Previously, we looked at why economic moats are important for finding great companies to invest in for the long-term.

In this article, we will take an in-depth look at one of the six different types of economic moat: the brand moat.

What are brands? How do companies create and maintain them? Most importantly, how can they be used to protect sales and profits from constant competition?

Let's start from the beginning...

What Exactly Is A "Brand"?

The word brand has its roots in quite a literal sense: the branding of livestock. This practice, originating in Egyptian times, identified livestock as belonging to one or another owner through a distinctive mark. This mark was important for identifying stolen livestock, discouraging the practice because they were hard to remove.

At a high level, the iconography of a brand is just an identifying symbol, much like the flag of a nation. They let a prospective client know, in a simple, memorable, visual manner, that a product or service originates from a particular source. Brands are almost always associated with a logo and/or distinctive visual cues that make them highly identifiable. For example, Coca-Cola (KO) drinkers know instinctively that red cans are regular Coke, silver cans are Diet Coke, and black cans are Coke Zero Sugar - even without seeing the actual logos or words.

While logos and visual clues identify a brand, it is up to the company to shape the consumer's understanding of what they mean. Does this brand stand for world-class quality (at a high price)? Does it stand for always low prices? Does it stand for environmentally friendly products that represent new ways of doing old things? Does it stand for outstanding customer service?

As you read through the prior paragraph, did your mind drift to any companies in particular? If so, that's the power of a brand. It is a quick way to convey the value of a product or service to its users.

How Do Companies Develop Brands?

All companies, from the largest multi-national corporation, down to the local mom-and-pop sandwich shop, have a brand.

Even down to the personal level, we all brand ourselves in one way or another.

A brand is equivalent to a reputation. It is shorthand for how others perceive us, our business, or our products.

So, a company builds its brand(s) the same way we build our reputations. Through their actions!

Take one of the world's most powerful brands: Ferrari (RACE). What do you think of when you think of Ferrari?

World-class automotive performance. Exotic styling. A luxurious lifestyle. Extremely high prices.

The red cars and prancing horse in a yellow background are just visual cues - they visually represent those thoughts. Ferrari built those thoughts through decades of conscious pursuit. Founder Enzo Ferrari was interested in building race cars first and foremost - road cars came later to fund his racing pursuits. But he was never interested in cost - only performance. This led to high performing, exotically styled consumer autos that cost a fortune. Through an unwavering focus on Enzo's principles, high profile racing pursuits, and word-of-mouth "advertising" from being owned by the rich-and-famous and appearing in cinema, the Ferrari brand is what it is today.

The process is not that much different for other brands. It is up to a company to define what a brand means, then communicate that effectively to the consumer, whether through paid marketing, viral marketing, influencers like famous people or movies, etc.

Importantly, the company needs to be consistent with delivering on their brand promise over a long period of time in order for that brand to be well-defined in the minds of customers.

OK, so we've defined what a brand is and how they are developed. The next question is: how are they used to build economic moats to protect against competition? There are two ways.

Brand Advantage #1: Automatic Purchases and Lowering Search Costs

The first way that a brand can protect a company is by creating "automatic purchases", and lowering the consumer's search costs.

This method is often referred to as "brand loyalty".

What does this mean?

Imagine your regular trip to the grocery store. There are a lot of things you probably buy that you don't even think about: soda, toothpaste, coffee, maybe diapers if you have young children, etc.

Now ask yourself: do I spend 10 minutes looking at ALL of the options for each of these items? After all, there is usually an ENTIRE aisle dedicated to different soda options!

Of course, we don't - that would be a waste of time. We gravitate to what we know and trust in these areas. For some (me), that might mean going DIRECTLY to the black cans in the Coca-Cola portion. For others, it might be the blue cans in the Pepsi area.

Why do we do this? Because one, it saves a lot of time, and two, we know we are getting something we like.

Sounds almost like an "automatic purchase" that lowers the time it takes us to "search" for product we need, doesn't it?

Now imagine you were a new soda company looking to make headway into the Coke and Pepsi hegemony. You could develop your logo, your distinctive cans, and put them on the soda aisle. But as you can see, without a ton of time and money spent on marketing, most people are not even going to see your product. They will walk right past it without even considering it.

