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One Sign of a Strong Stock

Think about your favorite company, the one you believe in the most. Now imagine getting its logo tattooed on your bicep.

What's your immediate, knee-jerk reaction? I'm going to guess you think it's a bad idea.

Even so, thousands upon thousands of Harley-Davidson owners have done it -- it's one of the oldest and most popular brands-as-permanent-affiliation. And they aren't alone.

So what's the difference between the company you thought of and Harley-Davidson? And why should it matter to your investing?

4 ways to get ahead
There are lots of things that make a great company: strong financials, excellent management, well-produced products or services. But however great a company is, it won't last unless it has some kind of competitive advantage, some way to protect its market share and grab more.

Competitive advantages come in many forms:

  • Economies of scale, which allow bigger companies to offer products for less. Think Costco (Nasdaq: COST  ) , which can use its mammoth size to bargain for better rates from suppliers.
  • Network effects, which make the value of the service increase the more people use it. Verizon (NYSE: VZ  ) , for example, doesn't charge wireless customers for calls made to other Verizon customers -- which means the more people who subscribe, the better value it is for everyone.
  • Intellectual property, such as patents. Drug companies like Pfizer and Novartis (NYSE: NVS  ) , for example, are dependent on drug patent protection to recoup the costs of research and development as well as ensure a steady stream of customers.
  • High switching costs, which make it difficult for customers to trade one company in for another. The sheer amount of time and data it takes for a hospital or medical practice to set up electronic medical records with Quality Systems (Nasdaq: QSII  ) , for example, will preclude that company from hopping to a competitor on a whim.

But not every company can avail itself of these gold-standard competitive advantages. Other than economies of scale, those competitive advantages are largely predicated on industry membership.

Everyday retailers don't have intellectual property rights, nor are they likely to have network effects or high switching costs. What they do have is brand.

Standing out in the crowd
A brand is the conglomeration of all of those "soft" associations customers have with a company or a product, the totality of the experiential and psychological aspects of their interactions.

Brand may be difficult to measure with any confidence, but it points toward something important: the customer's attachment to this particular product as opposed to all of the other options he or she could pursue.

Think about Nike -- people pay hundreds of dollars for athletic shoes that get far more wear on the street than they do on the court. True Religion (Nasdaq: TRLG  ) can sell a pair of jeans for more than $200 simply because it has a horseshoe logo, while an identical pair minus the logo would fetch a fraction of the price.

But brand loyalty on the basis of style fads isn’t sustainable over the long term; remember when Gap was the brand of choice?

The strongest retail brands are the ones that express people's identities -- and continue to do so no matter what happens in their lives. Harley-Davidson clearly has it; if you're a Hog lover, you aren't going to accept a Honda.

Are you sure you don't want that tattoo?
Every company will claim it has a strong brand, but the real test of a brand is how well it holds up through the slings and arrows of an outrageous economy. Many food and household products, for example, have excellent name recognition and substantial customer loyalty, but nearly 60% of Americans are currently forgoing their favorite brands for store brands.

Even in the worst economy since the Great Depression, however, Apple has continued to hit it out of the park with the iPhone, based largely on the way its sleek design and continued innovation feed into an identity people want to claim, and the stock is up 96% since the turn of the year.

It's that kind of market performance that demonstrates the importance of a strong brand to a great investment -- no matter what the economy.

You may not want to tattoo a company's logo on your body, but if you can't imagine trading its products in for those of its competitors, then that's a company worth investigating further.

A strong competitive advantage, including brand, is one of the things David and Tom Gardner look for at Motley Fool Stock Advisor. Their picks are currently beating the market by 49 percentage points on average. If you'd like to see what they're recommending today, you can take a free, 30-day trial of the service by clicking here. There's no obligation to subscribe.

Already subscribe to Stock Advisor? Log in at the top of this page.

This article was originally published July 25, 2009. It has been updated.

Julie Clarenbach owns shares of Apple and has two tattoos -- but neither of them are brands. Apple, Quality Systems, and Costco are Motley Fool Stock Advisor recommendations. Pfizer and Costco are Inside Value choices. Novartis is a Global Gains pick. The Motley Fool owns shares of Costco. The Motley Fool's disclosure policy is considering getting a tattoo of Select Comfort. Not.

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