“Advertising is based on one thing, happiness. And you know what happiness is? Happiness is the smell of a new car. It’s freedom from fear. It’s a billboard on the side of the road that screams reassurance that whatever you are doing is okay. You are okay.” – Don Draper, Mad Men season one

“Identities are the beginning of everything. They are how something is recognized and understood. What could be better?” – Paula Scher, first female principal at Pentagram, the world’s largest independently-owned design studio

“A brand is the set of expectations, memories, stories and relationships that, taken together, account for a consumer’s decision to choose one product or service over another.” – Seth Godin, bestselling author

A wise man was he Don Draper. He understood the human need to belong, to feel safe. And his contemporary would understand, that today, reassurance comes from counting the likes for your Facebook status update, having an Instagram following that exceeds the following enjoyed by your friends, or your ramblings on Twitter being retweeted by someone even moderately famous. The lowly billboard barely gets a look anymore. And household consumer brands, not unlike many of Don Draper’s fictitious clients, are none the better for it.

On 15 August, 2017 the Wall Street Journal ran an article titled “This Isn’t An Advertisement: Time to Buy Shares in WPP” in which they argued that “As the stock market climbs ever higher, traditional advertising agencies look like a rare pocket of value – none more so than the largest, WPP”. And as if almost on cue, WPP cut its revenue forecast – blaming weak client spending – and sent its stock price crashing.

WPP’s announcement received all manner of reaction. The idea that it is only a matter of time before the rot spreads to digital advertising juggernauts Facebook and Google, in particular, received plenty of airtime. This conjecture resonated with those calling for the FANG “bubble” to pop. For many, Procter & Gamble’s revelation that it had cut digital marketing spend by over USD 100 million with it having very little impact on its business, only a few weeks prior to WPP’s announcement, only further confirmed this hypothesis. A chart not too dissimilar to the one below may also have been used to argue that the disconnect between FANG and WPP stock price performance will duly close. We consider this type of thinking to be a formulaic type II error.

WPP and Google Share Price Performance (Normalised) Source: Bloomberg

An advertising agency’s business model is to aggregate advertisement placeholders across disparate media outlets and to provide an access point for advertisers to its network of placeholders. As the advertising market is becoming increasingly concentrated, with Facebook and Google grabbing all advertising spend growth, aggregating ad space is becoming a redundant competitive advantage. Especially when there is limited need for human interaction, and by extension privileged access, to place adverts on Google and Facebook. Advertising agencies have increasingly been disintermediated as access to ad space has become democratised.

Internet Share of Total Advertising Spend Source: Bloomberg Intelligence

Advertisers use ad agencies to communicate a uniform message about their product or brand to reach as much of their target market as is feasible. They typically focus on two types of advertising, one is the promotional kind to boost sales over a short period of time and the other is to increase awareness of their brand and to shape consumer perception – to create, in essence, a halo effect to drive long-term brand loyalty and sales. Household consumer brands, the likes of Andrex, Kleenex and Tide, produced by consumer goods corporations such as Procter & Gamble and Kimberly-Clark, generally spend the majority of their advertising budget on trying to create strong brand identities for their products.

Consumer goods companies combine their products’ strong brand identities with far reaching distribution. In turn, making their products available to as many consumers as is feasible. Awareness and availability have been the moats exploited most effectively by the largest and most successful consumer product manufacturers.

At a time of scarcity of information, consumers relied on brands as proxies for reliability and of quality assurance. You could be pretty much anywhere in the world and be comfortable with the fact that if you bought your regular brand of coffee, cereal, or soda that you would get what you expected. There would be no discovery, no adventure but there would also be no disappointment.

Today, however, the brand too is being disintermediated. We no longer need proxies. We have smartphones giving us access to a plethora of information at all times. We can instantly check reviews or recommendations for products, restaurants or hotels made my people who have experienced them. And being socially conforming animals, we tend to trust the judgement of other people over perceptions created by brands. Access to information has freed us to discover and try new things, which further frees us to make choices based on preference over perception.

