Sunday, August 23, 2009

Consumer Staples Stocks - Long term outlook for the FMCG industry, and what it means for investors

FMCG businesses like P&G, Unilever, and Colgate-Palmolive are often seen as reliable long term investments, because their products are seen as daily necessities and are perceived to have strong brands with economic moats. The major FMCG companies' decades long track record of steady earnings growth reinforces this image.

However the last century's structural factors that allowed FMCG companies to evolve their economic niche are changing rapidly. Changes in technology, lifestyles, and the business landscape have brought the FMCG industry to an inflexion point in its evolution. The playbook that gave FMCG companies their past success is gradually becoming outdated. As investors, we need to critically analyze this; we cannot blithely project their future earnings by extrapolating from their past successes.

The value proposition of FMCG

The FMCG business was made possible by the technological advances of the industrial age, mass production, cheap transportation, and chemical and materials technology. FMCG companies leveraged these advances to create affordable products that improved people's lives, products which gradually came to be considered essential for daily living like shavers, toothpaste, detergents, shampoos, and so on. They created this value for consumers by:
  1. Bringing new chemical and materials technologies to daily life. FMCG companies translated technological advances into new products that improved lives. Shampoos, better soaps and detergents, powders for washing machines, sanitary products, cheaper and safer food, and so on, brought technological advances to bear on improving daily living. This is similar to how Google, Amazon and eBay are today improving our lives by creating services based on advances in information technology.

  2. Using mass production and cheap transportation to make their products affordable. FMCG companies applied mass manufacturing to achieve low unit production costs and make their products affordable. The dropping costs of transportation allowed centralized manufacturing to serve ever more distant markets, further increasing the economies of scale in mass production.

How the leading FMCG companies succeeded up to today

The leading FMCG companies succeeded by (1) identifying and manufacturing products that people wanted to buy, and (2) providing a compelling reason for retailers to stock those products.
  1. Creating products that people want to buy. There are 2 ways for a FMCG company to have a product range that people are willing to pay for:

    (a) A company can manufacture products that are already in the market, at more attractive prices. This is the low cost executor strategy, to produce only goods which meet well identified needs, and use a low cost of manufacturing as a competitive weapon. For example, if it has been established that consumers are willing to buy margarine, then simply manufacture margarine on a large scale so that you can sell it to consumers cheaper than your competitors. Companies like Unilever excel at this strategy.

    (b) A company can innovate and develop new products (or features/solutions) that improve people's lives. This requires a large investment in market research and technical innovation, to identify hitherto unserved needs and use technology to create new products to serve those needs. P&G is an example of a company that has succeeded with this strategy. It has (a) mature market research and product testing capabilities, and (b) extensive expertise in chemical and materials technology. Such companies can typically charge a premium for their products, provided the differentiated value is communicated to, and perceived by, consumers.

  2. Providing a compelling reason for retailers to stock their products. FMCG companies rely exclusively on retailers as the channel to the consumers, and getting retailers to stock their products is key to their success. There are 2 ways they can do this:

    (a) allowing the retailer to earn more money by selling those products than other products. This was done either by (1) providing innovative products that consumers are willing to pay more for, and/or (2) providing products that people want at a price lower than what the retailer can find elsewhere or by manufacturing it on its own. Their adoption of mass manufacturing and increasing volumes achieved the latter, as FMCG companies gradually evolved to become many times bigger than individual retailers.

    (b) by making customers ask for their products by name, so that a retailer can't afford not to stock the product. FMCG companies needed to communicate with consumers to tell them why they should ask for a particular product. To do this, they developed brands, which are fundamentally a signaling mechanism to tell consumers something about their products. When managed properly, brands were very effective in the pre-information age, when information was scarcer, less accessible, and where consumers could not easily share information.

Changes in the world between the 20th century and the 21st century that affect the FMCG industry

The year 2000 roughly marks the watershed between 2 eras in the evolution of the FMCG industry. Several things have changed between the 2 eras:
  1. Some retailers are now as big, or bigger than many FMCG companies, nullifying the FMCG companies' economies of scale advantage. Prior to the 1990s, retailers were much smaller than FMCG companies. This meant that FMCG companies were much larger than retailers, and hence FMCG company produced products would inevitably have a cost advantage to private label / store manufactured products. However the size and scale of retailers today allow them to commission private label manufacturing for products (whose technology is available to private label manufacturers) on a scale as large as the major FMCG manufacturers.

