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One Sign of a Strong Stock

Julie Clarenbach
November 3, 2009

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

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?

Four 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 Procter & Gamble (NYSE: PG  ) , which can use its mammoth size to bargain for better rates.
  • Network effects, which make the value of the service increase the more people use it. As Google (Nasdaq: GOOG  ) , for example, gains search share, that increases both the usefulness and the value of AdSense for Google's customers.
  • Intellectual property, such as patents. Drug companies like Abbott Labs (NYSE: ABT  ) and Bristol-Meyers Squibb (NYSE: BMY  ) , for example, depend 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 company to set up their payroll systems with Automatic Data Processing (NYSE: ADP  ) 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. Polo Ralph Lauren (NYSE: RL  ) can sell a polo shirt for $200 simply because it has the polo-player logo, while an identical shirt minus the logo would fetch a fraction as much.

But brand loyalty on the basis of style fads isn't sustainable over the