The Invisible Hand - Revisted in Marketing Garb

We would probably award a Nobel Prize to the modern economist who described society’s economic balancing act as the work of an invisible hand. But the man who did, Adam Smith, pre-dated Dr Nobel’s generous endowment by one hundred years. What an insight. Unseen and seemingly operating outside the ambit of human interference the forces of supply and demand regulate prices and balance what we make with what we consume. More controllable but poorly understood is another silent power which also has its roots in what the incredible Mr Smith had to say about the wealth of nations.

Smith’s central thesis (or the one for which he is best known) is that if individuals are left free of regulation and government interference to pursue gain, society, as a whole, will benefit through material improvement. It is human nature to be inventive and to interact with one another. Not all of us do it successfully and what we do is not inevitably within the bounds of the ethical codes and rules we have set for ourselves. But mostly the efforts we make individually to improve our own lot impact positively on society as a whole.

The astute and thoughtful Scot also defined gain. It was he, not Joel Stern of Economic Value Added (EVA) fame, who decreed that you need capital to finance an enterprise and only when you earn more than the cost of that capital can you claim to have earned a true profit. And here lies the second mysterious force. What is it that generates a profit over and above the cost of capital? Logically if a company charges prices at this level it must be asking consumers to pay a premium for its goods or services. You only have to look at communist economies to see the opposite in action.

Regulation imposed by communist central planners ensured that all products were sold at even prices. There was no profit generated by innovation, superior product performance, self-image enhancement or branding. In fact there was no profit to re-invest in innovation or in sustaining a product benefit. Products were not differentiated. They were commodities that probably earned no more than the cost of capital employed in their production – possibly even less. Until the Berlin Wall was torn down there was no Coca Cola on its eastern side, no Lux Toilet Soap, no BMW and no Microsoft (if there was it almost certainly was not distributed under that name!).

Companies that earn more than the cost of capital are, by definition, successful. If they cannot achieve this, their shareholders could well look for a better home for their investment. But is it just the existence of an established brand name that generates what economists call super profits or EVA?

Perhaps not the brand name alone, but according to Rajendra Srivastava and his colleagues who’s research was published recently in the Journal of Marketing, marketing has a great deal to do with the creation and maintenance of what they call market-based assets. By concentrating on the traditional marketing roles of finding new customers, keeping existing customers and smoothing channels, marketers are generating a raft of advantages from product benefits, greater access to customer lists and a variety of specialised business systems. Patrick Barwise is a London Business School Professor of marketing who was deeply involved in the so-called Brand-Debate of the 1980s. He said as long ago as 1987:

“Does the product or service have enough value to enough customers to support volumes and values that exceed the cost of capital – or the opportunity cost of capital?”

His contention is that marketing plays a vital role in creating this added value and that the way it should be measured is by the extent of this value added and its contribution to shareholder wealth. Ten years later Srivastava coined the expression market based assets to make the point that whether these assets are on or off balance sheet, tangible or intangible, internal or external to the firm:

“the value (of these assets) is ultimately realised, directly or indirectly, in the external product marketplace.”

You should by now be wondering what these market based assets (I prefer to call them resources) are. A new way of identifying them is through the process of brand valuation.

One of the most difficult challenges in creating a valuation methodology is to find a way to separate the brand-generated profits from the rest of the business. The accountants say this is not possible. How can you tell, they say, what portions of the brand’s profits are attributable, for example, to the company’s negotiating power with the distribution channel, the supplier of raw materials, because it has a powerful sales force, or because the bank or retail chain has a well located network of branches.

Not only is it possible to do this but, in the process, the resources that drive the incremental profit are identified and isolated.

Having valued numerous South African brands over the past two years we have developed a database of these resources. We find that they fall into eight categories: financial; legal; branding (or marketing); customer; process; logistics; technology and management. . This is not necessarily an exhaustive list as the process we conduct still uncovers new items.

· Financial: Control of costs; beneficial raw material contracts; management of margins (financial services); management of fixed investments and investment returns.

· Legal: Registered legal rights; patents; trademarks; franchises; licences and copyrights.

· Branding (or marketing): Brand awareness and equity; price premium; market share; brand name; speed to market with new products and innovations, extensions; brand portfolio.

· Customer: Installed customer base; customer lists; stable customer relations and customer satisfaction/retention.

· Process: Consistent product quality; innovation; research and development.

· Logistics: Supply chain management; favourable distribution arrangements.

· Technology: Special computer systems; technological innovations and patented technology.

· Management: Strong leadership; stable management team; w quality management.

Hidden in the list are the resources that Barwise spoke of that produce the profits in excess of the cost of capital. These are also the resources that are captured in the premium over book value that is placed on shares by analysts and fund managers. Financial market experts have their own methods of squeezing this information from companies and their markets. That’s why most stockbrokers have specialist analysts who focus on specific sectors. But, for those seeking simplicity, it is possible to subject candidate resources to a simple four-way test.

If a resource is to make a contribution to customer and financial value it should be convertible. That means the firm must be able to use the asset in some way to exploit an opportunity or counter external threats. The resource must be rare, in other words, it is not available to rivals. It should be hard to imitate: if others can replicate it, it will not enhance company profits for long. There should be no substitutes. This sums up the other three that rivals do not possess similarly convertible resources and it will be hard for them to develop them.

Obviously, few resources will fully meet all four, but the closer they come to fulfilment the more powerful the resource is. We have found that in most cases that we have analysed between five and seven of these resources explain most of the incremental profits that companies generate. Some are stronger than others and in each case the brand exerts an influence on the resource.

The process of identifying the resource set that generates profits over and above the cost of capital is a vital and integral component in brand valuation methods. It results in a separation of the brand asset from the rest of the business drivers: the basic requirement for a forward looking, discounted cash flow estimation. But in conducting this insightful exercise, managers are provided with a tool of considerable value. The resource set is not only identified but is quantified as well giving relative importance scores to the items and showing the extent to which the brand influences each resource.

Over the past ten years or so since the knowledge-based society was identified the power to generate surplus profits has been attributed to intellectual capital, latent knowledge and a range of intangibles. Interestingly if the power of these unseen forces is related to the market to book premium, this has increased four fold over the same time period. Since the mid 1980s when the ratio was about one, according to the magazine CFO which carried a feature on intangibles in its April 2001 issue, it has grown to between four and five.

Advanced as he was Adam Smith did not have the sophisticated technology now available to us to flesh out the invisible structure that makes one business more profitable than another. Now that we have it will we use it, or will it become a general theory in textbooks, like supply and demand?

Ends