  2. It is harder for FMCG companies to sustain a technological edge and build brand value, because chemical and materials technology have moved to the upper end of the technology innovation S-curve. The last century was a period when chemical, materials and industrial technology were starting to evolve rapidly, and new industrial technologies brought us innovations like the washing machine, rice cooker, and other home appliances. During this time, well managed brands that communicated capability were a source of competitive advantage. It was also difficult for competitors and upstarts to manufacture the products because technology know-how was not widespread. They did not have the know-how (e.g. advanced detergents, shampoos etc) or scale to manufacture effectively.

    However, technology progress in chemical, materials and personal/household technology is now entering the upper end of the S-curve. While technology advances continue at a rapid pace, fewer of these advances are "paradigm changing". People are no longer experiencing "shock and awe" at new products coming onto the market, and are generally able to understand new FMCG products. There are also fewer radical advances in categories; for example, in many cases, the difference between a good detergent and a cutting edge detergent is not dramatic. The result is that the value of brands deteriorates for capability driven brands, and makes it hard for consumers to differentiate one product from another. The widespread availability of manufacturing and technology know-how also makes it easier for upstart competitors to manufacture functionally near-equivalent products. The result is that many categories of FMCG goods are in danger of being commoditized.

  3. The mindset and norms of people brought up in the Information Age reduces the value of brands. The generation that grew up in the information age is culturally different from the generations before. Compared to the past, when information was harder to come by, people are now used to looking for information on product attributes and sharing product reviews. Information is freely available and the new generation is mentally predisposed to looking for information. The value of brands as a signaling mechanism is reduced. For example, observe how the online jeweler Blue Nile has been able to build a large customer base relatively quickly. In the past, it would have been unthinkable for consumers to buy thousand dollar pieces of jewelery over the phone, much less over the Internet. High value purchases of such hard-to-assess products would only be done at trusted jewelry stores.

    It is also difficult to command a mass audience because of the decline in attention to mass media, and the change in people's attitudes to consuming information. The old formula for building brands through mass communications will no longer work.

    It is an open question if it is possible to build billion dollar brands in this new environment. In the annals of history, it is entirely possible that brands will be seen as an artifact of the industrial age, when information was consumed as a one-way feed through mass media.

Types of brands, their characteristics, and
how the changes described diminish their value

The FMCG companies used mass communications to market their brands, to induce an respondent conditioning response in consumers. So that for example, if a consumer thought of "cleaning power" he/she would automatically reach for a box of Tide. In some cases where the product delivers an assessable and keenly felt capability or experience, operant conditioning also kicks in. Fundamentally, there are several types of brands:
  1. Brands that serve as a Quality / Safety signal - the quality guarantee of a product. For example, Lea and Perrins Worcestershire sauce - the distinctive icon imprinted on the label combined with a past experience of the product, serves to communicate its taste and ingredient quality. This was particularly important in the era when there were many manufacturers and the market had many products of differing base levels of quality. For example, the Heinz brand conveyed an image of safe food made with good ingredients. The value of this type of brand decreases once all products presented in a market are of comparable quality or meet certain universally demanded specifications. It also decreases when people have the ability and predilection to exchange notes about the quality of a product. For example, an Auto Company may be known for making low quality vehicles, but with Auto review sites today, it is possible for consumers to identify the occasional high-quality car model from this manufacturer. The value of building a brand like Toyota that conveys quality gradually begins to diminish.

  2. Brands that serve as an Experience signal - the promise of a particular experience. For example, the Cadbury label conveys the promise that the chocolate bar insde the wrapper will have the same taste, or type of taste, that you expect from Cadbury products. The value of this type of brand erodes when people are able and have the predilection to exchange notes/reviews on a product. For example, the Hilton and other hotel brands used to serve as a signal of a certain experience. Smaller hotels who had no brands were at a disadvantage. Even if they provided better service than the big luxury chains, it was impossible for them to be well known for it. But this has changed in the new Internet age. With review sites like Trip Advisor, even small hotels without such brands can become known for their quality of service.

