Brand Capital: How Companies Create Lifetime Customers

Brand Capital & It’s Impact on Consumer Preferences

Brands have existed for thousands of years, with the first iterations used for marking physical ownership of property. The whitepaper A Brief History of Brands And The Evolution of Place Branding summarizes the dawn of branding (emphasis mine):

“For almost 4,000 years, brands have been used in order to establish the cattle livestock … The cave paintings from the south-western Europe, from the Stone Age and Early bronze Age, show branded cattle, as well as paintings and Egyptian funerary monuments, approximately 4,000 years old.”

Besides cattle branding, our ancestors understood the power of trademarking things like pottery, paintings, and other goods. Here’s another example (emphasis mine):

“Chinese ceramic goods, but also Indian, Greek and Roman objects had different engravings to identify the ceramic type, and information related to the property, the source of the materials and the period of realization.

There were even trademarks on Mesopotamian pottery dating as far back as 3,000 BC.

Fast-forward to the 12th century to England, where bakers and goldsmiths printed unique symbols on their products, representing “the measurement’s honesty.”

Finally, there are the brands and trademarks of the Industrial Revolution, where soap manufacturers desperately tried to figure out how to distinguish their products from locally-made stuff.

But to truly understand the power of brands, we look to the alcohol industry and how one company used its brand to create the largest spirits business in the world.

This essay will explore the following topics:

  • A brief history of the evolution of brands and the role brands played in building the largest alcohol company ever.
  • The mechanisms of brand capital and its impact on first-mover advantages
  • Hypothesizing the effect of brands on new industries like cannabis

By the end, you’ll gain a newfound appreciation for the power of great brands. 

How Branding Created An Alcohol Empire

Alcohol is a great vessel to showcase the power of brands for two reasons:

  • Alcoholic beverages have long life cycles
  • Brands have strong associations with tradition, heritage, and country of origin.

No alcoholic beverage better embodies these qualities than Maotai. Maotai’s origins trace back 2,000 years to the Qing Dynasty. Today, only one company produces the elixir, the Chinese monopoly Kweichow Moutai.

The company’s name symbolizes more than the product. It signifies achievement and celebration of the most special of occasions.

Maotai is China’s national beverage and is the drink of choice when entertaining foreign dignitaries. For example, when Deng Xiaoping visited the United States in 1979, Henry Kissinger told him, “I think if we drink enough Moutai we can solve anything.”

It’s no surprise then that Kweichow Moutai is the largest alcohol beverage company globally, generating over $10B in revenue and $5B in net profits.

Zooming out on the alcohol industry, it’s easy to see how important brands are in building multinational (and multigenerational) companies.

In Brands And The Evolution of Multinationals, we see various M&A waves sweep the alcohol industry. In a way, alcohol brands were treated like stocks. Companies “traded” money for brands, granting them access to new cultures, regions, and revenue streams.

Let’s go to the paper to see the impact of the 1985-1987 M&A wave (emphasis mine):

“… In order to grow and survive, firms felt the pressure to merge and acquire other large firms which owned successful brands. The resulting merger wave reversed the earlier trend of the 1970s, when firms had diversified beyond alcoholic beverages … The larger firms tried to reach markets culturally, politically, and geographically distant and to appropriate more value-added by acquiring firms which owned successful brands that would increase the availability and diversity of their portfolio of drinks.”

The whole point of buying/acquiring brands is to gain some durable advantage against competition. To do that, brands must possess two things:

  • A long “shelf” life in the mind of the consumer from past purchases (brand capital)
  • Persistence of brand capital over time

Together, these two components create nearly impenetrable brands with durable first-mover advantages.

Let’s explore how companies create brand value, how they’re valued, and what their staying power looks like in competitive environments.

Understanding Brand Capital & The Mechanisms That Drive It

Before we dive into brand capital half-lives and its effects on first-mover advantages, we must understand its two driving mechanisms:

  • Level of Advertising
  • Socially Visible Consumption

Bronnenberg defines a high Level of Advertising as “total expenditure by the top two brands is greater than the 75th percentile among all categories in the dataset.”

And when it comes to Socially Visible Consumption, Bronnenberg has rules for that too. Products are Socially Visible if they meet the following requirements:

  • They are frequently consumed together with others in social situations
  • They are frequently consumed or served directly from a package with the brand name visible.

We can think about the importance of Brand Capital as a function of these two mechanisms. For instance, advertising-intensive products have higher weighted Brand Capital stock than low-advertising ones. Concurrently, products with a high degree of social visibility also have a greater weight on Brand Capital.

This is one of the reasons why we love FIGS. Nurses interact for 12-18 hours a day in social settings, making the FIGS brand name extremely valuable as a social visibility signal.

These mechanisms matter because Brand Capital doesn’t apply to every product or industry. I wrote about this in my FIGS write-up:

“Not every commodity product can (or should) be a cult. Cults form around sociable products. Items you can bring to a friend’s house or post on Instagram. Nobody’s hash-tagging their latest toilet paper purchase, and for a good reason. We only share things that give us “points” in life’s never-ending social status game.”

