The post “Does the Market Efficiently Price the Value of Brands?” first appeared on Alpha Architect Blog.
Despite the fact that a company’s internally generated intangible investments create future value, under current U.S. generally accepted accounting principles, internally developed intangibles are not included in reported assets. While research and development is an important intangible asset, so too is branding. Omission of an increasingly important class of assets reduces the usefulness and relevance of financial statement analysis that uses book value.
Kai Wu, chief investment officer of Sparkline Capital, has done some very interesting and innovative work on the role of intangibles, including the papers “Investing in the Intangible Economy” and “Measuring Culture.” In his most recent paper, “Brand in the Influencer Era,” he noted: “Social media is democratizing consumer influence, empowering ordinary individuals to shape brand perception.” With that in mind, he identified brands with strong positioning using social media discourse and network structure. Wu then built a factor which he appropriately named “strong brand factor” that buys U.S. consumer stocks (trading on NYSE and Nasdaq) with the strongest brands and shorts those with the weakest, neutralizing industry exposure (i.e., zero net exposure to each industry) to ensure brands are compared only to their competitors. When I spoke with the author about his study, he told me that from January 1, 2010, through October 15, 2021, the strategy (in backtest) produced an annual excess return of 1.9 percent (t-stat = 2.35) before transaction and financing costs, and did so with a high degree of persistence; turnover was high, at 100 percent.
Wu then used Twitter to build a “brand social network,” explaining that if two brands have a lot of common followers, he drew a link between them. He noted:
“Many brand pairs are intuitive complements. Hikers buy both PowerBars and CamelBaks; homeowners use Terminix and Scotts lawn care.”
Having built a brand social network, he used it to backtest a network momentum strategy. He assigned each brand a score based on the 12-month rolling return of the brands to which it is connected. When a brandʼs friends did well, the strategy buys; and when they did poorly, the strategy sells. He noted that because research has shown that stock returns are higher after industry peers outperform (i.e., industry momentum), his strategy was industry neutral.
Wu also told me that over the period 2011-October 15, 2021, his brand network momentum strategy delivered an annual return of 3.4 percent (t-stat = 2.18) before considering transaction and financing costs. Again, turnover was high, at 200 percent. “Moreover, it had a blowout year in 2020, when the fast-moving Covid pandemic disrupted both supply chains and financial market price discovery. In times of crisis, having a detailed graph of the links between firms can be invaluable.” From 2011 through 2019, the strategy returned 1.8 percent per annum (excluding transaction and financing costs).
Wu next examined the issue of “sustainable brands,” one of the hottest current marketing trends. He noted: “Surveys indicate that rising generations are more likely to buy from brands that reflect their values, and firms are rushing to capitalize on this growing demand.” To address this, he focused on two facets of sustainability: environmentalism and equality.
“Over the past decade, our strong brand strategy has produced consistent outperformance. Strong brands are a deep moat that affords firms greater pricing power, sales volume, and customer loyalty. Furthermore, the robust historical performance of the factor implies that the market does not fully recognize the value of this powerful but intangible asset.”
Wu’s analysis supports the view that the market may be undervaluing branding—while companies invest billions to build brand equity, this intangible asset does not appear on balance sheets. Wu did note that the accounting profession’s decision to not capitalize brand investment is not completely without merit because efforts to build brand equity can produce a wide range of potential outcomes. However, he noted that:
“in the influencer era, the nexus of consumer power has migrated online. It has moved to the very domain that is the most fertile ground for NLP [natural language processing] and other modern data analysis techniques. With the exponential growth in user-generated data, investors are better positioned than ever to quantify this important intangible asset.”
Wu’s work highlights the importance of the value of intangible assets and the ability of artificial intelligence tools such as NLP to help quantify their worth. A few words of caution are noted. First, Wu’s analysis covered a period of only just over a decade, from 1/1/2010 to 10/15/2021. Second, this period was one in which value stocks severely lagged the market. This raises the possibility that this brand strategy tends to buy growthy stocks. If that is the case, it might lag notably when value stocks outperform. Third, the analysis did not consider transaction or financing costs, and the strategy does involve high turnover. With that said, given the increasingly important role that intangibles play, we are likely to see an increase in research into the value of intangible assets, including branding, research and development, and employees (including corporate culture). Stay tuned.
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