  3. Brands that serve as a Capability signal - a description of a new feature brought about by new technology. This is particularly useful when people are trying to adapt to something new. For example, when washing machines were first introduced, people relied on washing powder brands because they were unfamiliar with the difference between the various types of detergents. The value of this type of brand erodes once people are familiar with the technology, or are able to assess the product's capability, and have the predilection to exchange notes on the product or technology. Brand products whose capability cannot be easily assessed, such as the "beautifying power of a facial cream" or the "germ killing properties of a cleaning liquid", tend to retain their value better, since consumers cannot assess the product's capability and need to "trust" that the product is doing what its brand says it's supposed to do.

  4. Brands that signal an Identity or Message - For example, some brands like Harley Davidson are designed as an identity which people can take on. As social animals most humans want to belong to a group, and need to communicate their status or position to members of their community. Brands such as Harley Davidson provide for this. Other brands such as See's candies or Godiva chocolates are partly designed to indicate a message of "I bought something exclusive and expensive for you". The value of such brands is largely determined by how well they are managed, and the relevance of the message within the context of the zeitgeist of the day.

Perhaps brands in this new age of information will only have value for products that are:
  • (i) Edge of Consciousness (Mental shortcut). Low-priced and/or where it doesn't make sense to go spend so much time looking for information. In other words, products that exist at the edge of our decision-making consciousness. Brands are particularly useful in this area if the market is full of bad products/"lemons", because the value of a brand as a mental shortcut in decision making is enhanced.

  • (ii) Extreme Risk Aversion (Risk-reward ratio of trying new products is not good) Where there is extreme risk aversion, for either evolved, physiological, psychological or cultural reasons. For example, any product that comes into contact with the mucosa of the human body. In this category are products for whom the impact of a bad product far outweigh the potential benefits that come from trying a "better product".

  • (iii) Operant Conditioning. Where the brand is a signal of an experience which is part of a consumer operant conditioning, where the signal and the experience reinforce each other (typically where the brand is a signal of an experience which the consumer craves, and experiencing the product causes the consumer to react to future encounters with the signal).

  • (iv) Quality / Capability cannot be objectively assessed. For example, in cosmetics or nutritional products such as health foods and vitamin supplements, where the quality and effectiveness of the product is largely subjective. (This is not to say that such products cannot be assessed in clinical trials; rather within the context of an individual's assessment of the product effectiveness for him/herself, the assessent is subjective)

  • (v) Signal of a message or identity. For example, luxury brands which indicate exclusivity and the wealth of the owner. This taps into a primal human need to identify with a group and/or show-off. It also applies to expensive gift brands, where there is a need for a person to signal the importance with which he considers the gift receiver. This ties to a fundamental need of social animals like humans, and is unlikely to go away. These brands only need to stay in touch with the zeitgeist, to make sure that they are not "out of date".

Why the existing FMCG playbook won't work so well
in the next few decades

The confluence of these forces results in a world where (1) the cost advantage enjoyed by FMCG companies from economies of scale are now available to retailers too, (2) the value of brands is deteriorating as consumers are prone to searching for and sharing information, (3) the rate at which FMCG companies can introduce new product capabilities is slowing down, because chemical-materials technology has entered the upper end of the S-curve.

In this environment, it is easier for upstart competitors (local FMCG players, or retailer private labels) to surface. Just as a hypothetical example, consider yourself a next generation consumer walking into a large retailer: When you see a product on the shelf, what makes you decide to buy it /a competitive product? It's probably a combination of:
  1. the product proposition, communicated by its packaging and price, and whether it meets a need you have
  2. its shelf position
  3. its performance / technical ability, and your past experience with it (if any)
  4. what you've heard about it before
In the past, 1 and 4 would have be signaled by brands and brand marketing; and 3 would have been something that few companies could duplicate easily. Large FMCG companies had the advantage.

However, in today's world, 3 is easy for private label or upstart competitors to match. 4 is now becoming the domain of new communications technologies, and no longer communicated by brands. 1 & 2 are firmly in the retailer's court - they can confer the advantage here to house brands. In other words, retailers now have the upper hand.


The major FMCG companies won't disappear overnight because of consumer inertia. But long term investors need to reassess their long term prospects.

For investment analysis purposes, there are various wildcard scenarios that are also worth thinking about:
  1. The end of cheap transportation / rising oil prices. Global supply chains may be disrupted. End of cheap transport may make it uneconomical to manufacture at central location for the world, for lower value-to-weight goods. This would remove the economies of scale of large FMCG companies, and make it economical for local competitors to pop up because they can nullify the cost advantage of the big companies.