It’s also why brands like Lululemon (LULU) crush it. People who wear LULU gear to fitness classes, the gym, or out shopping are basically saying, “My body is a temple and I treat it as such.” High social visibility. 

With that in mind, let’s examine the role brands play in consumer purchase behavior and why they create powerful first-mover advantages.

Consumer Preferences, Half-Lives & First-Mover Advantage

If we want to understand brand capital, we must understand consumer demand. After all, consumers drive purchase preferences and create these brand moats. We’ll use Bart Bronnenberg’s paper, “The Evolution of Brand Preferences: Evidence from Consumer Migration,” to construct our mental model.

Bronnenberg assigns two critical parameters to his consumer demand model:

  • The weight on current product characteristics relative to the stock of past consumption (I.e., brand capital)
  • The Year-To-Year persistence of brand capital

The model assumes a few things about consumer preferences. First, past consumer purchase experiences are an important driver of current consumption habits. This makes intuitive sense as humans are habitual creatures. 

The second assumption is that a brand’s past market share in a given market is equal to today’s market share expectation. In other words, consumers assume that if a brand had a dominant share a few years ago that it will continue to have a dominant market share today.

Bronnenberg’s model serves two vital purposes in understanding consumer purchase habits. First, it allows us to calculate a brand’s half-life in the mind of consumers, revealing varying levels of purchase persistence. 

Second, it helps us consider the potential effects on short-term and long-term consumer demand curves, the importance of first-mover advantages, and the stability of market shares across time.

To test this model, Bronnenberg studied migrant consumer behaviors. These are people (or families) that moved from one city or state to another. Bronnenberg focused his study on migrants because it isolates the variable of past market share on present purchase habits. 

In other words, how likely is a consumer to purchase what they’ve historically purchased, even though they live in a new environment with different purchase preferences?

Bronnenberg’s Results: Consumers Take A Long Time To Change Preferences

Bronnenberg’s model confirmed the paper’s original hypothesis with enormous implications. After studying the preference habits of migrant consumers, Bronnenberg noted that it takes “~27.2 years for half of a given year’s contribution to the capital stock to decay.”

It takes consumers nearly 3 decades to reduce the impact of their past purchase behavior on their current purchasing decisions.

Like we said above, this brand capital half-life decay has enormous implications on both short-term and long-term demand curves. Let’s see how.

Implications of Brand Capital Half-Life Decay on Demand/Market Dynamics

A great brand can withstand various shocks to the market, including price cuts from competitors or a general increase in the number of competitors in the space. Let’s start with price cuts, a standard tactic for new entrants into a market. 

Bronnenberg notes that while price cuts are effective in capturing incremental purchase share, they’re not as effective against durable, long-standing brands. For example, Bronnenberg assumes that two firms (A and B) enter a market with identical purchase shares. One company (brand A) plays the price-cutting game to take share.

Here’s how the scenario plays out (emphasis mine):

” … However, these effects [price cuts] will typically be very small. If brand A reverts to its original price after one year, its purchase share falls from 0.563 to 0.502. The long-run effect of the price cut is, thus, 3.2%. This observation may explain why studies of temporary changes in advertising intensity have generally failed to detect significant long-run effects beyond a horizon of a few months.”

In other words, the dominant brand resumes its market share dominance the moment a competitor takes its foot off the price-cutting pedal.

It’s important to note that the above example assumes both Brand A and Brand B start with identical market shares. Yet, in practice, we know this isn’t normal. So what happens when we introduce incumbent brands with first-mover advantage? Let’s find out.

First-Mover Advantage: Head Starts Matter & Price Cuts Don’t (Usually) Help

Analyzing first-mover advantage requires answering one key question: 

For a given head start by Brand A, how much and for how long would Brand B have to discount its price to achieve parity in purchase shares?

And yes, there are more ways for brands to take share than price cuts. But this model gives us an idea of how hard it is for companies to compete under various first-mover scenarios.

Here are the results for a brand with a five-year head start on the next competitor (emphasis mine):

“If [Brand] A’s head start is five years, [Brand] B would need to discount its price by 18% to reach market share parity in just more than a decade.”

A five-year head start requires an 18% discount per year on Brand B’s products for twelve years to reach an equivalent market share. But what if Brand B wants to get even quicker? Bronnenberg continues (emphasis mine):

“To catch up in only three years, [Brand] B would need to discount its price by 34% [per year].

But what if the head start is longer than 5 years? Let’s say Brand A has a 15-year head start. Under those circumstances, it would take Brand B 23 years at an 18% per-year price discount to reach market share parity. 

Suppose Brand B wanted to reduce the time to market parity to seven years. That would require a 34% price discount per year! How many companies do you know could sustain a 34% price discount for seven consecutive years?

More importantly, such price discounts reduce a competitor’s ability to invest in sales and marketing, one of the first-mover’s most vital advantages.

By this point, we’ve learned how brands evolved over time from marking physical ownership to quality of work, the mechanisms of brand capital and how to calculate its half-life, and what brands do for first-mover companies. 

Now, we can take what we’ve learned and apply it to the cannabis industry. We’ll hypothesize how brands might impact the space and the implications of those hypotheses on firm values.

