Sundar Bharadwaj
According to Sundar Bharadwaj looking at brand quality metrics could be useful for investors as they evaluate companies. FILE PHOTO

As a brand’s quality improves, consumers are more likely to buy the company’s product—even at premium prices. But this good news in terms of a company’s cash flow can make an investment in the firm a riskier proposition, says Sundar G. Bharadwaj, a professor of marketing at Emory University’s Goizueta Business School. That’s because higher-quality brands can be more vulnerable to economic downturns.

According to Bharadwaj, this observation illustrates why looking at brand quality metrics could be useful for investors as they evaluate companies.

His paper, The Impact of Brand Quality on Shareholder Wealthwill be published in the Journal of Marketing (text).

For Japanese auto giant Toyota, the early months of 2010 provided a case study in how perceptions of brand quality can impact stock returns. As Toyota Motor Corp. contended with public reports of sudden acceleration problems in many of its cars, the company’s stock price was battered like a crash test dummy, dropping by about 20 percent in a matter of weeks. While the company’s share price has revved up since the crisis, the impact on Toyota’s reputation persists. In January 2011, Consumer Reports magazine published its annual report on car brand perceptions and found that Toyota had lost ground while Ford Motor Co. was gaining in the key categories of safety, quality, and value.

But brand quality has an impact not just on stock returns but also on the riskiness of an investment, says Sundar G. Bharadwaj, a professor of marketing at Emory University’s Goizueta Business School. In a paper slated for publication in the Journal of Marketing, the premier academic marketing journal, Bharadwaj and colleagues from Singapore Management University and the Australian National University examined stock price, brand quality, and risk for 132 firms over a six-year period between 2000 and 2005. The analysis found a potential dark side to improvements in brand quality. Since high quality brands typically command a premium price, unanticipated improvements in quality can make the brand more vulnerable to economic downturns, the researchers argue in a paper called “The Impact of Brand Quality on Shareholder Wealth.” The study showed how the impact of unexpected quality changes can be moderated by factors such as current-period earnings and increased competition. But the take-home message remains that brand quality metrics could be useful tools for investors as they evaluate companies. In that sense, Bharadwaj says, the paper is supportive of recent efforts by the Marketing Accountability Standards Board, which is trying to establish and improve marketing measurement and accountability standards.

“What gets measured gets managed,” Bharadwaj says. “If you don’t have systematic measurement and analytics, then you discount the importance of brand quality. We should get to a set of measurements that will help marketing be more scientifically evaluated.”

The link between increases in brand quality and better stock returns has been documented in prior studies, Bharadwaj says. As quality increases, brands have a greater likelihood of being purchased and repurchased by consumers, with the brand’s credibility leading consumers to perceive less risk. Consumers are willing to pay a premium price for higher quality brands and the products are easier to promote. While all these factors boost cash flow, investors evaluating a stock look not just at returns but also risk. In the paper, the researchers focused on both systematic risk, which means the degree to which the stock’s returns follow the broader market, and idiosyncratic risk, meaning fluctuations based solely on company factors. They found that unanticipated improvements in brand quality were accompanied by increases in systematic risk, probably because such goods usually command a higher price. When the economy is booming, many consumers will stretch to purchase higher quality brands, Bharadwaj says. But when the economy turns, the brand will lose those customers as well as others who suddenly find themselves needing to shop for lower-priced goods and services. The fates of retail giants Target and Wal-Mart during the recent economic downturn underscore the point, Bharadwaj says, as Wal-Mart has benefitted from cash-strapped consumers searching for the lowest prices for goods. Prior to the recession, the Target brand strengthened—and thus took on more systematic risk—as the company enticed consumers to buy slightly higher priced products such as designer teapots and clothing along with staples such as toilet paper and laundry detergent.

It’s a different story for idiosyncratic risk, which cannot be explained by movements in the stock market and therefore, according to the researchers, represents investors’ uncertainty regarding future cash flows. The study showed that idiosyncratic risk has an inverse relationship with surprise changes in brand quality. The inverse relationship makes sense, the researchers say, because increases in brand quality boost customer loyalty and therefore reduce a firm’s vulnerability to price cuts and promotions from competitors. Increasing brand quality also lets a firm expand its offerings to customers through brand extensions, thereby lowering idiosyncratic risk as well. The researchers noted, for example, that entertainment giant Disney Inc. uses licensing agreements to tap the value of its brand and diversify revenue.

