Intangible assets are the most common source of competitive edge in companies analysed by Morningstar. They include brands, intellectual property patents, proprietary technology, and are often protected by regulation. Intangibles generally create a pricing premium through brand familiarity or by meeting complex customer needs, or by limiting competition through patents or regulation.
Our equity analysts attribute an intangible asset moat – or competitive advantage - to approximately 500 companies, or around one third of our coverage, which towers above the 25% to which we assign a cost advantage, 20% for switching costs, 13% for efficient scale, and just 7% a network effect.
Brand power occurs most often in business-to-consumer world and can be the strongest antidote to the growing threats to the large consumer brands posed by private-label and niche products. When measuring brand strength, we look for evidence of pricing power. For patents, exclusivity represents a clear competitive advantage. Investors should focus on duration, diversification, and types of patents as well as the health of the product pipeline – a notable factor in the pharmaceutical industry - and disruptive threats.
Proprietary technology tends to benefit firms with complex products, although innovation and expertise in sophisticated industries often lead to customer switching costs as well. Regulation stems from licenses, rights, permits, or contracts that limit competition. Regulatory oversight can be a double-edge sword, however, as it can constrain pricing power and limit the potency of an economic moat.
A firm's competitive advantage is derived from more than one source, particularly when intangible assets are one of them. Among companies that have intangibles selected as a moat source, 75% of these firms have additional advantages. With the exception of the consumer and healthcare sectors, which are brand- and patent-heavy, most industries have an outsize proportion of other competitive advantages, with switching costs - particularly in industrials, financials, and technology - and cost advantages as the two most commonly shared with intangibles. Deciphering the strength of intangible assets is particularly crucial when multiple competitive advantages contribute to a firm's position.
Within our global coverage, brands permeate a number of industry sectors. However, brands drive competitive advantage only if they deliver pricing power; this most frequently occurs in the consumer sector.
The Key Factors for Intangible Advantages
1) Brand strength is often fairly limited by context: it is often above average in alcoholic beverages such as those made by Diageo (DGE), which are usually consumed in a social environment.
2) Pricing power is also strong where consumers have an aversion to taking a risk on an unfamiliar product. Products for which consumers employ risk aversion include baby food, pet food, and consumer health – such as in products made by FTSE 100 firm Reckitt Benckiser (RB).
3) The high level of spending on marketing and research and development by the large-cap consumer firms, as well as the vast amounts of fees paid to retailers, will also prove a competitive advantage online and see off smaller rivals.
4) Arguably the greatest challenge facing consumer goods manufacturers - and the primary reason for the high level of competition among the leading players - is the finite nature of shelf space and distribution capacity in the traditional brick-and-mortar grocery channel. Category leaders tend to be in an advantaged position to gain and retain shelf space, especially in Western markets.
5) In luxury goods, new entrants come and go, but the perception of established brands can take decades to change, so their pricing power tends to be long-lasting. The most dominant firms tend to maintain longer product lifecycles while also possessing greater control of distribution, which enables the sustainability of excess returns over a longer time horizon.
5 UK Stocks With Intangible Assets
Diageo (DGE)
Strong intangible assets and a cost advantage are at the heart of Diageo's wide economic moat. While we believe the firm's total alcohol product portfolio is far from complete, it contains 14 of the top 100 global premium distilled spirits brands and seven of the top 20. Its presence with number-one or number-two brands in most of the major spirits categories would be difficult for a new entrant to replicate. Diageo's positioning in most of the leading categories means that its brands have high turnover of goods in bars, restaurants, and retailers, and the firm works closely with its customers to optimise product displays, promotions, and pricing at retail. We believe this is a competitive edge over less valued distillers, even one as large as Pernod Ricard.
With 27% global volume market share according to Impact Databank, Diageo has greater scale than its competitors. It sold 242 million equivalent units of beverages in fiscal 2016-17, including its beer and wine portfolios, more than double that of its closest competitor, Pernod Ricard. With only a limited number of raw materials used in the spirits production process across categories and with some synergies with beer and wine, this scale gives Diageo greater pricing power in its raw material procurement than its competitors, as well as efficiency in its distribution and capacity utilisation.
Reckitt Benckiser (RB)
Although RB generates best-in-class margins among the large-cap food and health and personal care companies, this is more reflective of its relatively lower spending on discretionary costs such as R&D and marketing. RB’s profitability and costs per employee appear to be around average for the HPC space. This gives it the financial flexibility to outmanoeuvre startup new entrants, but little in the way of a cost advantage over its large-cap competitors.
