Retail brands with more in store

When my son lost a tooth, instead of profitably exchanging it with the ‘tooth fairy’ he opted to take it to school in the name of science.

His class was conducting the same experiment I had conducted in 1980, observing the effects of different substances on a tooth. How would a tooth react, over time, with a glass-full of water, a glass of juice, a glass of milk and a glass of Coca-Cola? Notwithstanding the fact that we don’t hold mouthfuls of juice or Coca-Cola in our mouths for weeks on end, I believe you would be just as astounded as my son was with the erosion that the juice causes in just a week or two and the far worse erosion of the tooth deposited in the glass of Coca-Cola! Back in Mr Johnston’s year 4 class, in 1980, I recall the tooth completely disappeared!

But the experiment had me thinking about something much stronger than tooth enamel – the Coca-Cola brand. Various studies have revealed that the frequent consumption of carbonated soft drinks are bad for us, and yet brands like Coca-Cola have become enormously successful while building and enjoying insurmountable competitive advantages.

Having a positive brand image can be incredibly valuable, and it is particularly important when the health benefits, the impact of the underlying product, or its quality are hotly disputed.

In Australia, several companies are building credible brands in sectors not usually perceived favourably by the broader consumer.

The first company in a sector with an image problem is Cash Converters. The company operates a network of stores that deals in second-hand goods, while also providing short-term finance (also, and perhaps unfavourably, compared to pawn shops). This is a company whose shares I have owned for some time, and which were added to in the November placement the company initiated at 85 cents to raise $32.75 million for the purposes of funding store acquisitions and its loan book.

Cash Converters ideally want to be servicing loyal customers that are capable of repaying their debts. As such, the company has invested considerable funds buying back franchised stores, transforming its own image, presenting a welcoming and friendly environment and lifting its brand values. It has revamped its stores, installed bright lighting and signage, and is entirely transparent about fees and charges. What’s more, having a large network of stores instills confidence in the consumer that they are being financed by a credible merchant. This results in customers feeling perfectly comfortable and returning with repeat business.

The Reject Shop is another business that must fight to ensure its brand is not perceived as a typical discount-variety store. At Montgomery Investment Management, we have long waxed lyrical about the merits of the Reject Shop and its business model but we have also called its maturity. I believe The Reject Shop is a quality business and have thought so for many years, but this perception is not shared with equal enthusiasm by all shoppers. They associate discount stores with “poor quality”.

The Reject Shop enjoys high brand awareness among consumers – it was recognised by about 90% of the Australian adult population at the time the company floated. Such awareness, of course, can work against you if the products you sell don’t fulfill their promise to the consumer. This is not generally The Reject Shop’s problem.

The Reject Shop is managing to shake the “poor-quality” stigma associated with discount variety stores through strong inventory management. The company offers the same products you might find in a supermarket or Kmart but at much cheaper prices and, as so many companies before it have demonstrated, you can build a substantial and enduring business even selling goods at low prices.

Discount-variety stores offer a wide range of standard goods at bargain prices, but in order for shoppers to keep returning they must offer new goods on a fortnightly basis. The Reject Shop’s management team has worked hard to source quality products in a timely manner. The fact that The Reject Shop is on track to open 40 new stores this financial year, while a major competitor is in receivership, speaks volumes about how strong The Reject Shop’s has become over time.

The Reject Shop (ASX:TRS) receives Skaffold’s rare A1 Quality Score (see Fig 1). A decade ago the company had equity of $15 million returning 35%, helped by about $9 million of debt. In 2013 the company has five times as much equity, less debt and it is still earning almost 30% returns on equity. Remembering that all we need is big equity and big returns on equity, The Reject Shop fits the bill and may continue doing so for another few years. The Reject Shop is currently no bargain, but recent weakness has seen the shares trade below the 2015 estimated valuation. Further falls may make an investment in the company compelling.

Click to enlarge

Once a perception becomes ingrained in consumers’ minds it can be very difficult to shake. The Reject Shop and Cash Converters have successfully created quality brands that rise above the negative stereotypes associated with their respective niches.

We see a lot of potential in store (pun intended) for these companies, their quality brands serving as strong and sustainable competitive advantages. To discover the power of a brand for yourself, I encourage you to try the tooth experiment. I reckon it will shock you, but will it stop you from drinking carbonated soft drinks?

Roger Montgomery is the author of Value.able available exclusively at www.rogermontgomery.com and the founder and Chief Investment officer of The Montgomery Fund www.montinvest.com