“We find that while unanticipated changes in brand quality can enhance stock returns and lower idiosyncratic risk, they can also make a firm’s stock returns more vulnerable to the stock market movements,” the researchers write. “This finding resonates with the recent anecdotal evidence that companies with higher quality were hurt more during the recent recession.”

But the message about risk that investors can take from unexpected shifts in brand quality sometimes will change when combined with other signals. Researchers looked at what happened to the systematic risk and stock returns for companies when unanticipated changes in brand quality are coupled with unanticipated changes in current-quarter earnings. They found that as brand quality improves at a time of strong earnings, the increase in systematic risk isn’t so pronounced and the stock return benefit is enhanced. It makes sense that investors would be reassured by this coupling of factors, the researchers concluded, because the quarterly numbers suggest the firm is able to build brand quality without sacrificing performance. Conversely, investors have reason to be wary of an unanticipated increase in brand quality at a time of weak earnings because the financial results suggest the firm won’t be able to sustain the brand. Reader’s Digest and Blockbuster are two current examples, Bharadwaj says, of well-known, high quality brands that nonetheless are likely to disappear due to a lack of resources to support them.

The study documented another moderating factor—the degree of industry concentration. When quality improves at times of greater competition, it provides an even bigger boost to stock returns, the researchers found. That’s because investors recognize that as industry concentration decreases, managers have more pressure to raise productivity, innovate, and differentiate their offerings against the competition. So, investors appreciate shows of strength by a brand against a crowded field. Conversely, brand quality is less important when there is less competition, since customers have fewer choices. That particular finding fits with other studies that have suggested marketing metrics are more valuable in competitive environments.

Surprise changes in brand quality have such a clear impact on stock returns and risk metrics that the researchers suggest at least two action items: firms should consider discussing brand quality trends with investors, and regulators should consider disclosure requirements for quality metrics. For managers, the findings about moderating factors provide some clues for how best to send messages to investors about brand quality, the researchers say. Investors likely will be less impressed by unanticipated changes in quality at times when earnings are down for the quarter or when a company is facing less competition. In those circumstances, it could be that managers should stress the long-term benefits of quality brands such as higher customer loyalty and lower price sensitivity, although more research on the subject is needed. As for regulators, Bharadwaj says the significant impact of unanticipated changes in brand quality on shareholder wealth could argue for the inclusion of brand quality metrics in annual filings with the Securities and Exchange Commission. Here, too, more work is needed, since marketers need to develop industry-wide standards to measure marketing metrics and encourage adoption by the financial community. Otherwise, information on brand quality won’t be standardized in ways that allow comparability, Bharadwaj points out. The Marketing Standards and Accounting Board, which was created in 2007 to establish marketing measurement and accountability standards across the industry, is a step in the right direction, he adds. Support for the board’s work grew in 2010 not only among business schools but also among firms, with The Coca-Cola Company becoming a new charter member in September.

“They’re trying to come back with more systematic metrics for marketing,” Bharadwaj explains. “With these metrics, it becomes not only easier to evaluate brand quality but also firms become more comparable. . . . Marketing needs to get there in some way.”

Beyond investors and regulators, senior managers also have good reason to mind the link between risk and unexpected changes in brand quality. A reassuring note from the study, researchers say, is that the decrease in idiosyncratic risk that comes with increases in brand quality is not moderated by current-quarter earnings or the degree of industry consolidation. So managers presiding over surprise gains in brand quality need not worry about the impact on idiosyncratic risk, which is a key metric for financial analysts and investors. High idiosyncratic risk can threaten a firm’s survival, not to mention the value of stock options. On the other hand, managers must be aware of the tradeoffs between unanticipated improvements in brand quality and increases in systematic risk. Systematic risk is a key driver of the returns expected by investors and stock analysts, the researchers point out. As systematic risk increases, investors expect higher returns and the cost of capital also increases.

“The challenge for managers is to harvest the benefits of brand quality without increasing systematic risk,” they write. “Results suggest that the deleterious impact of unanticipated changes in brand quality on changes in systematic risk is mitigated in the presence of unanticipated increases in current-period earnings. Consequently, managers need to adopt a joint focus on building brand quality and ensuring that current-period earnings are not compromised.”

For text of the paper (PDF) click here.