Brand Capital & Its Impact on Cannabis Companies

Cannabis is a fascinating industry and a ground-zero for research into brand capital dynamics. As a federally illegal substance, advertising cannabis products and brands via traditional media outlets remains extremely difficult. 

This forces cannabis companies to promote their brands through brand ambassadors, demo days, event sponsorships, and word of mouth. All of which result in high customer acquisition costs.

That said, we can use the alcohol industry as a proxy for the future of cannabis. This isn’t an original opinion, however. Ben Kovler, CEO/founder of Green Thumb Industries (GTII), suggests that cannabis is “Prohibition 2.0.”

If that’s true, there are only a few things that matter going forward:

  • Brands
  • M&A
  • Distribution

Cannabis companies have two options around brands. They can make them in-house or acquire them via M&A. Again, there’s a lot that cannabis can learn from the alcohol industry. 

For example, in 1985, Guinness acquired Arthur Bell’s, a leading Scotch whisky company. They then bought Distillers Company, the world’s largest Scotch Whisky and gin company which owned brands like Johnnie Walker, Dewar’s, White Label, and White Horse. Companies like GTII are making this straight bet today with cannabis brands.

Then there’s distribution. Distribution is often the most important (yet overlooked) competitive advantage in consumer packaged goods. Best-in-class distribution fixes a plethora of product errors. 

The better the distribution, the greater the chance your product ends up in the hands of consumers.

Again, GTII knows this and is creating one of the best cannabis distribution networks in the country through their branded Rise retail stores. Each Rise store carries GTII in-house products along with third-party consumables, edibles, and pre-rolls. The idea is to create a one-stop shop for cannabis consumers regardless of which product they buy. 

By creating the largest distribution network, GTII benefits from scaled economics and command lower prices for its third-party goods, resulting in higher incremental margins.

Finally, I want to talk about brands and switching costs. 

Cannabis is a unique product in that consumers ingest a drug that has varying degrees of physiological effects. These physiological effects create (whether natural or artificially) high perverse consequences like a bad high experience. Such consequences make cannabis different than other packaged consumer goods like chips, candy, or even beer. 

Why is this so important to the average consumer? 

Once a customer finds a product they enjoy and understand how their body reacts to it, the cost to switch from that product is high. Knowing the potential risks, why would the average consumer experiment with different brands? Especially if the company providing that brand had superior distribution capabilities?

Here’s the exciting part. If the above assumptions are remotely accurate, and if we can use the alcohol industry as a proxy for cannabis, then today’s leading cannabis MSOs are drastically undervalued based on potential future cash flows. A future where premium products command higher margins, consumers develop long-lasting preference half-lives, and first-mover advantages create impenetrable moats.

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Brandon Beylo

Value Investor

Brandon has been a professional investor focusing on value for over 13 years, spending his time in small to micro-cap companies, spin-offs, SPACs, and deep value liquidation situations. Over time, he’s developed a deeper understanding for what deep-value investing actually means, and refined his philosophy to include any business trading at a wild discount to what he thinks its worth in 3-5 years.

Brandon has a tenacious passion for investing, broad-based learning, and business. He previously worked for several leading investment firms before joining the team at Macro Ops. He lives by the famous Munger mantra of trying to get a little smarter each day.


Investing & Personal Finance

AK is the founder of Macro Ops and the host of Fallible.

He started out in corporate economics for a Fortune 50 company before moving to a long/short equity investment firm.

With Macro Ops focused primarily on institutional clients, AK moved to servicing new investors just starting their journey. He takes the professional research and education produced at Macro Ops and breaks it down for beginners. The goal is to help clients find the best solution for their investing needs through effective education.

Tyler Kling

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Former trade desk manager at $100+ million family office where he oversaw multiple traders and helped develop cutting edge quantitative strategies in the derivatives market.

He worked as a consultant to the family office’s in-house fund of funds in the areas of portfolio manager evaluation and capital allocation.

Certified in Quantitative Finance from the Fitch Learning Center in London, England where he studied under famous quants such as Paul Wilmott.

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Founder and head macro trader at Macro Ops. Alex joined the US Marine Corps on his 18th birthday just one month after the 9/11 terrorist attacks. He subsequently spent a decade in the military. Serving in various capacities from scout sniper to interrogator and counterintelligence specialist. Following his military service, he worked as a contract intelligence professional for a number of US agencies (from the DIA to FBI) with a focus on counterintelligence and terrorist financing. He also spent time consulting for a tech company that specialized in building analytic software for finance and intelligence analysis.

After leaving the field of intelligence he went to work at a global macro hedge fund. He’s been professionally involved in markets since 2005, has consulted with a number of the leading names in the hedge fund space, and now manages his own family office while running Macro Ops. He’s published over 300 white papers on complex financial and macroeconomic topics, writes regularly about investment/market trends, and frequently speaks at conferences on trading and investing.

Macro Ops is a market research firm geared toward professional and experienced retail traders and investors. Macro Ops’ research has been featured in Forbes, Marketwatch, Business Insider, and Real Vision as well as a number of other leading publications.

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