“To not decide where to go, is to decide where to go.”
Marshalls and Hermès
At the extremes, there are two strategies in retail: 1) work hard to get people to spend a lot for your product so you can charge a high price, 2) work hard to get your product cost down so you can charge a low price.
The first strategy works well with luxury goods where the price is high, and since a condition of high price is usually capped product runs, inventory turns are low. Despite low sales velocity though, the high price enables a high margin, which can still translate into meaningful earnings.
The first strategy is commonly employed by retailers who want to build a brand so they can charge a premium. They do this by getting the consumer to have a “positive valence” towards a product (positive valence is a psychology term for a “good feeling” towards something that is usually not consciously noticed). They do this through “association”, one of the main principles of advertising. By putting their brand next to things that you feel good about, that feeling gets transferred to the brand as well.
This is partly why Nike spends billions of dollars every year on athletic sponsorships; they want Nike to be synonymous with sports, training, and excellence, so anytime you want to buy gear for training or working out, you buy Nike. Charlie Munger talks about how this worked out magnificently for Coca Cola.
Coke made the soft drink an icon of American culture, prosperity, and happiness globally by inundating the consumers with ads of smiling people holding their soft drink, so when you buy the carbonated beverage, you aren’t just getting a sugary drink, but also a feeling (one that identically-tasting private label products can’t mimic).
Look at the two ads above. Coca Cola advertises happiness and Axe sells the ability for the average man to “get ladies”. These ads are basically aimed at making an otherwise commodity product something unique. If we think of The Consumer’s Hierarchy of Preferences, the basic idea is that hitting a higher-order desire for a consumer is hard but allows you to fill more of a consumer’s desires. It is easy to make a comparable soda that fills a consumer’s low-order desire for “soda”, but if you could convince your customer that what you are really selling is happiness, then your product is in a more unique and defensible position since it is serving more consumer preferences. The relative unpopularity of cheaper but similar tasting RC Cola and other rip-off sodas supports the notion that these nuanced aspects can be crucial to a product.
LVMH uses the same principles Coke did when they pay for celebrity endorsements, advertise their product next to expensive-looking goods, or spend prolifically to design and refresh their stores. Their purpose is to create psychological associations, so they can ultimately charge a vastly higher price than a similar unbranded product.
With the second strategy, a retailer is focused on increasing volumes rather than price. In fact, they hope to decrease costs as much as possible in order to pass off the cost savings to consumers and spur more demand, which in turn allow greater economies of scale to further decrease cost. These sorts of retailers work at cost efficiency and will position their brand in terms of consumer value, usually even having their biggest competitive weapon, low prices, stated in their moto. Think of Ross’ “Dress for Less”, TJ Maxx’s “Get the Max for the Minimum”, or Target’s “Expect More. Pay Less”.
These retailers’ advertising is aimed at convincing you that you will get the best deals at their stores, so their operations and pricing strategies have to align with that. This means that increased earnings largely come from improving their cost structure and increasing volume. This is in contrast to Hermès, whose increased earnings largely come from increasing prices rather than volume expansion. In fact, increasing volumes too much is the surest way for Hermès to deteriorate their earnings power over time1.
Now, Ross and Hermès represent the extremes of these strategies. In actuality, many brands and retailers fall in between. For all of the brands that are not focused on the ultra-high-end or low-end markets, retailers will shift their brand positioning to focus on other elements. Lululemon, Nike, Patagonia, American Eagle, Topshop, Quicksilver, Vans, and Allbirds are all brands that price their goods very differently, but if you were to think of the Consumer Hierarchy of Preferences, price is seldom a top consideration when purchasing any of these brands.
Installing a Brand’s Software in Your Mind.
As we move from the low-end of the market to the higher-end, the Consumer’s Hierarchy of Preferences shifts from the lower-order desires like “I need clothing” to incorporate a myriad of different factors like comfort, looks, perception of appearance, functionality, wardrobe compatibility, weather versatility, environmental impact, labor practices, and identity, amongst others.
As of late, many corporations may be jumping at the opportunity for their brands to be seen as “environmentally-friendly” or “socially-just”, but for branded clothing retailers, this has been a part of their advertising recipe for decades, and we don’t mean so cynically either (at least not always).
Think of Patagonia, who originally started out as a climbing hardware manufacturer, but over time saw an opportunity to sell clothing to outdoors enthusiasts. They prided themselves on being “in business in order to save our home planet”, and this ethos helped give their brand a unique positioning. They would become associated with all sorts of pro-environmental activities and they would go to lengths to reduce the environmental impact of their clothing2.
To sum all of this up in an example, a Consumer’s Hierarchy of Preferences may go: 1) a sweater that looks good, 2) a sweater that looks good and fits, 3) a sweater that looks good, fits, and is under $60, 4) a comfortable sweater that looks good, fits, and is under $60, 5) a comfortable sweater that looks good, fits, is under $60, and is sold by an environmentally friendly company. Perhaps meeting just the first 4 conditions was sufficient to induce a purchase, but if there was a sweater that also met the fifth condition (environmentally friendly), that company would win the sale every time.
Companies that meet more conditions on a Consumer’s Hierarchy of Preferences, beyond the point that the consumer would have already satisfactorily purchased the item are effectively increasing the consumer surplus. Getting more higher-level items filled on The Consumer’s Hierarchy of Preferences is crucial to creating loyal customers with a unique value prop that cannot be easily mimicked by competitors. This is precisely why brands want to become “lifestyle” or “aspirational” brands—it is a more unique node on The Consumer’s Hierarchy of Preferences.
