Hallmarks of Success in Consumer Goods

When you're checking out a potential investment in consumer goods, look for several characteristics.

Companies with brands that hold dominant market share are likely to stay in that position because shifts in share tend to be fairly small from year to year. Thus, whoever is number one right now is likely to remain in that position over the next several years (barring any truly extraordinary events such as product contamination). For example, Tide has been the market leader in laundry detergent for about as long as anyone can remember. It's not always easy to find specific numbers on market share, but you'll sometimes see this discussed in the company's annual report. General business publications such as BusinessWeek and The Wall Street Journal can also be good sources of information on market share data.

In this mature sector, the name of the game is tons of free cash flow—cash flow from operations minus capital expenditures. Unlike a young company that must invest most of its cash flow back into its business to expand and meet growing demand, many of these century-old consumer goods firms are in the enviable position of raking in cash. Additionally, because many of these firms enjoy wide economic moats, you can expect them to continue earning returns on capital in excess of their cost of capital for some time to come.

With so much cash remaining, these firms often dispense a portion of it to shareholders in the form of dividends and share buybacks. Checking on just how much of a firm's free cash flow is transferred to shareholders can be a good way to assess whether management really has the shareholder's interests at heart. For example, Coca-Cola's track record suggests the firm doesn't hoard cash and prefers to return it to shareholders. Of the immense S3.5 billion in free cash flow generated in 2OO2, Coca-Cola paid out nearly $1 billion in dividends. Yim can look through the statement of cash flows to find out how much a firm has paid out in dividends to shareholders.

The strength of management's belief in brand building provides the foundation for the birth and cultivation of powerful brands. Firms that consistently invest in their brands through advertising and other non-sales-oriented communication will build up a brand's perceived value. For instance, Anheuser- Busch has consistently spent ad dollars to support its key brands in high profile (and expensive) media events such as the Superbowl. This helped lead to seven consecutive years of domestic market share gains between 1996 and 2OO2.

However, watch out for firms that cut corners by consistently putting their brands on sale. Although this may initially lead to increased volume and higher market share, it hurts profitability, and, in the end, constant discounting erodes even the most premium of brands. If a company is falling into a pattern of cutting its advertising spending every few quarters when sales aren't going so well, the firm may be more concerned with meeting earnings expectations for the next quarter than building a brand that will still be strong 5 or 10 years from now.

Considering the degree to which consumer goods firms rely on a steady stream of new products to stay competitive, a firm's level of innovation is critical. Keep an eye on which companies consistently introduce new products that are successful in the marketplace and which ones always seem to come out first with a new product. Further, it's important to distinguish between whether a firm is simply introducing a new flavor of an existing product, such as Keebler launching another version of Pecan Sandies cookies, or if the company is rolling out a revolutionary product that didn't exist before but which meets some consumer demand, such as Procter & Gamble's Dryel home dry cleaning system or Listerine's PocketPak breath-freshening strips.

Companies often prefer the former type of new product because it's less risky and consumers are already familiar with the mother brand. However, innovation by line extension raises a greater possibility that consumers will substitute the new flavor for the flavor they usually buy, which reduces the opportunity for a larger boost in incremental sales. At a minimum, the product must offer some sort of substantial advantage over existing substitutes. In addition, the company must successfully educate consumers on the benefit of this product and familiarize the potential audience with the new brand. There are advantages to both approaches—neither one is wholly superior. The best bet is a company that does a good job of launching a string of single hits with line extensions and occasionally hitting a homerun with a revolutionary new product.