Urbem’s ‘Quality Strategy’ Series: Pricing Power

In 2011, Warren Buffett (Trades, Portfolio) was interviewed by the Financial Crisis Inquiry Commission (FCIC) about what caused the financial crisis. In the interview, he shared some of his thoughts on pricing power:

“If you own the only newspaper in town, up until the last five years or so, you had pricing power and you didn’t have to go to the office… 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.”

In a 1991 lecture with Notre Dame Faculty, MBA Students and Undergraduate Students, Buffett provided a few fast tests on assessing business quality:

“A couple of fast tests about how good a business is. The first question is ‘how long does the management have to think before they decide to raise prices?’ You’re looking at a marvelous business when you look in the mirror and say ‘mirror, mirror on the wall, how much should I charge for Coke this fall?’ And the mirror replies, ‘More’. That’s a great business. When you say, like we used to in the textile business, when you get down on your knees, call in all the priests, rabbis, and everyone else, and say ‘just another half-cent a yard.’ Then you get up and they say ‘We won’t pay it.’ It’s just night and day. The ability to raise prices – the ability to differentiate yourself in a real way, and a real way means you can charge a different price – that makes a great business.”

Robust pricing power provides an unfair advantage for businesses to raise prices, gain profit, accelerate growth and lift returns on capital. Per numerous studies, companies with the durable “right” to charge more on their products and services generate more shareholder value with the protection from inflation, which cannot be of more significance in today’s money-printing era.

Some even see the pricing power as the “fastest and most effective way for managers to increase profits,” citing the fact that a price rise of one percent could incur an eight percent increase in operating profits for an average American large-cap or mid-cap company. This is an impact that is roughly 50 percent greater than that of one percent save in variable costs, as well as more than three times greater than that of a one percent gain in volume.

At Urbem, we highly regard this group of “price autocrats” as a decent source to explore well-moated, quality-growth stocks that are hopeful of delivering alpha for us if we hold them for the long run. But how can a company consistently gain pricing power over time? More importantly, what is the easiest way to uncover these opportunities?

In our opinion, a few common opportunites for a business to build long-lasting pricing power are:

• Price-inelastic items;
• An increasing demand that outruns the supply;
• A lack of substitute;
• A legal monopoly position;
• A high barrier of entry.

We have to note that most competitively advantageous companies capitalize on multiple of the scenarios from above. For instance, Hermes International (XPAR:RMS) serves the increasing global demand from ultra-high-net-worth consumers with its iconic heritage that is unmatched by its peers in the luxury sector. Be mindful of the long waiting list if you plan to get your hands on one of their hyper-limited supply of Birkin bags.

Also, Norway-listed Bakkafrost (OSL:BAKKA) takes advantage of the increasing desirability of Faroe Islands salmon from sushi chefs and other health-conscious customers, as well as the unique natural conditions that provide the company’s salmon farms with the ability to grow large-sized salmon without even using antibiotics. At the same time, the barrier of entry is high, as competitors elsewhere would have difficulties in finding similar geographic advantages enjoyed by the Faroe Island farmers. Notably, Bakkafrost controls more than three-quarters of the Faroe Islands salmon market.

As a cheat approach, we like to closely monitor gross margins to search for evidence of reliable pricing power. We are particularly attracted to businesses that managed to consistently achieve super-normal gross profitability or, even better, steady increases in already high margins.

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