. But I think someone will, and that the bagged-salad-and-vegetable segment was a key difference between Performance Good Group and the rest of the food-service distribution industry. I'm selling these shares essentially at breakeven; I purchased them at $26.79 on July 9, 2004. (Full disclosure: I will be selling my own shares of Performance Food Group three days after this column is posted.)
New developments on past columns
Spend. Lie. Stick your kids with the bill
XTO Energy (XTO, news, msgs) will split its stock four-for-three effective as of trading on March 16. (Investors will get one additional share for every three shares held, but the price per share will be reduced proportionately. A split is a net wash for investors although, despite that, shares often rise in price after a split as new investors are attracted by the lower price per share.) The company will maintain its current quarterly dividend of five cents a share, which will produce a de facto 33% increase in the dividend.
6 winners for tech's hard times
You've got to call these hard times for ChoicePoint (CPS, news, msgs), one of my winners in this tough market for technology shares. On Feb. 15, the company acknowledged that thieves had stolen data, including names, addresses, Social Security numbers and credit reports, by setting up accounts as ChoicePoint customers after claiming to be legitimate businesses. The thieves operated for more than a year before they were caught. That's a big enough problem for a database company that conducts background and security checks using sensitive personal data, but the company made it worse by initially minimizing the extent of the problem. The company learned of the problem in October 2004 but did not begin telling the 144,778 people across the county that might have been affected by the identify theft until this month. Initially ChoicePoint notified only 34,114 individuals in California, which has the only law in the nation requiring such notification. You can expect that to change as more states move to require notification. Georgia has introduced just such a law, and New York, Texas and New Hampshire were considering similar measures before this story broke. California Sen. Diane Feinstein has reintroduced a national version of the California law. In addition to this heightened oversight, the company has announced that it will screen its 17,000 business customers to make sure that no other thieves posing as businesses are lurking in the system.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Microsoft and PepsiCo. He does not own short positions in any stock mentioned in this column.
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