Category leaders such as Reckitt tend to be in an advantaged position to gain and retain shelf space, especially in Western markets. This creates a mutually beneficial relationship with retailers and manufacturers. We believe that all of RB’s 21 “powerbrands” fall into a leadership bracket: for example, Nurofen is the number one painkiller in the UK with a share of roughly 25% and is a close number two in Australia with a 22% share. RB is the market leader in China, with 13% share in a more fragmented market. We think RB has substantial pricing power in its consumer health and baby food franchises, which in aggregate represent 50% of the company’s profits before tax.
Our wide moat rating, which indicates a strong and defendable competitive advantage, is supported by RB’s ability to sustain excess returns on invested capital.
Unilever (ULVR)
We think Unilever has a wide economic moat derived from two sources: its entrenchment in the supply chain of retailers and a cost advantage. The firm’s broad portfolio of products across multiple categories and supermarket aisles creates a virtuous cycle of competitive advantages, comprising intangible assets, switching costs, and cost advantages, that new entrants simply could not replicate. Unilever’s portfolio spans multiple household and personal product categories as well as food and, to a lesser extent, beverages, and the firm generates nearly €60 billion in revenue. This makes Unilever one of the most important suppliers to retailers globally and differentiates it from narrow-moat competitors – or companies with slim competitive advantages - with smaller product portfolios.
Unilever’s scale and scope help the firm achieve levels of cash flow generation that allow it to invest behind its brands and to finance the slotting fees necessary when introducing new products, an intangible asset that cannot be replicated by new entrants. Higher spending on marketing and line extensions can drive volume and category growth, and also allows Unilever time to adjust to the entrance of a new brand.
British American Tobacco (BAT)
There are two sources to BAT’s wide economic moat: intangible assets and a cost advantage. Both occur in the tobacco business and have not, yet, transferred to the company’s platform of next generation products.
Tobacco brands' intellectual property has created loyalty among tobacco users. British American has an impressive brand portfolio that is fairly evenly balanced across price points. Despite the advertising ban on tobacco products in many developed markets, brand identity through product differentiation and trademarks allows manufacturers to charge premium prices for their products, and cigarette brand loyalty is higher in premium segments. British American’s premium offerings, which constitute around one third of its portfolio volume, include Dunhill, Kent, Lucky Strike, and Rothmans; these offerings are growing at a rate well above the market.
Regulation plays a part in securing the economic profits of the cigarette manufacturers. It is the bans on advertising that help to keep market shares stable, as it limits the ability of competitors to communicate with smokers. New product launches are tightly regulated, particularly in the US. The substantial equivalence test, imposed by the Food and Drug Administration, limits the ability of both established manufacturers and new entrants to launch new tobacco products. There is an inverse correlation between cigarette manufacturing volume and average cost of production, with economies of scale generated throughout the supply chain.
Imperial Brands (IMB)
Strong intangible assets at the premium end of its portfolio are at the core of Imperial Brands' wide economic moat. In addition, the company's broad platform of tobacco products, which is being extended to include e-cigarettes, gives the firm economies of scope and scale that make it difficult for new entrants to overcome. Finally, the addictive nature of tobacco products makes demand fairly price-inelastic, and with few substitute products outside the portfolios of the Big Tobacco firms, a favourable industry structure exists for the largest players in which pricing, for the most part, is rational.
Despite the advertising ban on tobacco products in many developed markets, brand identity through product differentiation and trademarks allows manufacturers to charge premium prices for their products. As the fourth-largest cigarette manufacturer behind Philip Morris International, British American Tobacco, and Japan Tobacco, Imperial holds 9% of the global market (excluding China), a share that has remained organically fairly flat since 2008. It is in loose tobacco that Imperial Tobacco holds the most brand loyalty, particularly through Golden Virginia, the global leader in roll-your-own tobacco, and Rizla, the number-one paper brand, but its cigarette labels also contribute to its intangible assets.
Brands Should be Measured by Financial Success
Regardless of the industry, we believe there is more science than art to measuring brand strength. If a brand truly provides a competitive advantage, this should be apparent in a company's financial performance. Usually, this will be manifested in the form of pricing power, as this is the most reliable signal that economic profits will be sustained. It is important to differentiate between real brand equity and trademark familiarity from a brand owner with a larger, but ineffective, marketing budget. Our framework for measuring brand strength, therefore, focuses on the financial benefits that brands generate for their owner. Usually this is observed at the business unit level, but can also be observed at the brand level, where possible.
Where brand strength is weak, competition tends to occur on price as well as product innovation. Given the highly competitive landscape, we view efforts to consistently bring new products to market as essential but recognise that any potential benefit from such investments can prove fleeting. The inability to realise sustainable gains stems from the rapid pace at which competitors can replicate innovation, making it difficult and costly to continually stand above peers. Just elevating the level of brand spending does not simply increase revenue growth. Marketing is a cost of doing business rather than a source of competitive advantage, since even value-added new products can fail if consumers do not know about them.