Household consumer brands have been the mainstay on shelves across all major retail grocery and supermarkets chains for decades. Limited availability has made it difficult for little known brands to get much shelf space, especially as purchasing managers tend to take the low-risk decision of sticking to the tried and tested. Amazon and online retail in general, however, has no such constraints. There is no limit to the number of products that can be promoted on an online platform. At the same time, door-to-door delivery and third party logistics solutions have become far more affordable, enabling small businesses and sole proprietors to match delivery solutions offered by the largest of companies.

Distribution, too, is losing its lustre as a source of sustainable competitive edge.

The design services ad agencies offer their clients are a tax on the advertiser to gain access to an agency’s ad network. Advertisers have been willing to bear this tax historically. However, the effectiveness of traditional media outlets, particularly television, in getting the message across to the masses is being challenged by social networks and other disruptive technologies. It is unsurprising that advertisers are reigning in their ad spend budgets.

If digital advertising platforms have been so effective at disrupting traditional advertising channels, how does one reconcile that Procter & Gamble cut digital spending and it had minimal impact on their business? Firstly, the company has long been the largest spender on advertising in US and the cut represents less than 5% of their total annual ad spend. Secondly, and more importantly, the company has spent billions year in and year out for decades in building brand identities for its product. Consumer behaviour patterns suffer from inertia. Brand loyalties and affinities will not be wiped out immediately but are likely to gradually fade away. Somewhat akin to the explanation on how one goes bankrupt in Ernest Hemingway’s The Sun Also Rises:

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

Lastly, digital advertising platforms’ major strength is targeting specific consumer groups based on precisely defined criterion. Such platforms are best suited to products that have a great deal of appeal to a select group of consumers. In such instances, the return on investment will tend to be high. In contrast, household consumer brands have been built upon creating mass awareness and offering acceptable levels of quality – traits that are unlikely to garner much consumer enthusiasm and therefore likely to result in a low return on investment on digital media spend.

Investment Perspective

In our opinion, the decline of WPP is not a signal for the coming decline of Facebook or Google but rather a confirmation of their strength as legitimate advertising platforms. We expect the demise of the traditional advertising agency model to accelerate. The next great businesses of our generation are unlikely to rely on the advertising models of the past. While existing clients of ad agencies will continue to cut back spending or take away their business altogether. Neither outcome supports the flow of talent into the advertising industry. Without fresh and new talent entering to disrupt the industry, the industry is likely to cling even more strongly to the past. Traditional advertising agencies do not represent pockets of value, in our opinion, they are value traps.

The weakness in traditional advertising agencies also represents potential for deterioration in household consumer names, much like many of the constituents of the Consumer Staples Select Sector SPDR ETF ($XLP) and iShares US Consumer Goods ETF ($IYK). We would avoid investing in either of these ETFs at present and potentially look to get short some of the weaker names within the sector.

WPP vs. Consumer Staples Select Sector SPDR ETF (Normalised) Source: Bloomberg

Our analysis suggests that well-known consumer stocks such as PepsiCo ($PEP), Philip Morris ($PM), Kimberely-Clark Corp ($KMB), The Clorox Co. ($CLX), Dr Pepper Snapple Group ($DPS), Pinnacle Foods ($PF) and Tupperware Brands Corp. ($TUP) are susceptible to significant deterioration in fundamentals. We may cautiously look to short a basket of these names opportunistically.

To counterbalance our negative stance on a number of consumer stocks, if one is to get long consumer plays we find that the greatest upside potential is in aspirational brands.

We define aspirational brands as premium products that have appeal not only in the US but beyond its borders also. These brands have far more potential to benefit from the rising disposable incomes of consumers in emerging markets than do household brands. Companies that fall in the aspirational brand category include the likes of Michael Kors Holdings ($KORS)*, Estee Lauder ($EL) and Tempur Sealy International ($TPX).

* Note: We recommended $KORS as a long idea to LXV Research subscribers on 13 September, 2017

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.