Automatic purchases and lowering search costs is an effective use of brands in highly competitive product categories. Some examples of companies that use branding in this way include the aforementioned Coke (KO) and Pepsico (PEP), Proctor & Gamble (PG) (Pampers, Gillette, Tide, etc.), McDonald's (MCD), Amazon (AMZN), and numerous others. For all of these, consumers choose them over competitors because there are too many choices and they gravitate to the choice they know and trust.

Brand Advantage #2: Pricing Power

The second way that brands can provide a competitive advantage to a company is through pricing power.

Let's consider coffee for a second here.

For a regular 16 ounce cup of coffee, with cream and sugar, the costs look something like this:

Made at home with a Keurig machine: $0.50 (coffee) + $0.22 (creamer) + $0.01 (sugar) = $0.73
At McDonald's: $1.00
At Starbucks: $1.85

Starbucks (SBUX), for essentially the exact same product (their coffee is even sold for Keurig!), is able to charge 85% more than McDonald's and 153% more than it costs to make at home or the office!

When you consider that making coffee at the office is essentially free, it is even more amazing that folks will stop at Starbucks on the way to the office and stand in line to get that expensive coffee!

Starbucks, through effective marketing and positioning of itself as a premium experience (through decor, presentation, and upscale product offerings), is able to consistently get away with charging massive premiums over its competition. With those excess profits, Starbucks can invest more in marketing, in new stores, in new product categories, or even as a means to reward shareholders with stock buybacks and dividends. Lacking these excess profits on coffee, its competition does not have the same advantages.

Brand pricing power is all around you, in nearly every industry. In vehicles, BMW and Mercedes make cars that are substantially similar to Volkswagen models but can get away with charging 2-3x the price for them. Diesel jeans are not much different than Levi's (LEVI), but can cost 6 times as much! Is a Rolex Submariner wristwatch really worth nearly 100x (!!) the price of a very similar looking and functioning Seiko Series 5?

The answer, objectively, is no. But people pay these crazy prices because owning the brand makes them feel the way they want to feel. That is an extremely powerful thing, something that takes a lot of care, money, and time to develop. A brand with strong pricing power is a rare and valuable asset.

False Brand Moats

Automatic purchases and pricing power are the ONLY two ways a brand can help a company build a competitive moat.

A brand must provide one or both advantages to its company to grant any competitive protections.

Therefore, it is very important that investors be able to identify brands that have them, with brands that don't.

BRAND RECOGNITION ALONE IS NOT A COMPETITIVE ADVANTAGE! This is a very common mistake some investors make.

There are tons of very well known brands out there that do not provide automatic purchase, nor pricing power, advantages to their companies.

Think of a brand like Ford (F). Super well-known brand, an American icon, has existed for over 100 years, has a great history. Possibly one of the most recognized brands in the world.

But does it grant any competitive advantages to Ford Motor Company?

It doesn't generate automatic purchases in any meaningful volume. Sure, there are some families or people that have always been "Ford people", have the sticker of the little guy peeing on the Chevy logo, etc. But this small group alone hardly matters in an industry moving 91 million units a year. For large purchases like-new vehicles, consumers tend to take their time, look at all options, cross-shop, and just generally carefully consider the purchase. The Ford brand matters little in this comparison. While BMW stands for performance and prestige, Ford stands for... what exactly?

It also doesn't provide any pricing power. Ford models in similar product categories sell for comparable prices to Chevrolets, Toyotas, Nissans, and Hyundais. Ford cannot sell a small sedan for over $40,000 - but Mercedes can!

At the end of the day, the Ford brand provides really little of economic value to Ford Motor Company, despite its ubiquity.

Conclusion

Strong brands can be an important source of economic moats. This is why companies spend so much time and money to build them, and why companies that neglect or damage their brand can quickly unravel.

It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently. - Warren Buffett

It is important for investors to differentiate brands that are simply well-known from brands that actually provide a tangible economic benefit against their competition.

Brands aid a company in two ways and two ways only. They can lower search costs for consumers, setting up "automatic purchasing" decisions that cut their competition right out of the running for a sale.

Or, they can allow a company to sell similar goods and services for much higher prices than their competitors, putting the competition at a major economic disadvantage.

The next time you consider making an investment with brand as the moat rationale, ask yourself if the brand has one of these two characteristics. If so, you might have found yourself a green dot stock!