Case StudiesGeneral Thoughts

The Importance of Pricing Power

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

–Warren Buffett, 2011 (Financial Crisis Inquiry Commission)

I wrote a post about Amazon a couple weeks ago. I don’t own it, and I don’t really know enough about the business at this point to determine if it’s cheap or not (it appears to be expensive, but then again… appearances can be deceptive).

I do think that Amazon is a great business, and regardless of the price of the stock, I think it’s a business worth studying. I may not own it in the near future—and I may never own it—but there is a lot to learn from studying Bezos, Amazon, and their model.

One aspect of Amazon’s model that is worth ruminating on is their potential real pricing power. I won’t comment much more on Amazon’s untapped pricing power for now, as I thought I’d post some general thoughts on this topic for now. These thoughts stemmed from some things I read a few weeks back by Josh Tarasoff, a value investor who has some interesting things to say regarding pricing power, and he thinks about this important subject differently than most investors.

Basically, as value investors, we are all conditioned to think linearly when it comes to pricing power. How often have we heard Buffett talk about See’s Candies and how every December 26th they raise prices? This is a very attractive business to own. In other words, a business that can raise prices each year in a nice, steady upward trend is ideal. This is a business that we say has pricing power, as it can increase the cost of its product or service to reflect the general increase in prices (inflation).

But Tarasoff brings up three really good points regarding pricing power:

  1. Nominal vs Real Pricing Power: A business that can increase prices at a rate that only offsets inflation is good, but not exceptional (if it can’t raise nominal prices at a level that meets the inflation rate, it’s a bad situation). Ideally what we’d like is a business that can raise prices in excess of inflation (real pricing power).
  2. Real pricing power actually indicates an inefficiently priced product or service. In other words, just as stock prices occasionally get priced below fair value, sometimes a business’s products or services get priced below fair value to a customer. This undervalued product is a source of potential value as a business begins to price their product more efficiently (raise prices in real terms).
  3. Real pricing power is finite. Just like a stock that reaches fair value and is no longer mispriced, at some point, a businesses’ ability to increase real prices without impacting unit volume comes to an end. This means that a long history of real price increases doesn’t necessarily indicate future real price increases.

Let’s discuss the first point…

Nominal vs. Real Pricing Power

If you are a business owner, the minimum amount of pricing power that you would demand is to be able to price your goods or services in a way that keeps up with inflation. If you can’t offset inflation, you don’t have a very good situation. So nominal pricing power is really just a necessary, but not sufficient condition of business quality. A better situation for a business owner would be the ability to raise the prices of his product or service in excess of inflation. This type of real pricing power can create significant value for owners.

This is rare. It is also inefficient. And it leads us to the second bullet point…

Real Pricing Power = Undervalued (Mispriced) Products

If a business can raise prices in excess of inflation, it actually means that it is not actually maximizing its current pricing. In other words, if a business can actually raise prices in excess of inflation without negatively impacting unit volume, it was not charging as much as it could have prior to the real price increase.

Tarasoff likens this “inefficiency” to a stock that is “inefficiently priced” in the market. Just like there are undervalued stocks, there are also undervalued products and services. This means that customers are getting a bargain. They collectively would be willing to pay more in real terms for the same product or service. In this situation, businesses can raise their prices in real terms without affecting unit volume, creating an enormous amount of value for their shareholders.

All Good Things Must End—Point 3

Now, although some companies can experience very long periods of real price increases, it is true that real pricing power is finite.  There is only a certain amount of real pricing power that a business has before it reaches the maximum price per unit that it can operate at without negatively impacting volume.

The contrarian aspect of Tarasoff’s thinking is that while it’s nice to see a business that has consistently raised its prices, it might actually be better to find a business that has not raised its prices in a long time for one reason or another, thus causing its product or service to become underpriced—and undervalued to customers. This situation creates a sort of pent-up pricing power that can be released in the form of future real price increases for a certain amount of time.

Look For Undervalued Products/Services

Tarasoff references the railroad industry as a general example of this type of thinking… real prices declined for decades until 2004, creating an underpriced service and pent-up pricing power for a consolidated industry.