Nike’s competitors sell shoes; Nike sells athleticism and excellence. Dell sells computers; Apple sells perfectly crafted, consumer-friendly technology that “just works”. Just think—can you ever recall a Nike commercial talking about shoes, or an Apple advert talking about their computer specs?
A good brand doesn’t have to explain what it is; all of the emotions and narratives it evokes are simply distilled down into their name or logo. Just think about how long you could talk about what Nike means to someone who has never heard about them without ever actually conveying the full “sense” of the brand. This is precisely why most brands use imagery, music, and videos to express themselves, as much of it is out of the realm of language.
Now, the way a brand positions itself has to tie into its larger business strategy. You cannot be a mass-produced ultra-luxury good or sell $3 hamburgers served on a plate in a formal sit-down restaurant. This is because everything about how you structure your operation is a signal to consumers, which can either confuse them, or reinforce your value prop.
Of course, there are brands that push limits and change expectations. Before Sam Walton, stores were rarely self-serve. Before Steve Jobs, stores optimized for the maximum number of product displays per square foot. What matters is not that the retailer conforms to expectations, but that their business operations reflect a consistent value prop that comports with the branding. Costco purposely keeps its oversized hot dog + soda combo at $1.50 because it is a signal of the value a customer can expect to receive at Costco3. Hermès will display a product that they don’t have any inventory for because that signals the exclusivity of the brand’s products.
The need for every piece of a business’ operation to be consistent with the brand is where many companies make mistakes. For decades Coach was a high end brand; then they started rolling at more products at lower price points (so called diffusion lines which they plastered with their logo). This, combined with pushing their products through outlet channels, quickly degraded their luxury brand, and they could no longer sell their $1,000+ line of bags. Avoiding brand dilution is critical because it is hard to build back4, 5.
To Monetize or Compound Goodwill.
The other side of this is Hermès not increasing their prices today as much as they can. This effectively leaves “consumer surplus” in reserve. Recall in our first piece we noted how management can exploit this consumer surplus today to increase profits, but that comes at the cost of lower expected company longevity. Having a product offering that creates consumer surplus tends to compound over time, as growth in the business allows a company to continue to work to improve their core value prop. In a sense, this consumer surplus is effectively compounded over time, and increases the intrinsic value of a company.
Price and volume are the only ways that consumer surplus can be intentionally “released”. But it can be unintentionally released in many ways. This, essentially, is when a business disappoints the consumer, which can happen for a myriad of reasons, such as a store being disorganized, an employee being rude, or a scandal plaguing the C-suite.
When you disappoint a customer, it is a lose-lose because you not only lost this investment in “consumer surplus”, but you didn’t receive anything for giving it away either. The original playbook of private equity was in part thoughtfully extracting this consumer surplus by raising prices and cutting services that weren’t valued6. These private equity companies are temporally shifting value from the future to the present (which works especially well when you know you won’t own the company in the future).
Hitting higher-order consumer preferences allows a retailer to create a unique value prop. Leaving some of the consumer surplus (instead of extracting it all) allows a retailer to be in a better competitive position. The two retail strategies at the extremes (low margins with high volume) or (high margins with low volumes) offer very different value props, but both create consumer surplus.
However, as most retailers are somewhere in between, the question arises: How can we judge how good a retailer is at capturing value?
We will dovetail into a quantitative method that will answer this question in our next piece, which will introduce the Value Capture Index.
Thank you so much for reading! This was a continuation of our first experiment with sharing our frameworks, and is the third of our Business Philosophy pieces. If you enjoyed this piece and want to see more of these kinds of write-ups, please let us know via email or Twitter and share it with a friend!
Footnotes
[1] If Hermès increased their volume, they would look much more profitable. However, it would dilute the brand, and demand would wane over time. It is rare for a company to be so disciplined for so long, as most incentives push management to chase short-term profit.
[2] The test of whether a business is genuine in its mission and isn’t simply greenwashing is whether their mission came to fit a business need or whether a business was built around the mission. However, when a company is genuine in its mission or not is seldom clear. Many see Patagonia’s 1% self-imposed “Earth Tax” as simply being savvy marketing, but frankly, as far as the business is concerned, perception matters much more than intention.
[3] The loss they take on it can also be thought of as brand marketing.
[4] It is very hard to change a consumer’s perception once an opinion has been ingrained. Cable companies built a terrible reputation for poor customer service because they knew that customers had no local alternative and so they focused on customer acquisition, knowing poor experience was unlikely to lead to churn. As more internet and TV options proliferated, they had to work harder at keeping customers from leaving, and now put extra emphasis on the consumer experience, with much quicker response times than the “10am to 4pm service windows”. Pizza chain Domino’s is one of the few success stories, having successfully turned their reputation around for serving terrible pizzas that taste like “cardboard” with sauce that mimics “ketchup”.
[5] This is related to value networks, a topic we will cover in our next piece.
[6] The Consumer’s Hierarchy of Preferences idea can be extended to employees as the Employee’s Hierarchy of Preferences. This would pertain to all of the factors that an employee preferences when picking a job beyond just salary, like location, work/life balance, colleagues, meaning of work, etc.
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