Consumer discretionary companies are the ones we are familiar with. Nike, Under Armour, Disney, Starbucks, and Apple to name a few. These companies have provided investors huge returns in the past, but can it continue?

 

Consumer discretionary companies have more risk built into them because their products are, well, discretionary, meaning that we, as consumers, want them but don’t necessarily need them. The reason these companies have provided investors with such high returns is, in fact, the same reason that they are inherently more risky though: the size of their markets. All of the aforementioned companies have gigantic markets. Starbucks has nearly 27,000 locations, Apple has sold over 1 billion iPhones, Nike sells about 25 pairs of shoes per second. The numbers are mind-boggling. But how are you supposed to have a competitive advantage in a market that is so vast, with so many competitors?

 

Competitive Advantage

Brand, brand, brand. And thereby pricing power. A consumer discretionary company without a strong brand might as well be nothing. You can learn more about brand ideology here, but thinking about brands is very interesting. What do you pay more for Nike shoes than Skechers? Or more for an iPhone than an Andriod even though every Andriod users swears by its customization and functionality? While there’s not a black and white answer, the first thing that comes to mind is quality. Tiffany’s jewelry and Ferrari. That’s quality. But I have a feeling that the owner of a Ferrari is not buying it because of the superb handling, there is something else: social status. Brand usually represents social status. A high schooler with a flip-phone will probably get ostracized, but not if he owns an iPhone.

 

A lot of times brand is associated with social status. But brand as a competitive advantage can be fickle. General Mills and Proctor & Gamble, makers of household items like Lucky Charms and Crest toothpaste have commanded strong presence with their brands. They could charge higher prices because people would be willing to pay more for the name brand of Lucky Charms rather than Trader Joe’s version, Lucky Joe’s or something. However, there is no social status at risk. Maybe if you’re in elementary school and your friend sleeps over and starts crying because there are Lucky Joe’s in the pantry rather than Lucky Charms but there is a lower risk of social shaming. Therefore, I believe the brand power of those goods like cereal and toothpaste are at a higher risk of deterioration.

 

Fitting in to social pressures is undeniably human. And companies and brands play to that weakness. Therefore, the more social status that is on-the-line, the higher the pricing power a company has. If General Mills charges double for cereal than the generic version, people likely won’t pay it. The risk of your child being shamed by the next-door neighbor’s spoiled kid is not worth the extra $2.50. But if you really want to impress a date, will you go to Nobu sushi or Jack-in-the-Box? Both places do the same thing; feed you. But one can command 100x the price because of social signaling.

 

With that said, it is difficult to say whether brand is a strong competitive advantage. Consumer attitudes are fickle and change rapidly. Under Armour is not nearly as popular as it was a couple years ago. Two bad shoes releases in a row can put your brand in a rut. But on the other hand, Apple can command huge margins selling hardware. The thing about brand is the consistency. People expect great phones from Apple and great movies from Disney. It’s on those companies to deliver. If they don’t, people will move on…fast. So it’s a dangerous game. The underlying reason that these companies keep producing though is the people they attract. These companies employ the best people and those people do the best work. It is a virtuous cycle. This is the real competitive advantage of a brand. And one that is underappreciated. Who is going to hire a more quality employee, Apple or Nokia? Enough said.

 

Financials and Valuation

Most consumer discretionary companies trade at a market premium, meaning they are not cheap. Pricing power and brand definitely are reasons for the inflated valuations. But so is the overall notoriety. People simply knows these brands so they are comfortable investing in them. Netflix trades at a nosebleed valuation but it keeps producing. So the question you have to ask yourself when looking at a consumer discretionary company is: how much pricing power does this company have? I’m sure people would pay more for Netflix and Amazon Prime. Can Nike raise prices or will Adidas undercut them with higher quality? Think through the scenarios and see if they apply in your own judgment as a consumer.

 

You can tell if these companies have pricing power in the gross margins. Look at the gross margins of competitors and see if they are lower. If they are dramatically higher that might be the product is that much better or the company might not have any more room to raise prices. You should look at the margins in conjunction with revenue growth. If the margins are similar to competitors and revenue growth is stagnant, demand is simply not higher.

 

It sure is interesting to analyze these companies we know so well as consumers, but go ahead, try looking at them through the eye of an investor!