Railroad Real Rates

Some were surprised when Buffett made a massive acquisition of a major railroad in 2009, as these capital intensive businesses are typically not what Buffett finds attractive. But as the quote at the top of this post suggests, Buffett has pricing power at the top of his investment wish list, and Burlington Northern Santa Fe certainly has the potential to grant this wish.

There are other examples of general situations that can lead to potential real pricing power—one is the situation that occurs when a not-for-profit organization converts into a for-profit business. This change in structure can lead to more efficient prices, as management and owners are incentivized differently in for-profit enterprises.

And occasionally it is not an industry trend or a structural change, but simply an individual business case where for some reason, management has not priced its products or services correctly, leading to pent-up pricing power. Occasionally a management team discovers that their business possesses the ability to raise real prices—a pleasant finding that they may not have been aware of previously.

To Sum It Up

The main idea here—which I think is quite contrary to what most investors do—is that in order to find real pricing power, it might be helpful to locate businesses that have NOT raised prices for a long period of time for some reason. It’s an interesting take…

I still love finding the See’s type businesses with a history of price increases, but I can understand Tarasoff’s logic that real pricing power can only exist for a finite period of time, and so a business with a history of raising real prices might be nearing the end of its run (as its product becomes more fairly priced), which might cause investors to overvalue this real pricing power, and thus place too much emphasis on the business’ margin expansion and future earning power.

Like a stock that has gone up faster than its value, a long history of real pricing power and margin expansion may mean that the business’ products/services are now much more “fully valued” than they once were.

To summarize these thoughts on real pricing power:

  • Pricing power is good
  • Real pricing power (as opposed to just nominal pricing power) is what we really want as business owners
  • Nominal pricing power (ability to offset inflation) is really the minimum pricing power we would demand as a business owner
  • Just like we search for undervalued, or “mispriced” stocks, we should also be on the lookout for undervalued, or “mispriced” products or services (or “untapped pricing power”), as both situations eventually tend to correct themselves creating future value for shareholders.

13 thoughts on “The Importance of Pricing Power

  1. Good article. Playing devil’s advocate though, just because a company hasn’t flexed its pricing power muscle for a long time, doesn’t mean that it will eventually. Some companies may underprice their product/service indefinitely due to poor management. This is why I’m not sure it is a very useful aspect to consider when evaluating a potential investment other than when that mispricing is occurring across an entire industry.`

    1. Yeah, it’s a very difficult concept to quantify. Often times, management doesn’t even know they possess this type of pricing power (otherwise they would have not underpriced their product). I agree that it can be very difficult to interpret, but it’s a huge value creator when it occurs, especially when combined with a business with relatively low operating margins. The example Tarasoff used was basically the following: a business with a 5% operating margin that discovers that it can raise prices in real terms by 1% will see a 20% rise in operating income. This formula is basically the real price increase multiplied by the reciprocal of the operating margin… or more simply: real price increase divided by operating margin = % increase in operating earnings. This might be obvious to some, but worth stating: this pleasant situation occurs because when you raise your prices in excess of inflation (real price increase), your margins expand because your revenue increases faster than your expenses. Thus, a 1% real price increase increases operating earnings by 20% in a business with 5% margins. A 1% increase in a business with 20% operating margins increases operating earnings by 5%, etc…

      This can create significant value over a finite period of time for owners. It is less valuable in high margin businesses, but even then-it still can create margin expansion, growth, and intrinsic value creation.

      But I see your point… it’s difficult to discover and correctly identify this type of pent up pricing power. I do think it’s a concept worth understanding though, because even if it’s hard to go out looking for this situation, you may serendipitously discover this when looking at a business and analyzing other aspects of it.

    1. Has anyone here tried reproducing the Novy-Marx profitability factor results? I wasn’t able to find that it made as much of a difference as he claimed…

      John, this is another thought-provoking article. I guess in most businesses with pricing power, the price is concealed, not readily discoverable, or a secondary factor to a primary decision based on quality (e.g. Veblen goods, premium services). For example, going to a nice restaurant, sometimes the drinks menu has no prices, or getting a nice suit, the salesperson will talk about fit but avoid price. Or the medical system, which has basically no price discovery. To me this is endlessly annoying and I usually refuse to buy goods that have no price quotes, as a matter of principle, but sometimes in e.g. medical it’s unavoidable. But there are lots different psychological makeups in the world, so it’s interesting to me that some people have really different attitudes.

      I remember one of my least enjoyable purchases involved me getting a bed. The bed salespeople (I went to many stores to get competitive quotes) kept arguing with me that I should not be price sensitive since quality matters in the long run. I kept explaining that my happiness would be decreased enough that I would resent the bed if I didn’t get a fair price or bargain. My wife also grew up sleeping on a “mattress” as hard as a board in China, so I also found it amusing that they kept trying to sell her soft premium beds, which she didn’t like.

  2. Great article. I remember another stock Buffett owned was Moodys, and he always used to say they have virtually infinite pricing power, because even if they kept increasing prices in real terms, customers still would buy the product.

    1. Yep, and the quote I referenced came from Buffett’s testimony to the FCIC regarding Moody’s pricing power.

  3. Great article John. Like your “go where the puck is going” considerations on pricing. I think it’s also worth considering what Munger often says, sort of that even if you increase prices, your volume may go up just because of the price increase alone. Also, it can be a good thing if you increase prices – even if your volume goes down – you can make more money while shrinking your volume – and sometimes this is easier, perhaps still the correct move for the bottom line. Thank you, Danny

  4. I think that pricing power is one of the most difficult criteria to identify. I’m actually not sure I have ever found an investment with real pricing power, at least at any price I was willing to pay (of course, Buffett shows us that we need just a fair price for such a business). It’s really based on an analysis of competition – not just within an industry, but more broadly in the vein of Porter’s Five Forces – and I think that is the toughest part of an investment to analyze. And probably the most important.

    It may be getting tougher to maintain pricing power. The Internet, and particularly mobile internet, is enhancing price and product/service discovery but also tearing down barriers to entry. This is right in line with Marc Andreesen’s “software is eating the world” thesis. If someone can “hack” into an industry using software, delivering the product or service via mobile, the margin costs of delivery drop substantially and we’ve generally seen the savings passed onto consumers. Amazon has done this in every business they’ve entered. Any previously existing pricing power is eliminated.

    But let’s stay with Porter for a second and look for different perspectives on pricing power. We typically think of pricing power by looking at relationships with customers and competitors. However, one of the 5 forces is the bargaining power of suppliers. What about companies that can reduce their costs, and are able either 1) to maintain their own prices, thus increasing margins even though nominal prices don’t change, or 2) to pass along those savings to customers, which can increase loyalty and drive more sales?

    For example, look at Amazon. Bezos believes strongly in the virtuous cycle (the “flywheel”) where low prices leads to more customer visits, which leads to more operating leverage, which in turn leads to lower prices, which starts the cycle over again. It may be that Amazon never raises prices, but perpetually lowers them. Nonetheless, they have used their leverage to lower costs (both from suppliers and internally) to drive enormous sales growth. Whether this leads to greater profitability in the future remains to be seen, however.

    Another example is Wal-Mart. They have a reputation for ruthlessly squeezing suppliers on costs. They can either keep the savings for themselves, or pass them along to consumers and increase their inventory turns and ROIC (given their historical margins, I think they’ve generally done the latter). This model has run into trouble in recent years because of increased competition for customers from dollar stores and online. However, Wal-Mart’s ability to exercise its purchase power to LOWER prices helped fuel its momentous rise. In effect, they destroyed the pricing power of many of their suppliers.

    This brings up an interesting issue for investing: perhaps we should invert the thinking on pricing power to locate opportunities. What about those companies that have absolutely no pricing power, and may actually see their margins erode over time? Some of these are consumer facing, but for those who are in the position of suppliers, perhaps it is THEIR customer that is the wonderful business.

    I haven’t done the research to see where this goes. Just some food for thought.

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