Invest in companies with pricing power the Warren Buffett way
The ability to raise prices with inflation is an important characteristic of a company that creates wealth for its shareholders
Jun 11, 2018
The best companies to invest your money in are companies with pricing power. This is the lesson the world's most successful investor has learnt with years of experience. In this issue of Value Guru, let's learn about one of the most important decisions in evaluating a business - pricing power.
What's pricing power?
Pricing power is the ability of a firm to raise prices higher than inflation without taking a hit on sales. Very few businesses are able to do this. Most have to contend with customers bolting to competitors, falling sales or loss of market share. Those that can raise prices make higher profits, not only in their own industry but often across various others.
Buffett's favourite metric
Pricing power is what makes businesses great. A number of times, Buffett has talked of the importance of pricing power. Here is Buffett on 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.'
The concept of pricing power is not new for Buffett. Close to 30 years ago, in a lecture at a university, he talked about pricing power. 'A couple of fast tests about how good a business is. First question is 'how long does the management have to think before they decide to raise prices?' You're looking at marvellous 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.'
Why is pricing power important?
The ability to raise prices higher than inflation hides a fabulous consequence. Firms that can hike prices without affecting sales can often drive earnings higher, without making incremental investments in capacity, plant and machinery and other capital investments.
Here's how See's Candies, a Berkshire company, has grown profits over the years. At the time Buffett acquired See's, it earned $4 million in profit on tangible assets of $8 million. Four decades later, See's has generated profits of close to $2 billion that required additional investment of only $40 million in this period.
With his vast experience of buying companies in whole or in part, Buffett has first hand experience of how important pricing power is to the returns of a company and its shareholders. In the following section, we look at two of Buffett's businesses that he has contrasted for their pricing power.
Berkshire Hathaway - the textile-mill business
When Buffett started buying Berkshire Hathaway in 1962, it was different from the conglomerate of diverse high quality businesses we know it as today. Berkshire was a textile manufacturer, which, in 1955, operated 15 plants, employed over 12,000 workers and had revenues of $120 million. A steady decline in business over the following years would see the company shutting down plants and lay off workers. After unsuccessful attempts to revive the business, Buffett shut down the last textile operation in 1985. Years later, he would say it took him 22 years to realise that Berkshire was not a good business.
Here he explains Berkshire's pricing power,
'Well, in the textile business, we made over half of the men's suit linings in the United States. If you wore a men's suit, chances were that it had a Hathaway lining. And we made them during World War II, when customers couldn't get their linings from other people. Sears Roebuck voted us 'Supplier of the Year.' They were wild about us. The thing was, they wouldn't give us another half a cent a yard because nobody had ever gone into a men's clothing store and asked for a pin-striped suit with a Hathaway lining. You just don't see that.'
See's Candies - the boxed chocolate business
Buffett acquired See's Candies for $25 million in 1972. This California based business does most of its business in the pre Christmas season when people buy candies and chocolates as gifts.
See's proved a complete opposite of Berkshire linings. Buffett has spoken many times how he raised the price of chocolates every 26th December, without taking a hit on the sales or bottom line. Here's Buffett contrasting both See's and Berkshire's lining business.
'Essentially, every year for 19 years I've raised the price of candy on December 26. And 19 years go by and everyone keeps buying candy. Every ten years I tried to raise the price of linings a fraction of a cent, and they'd throw the linings back at me. Our linings were just as good as our candies. It was much harder to run the linings factory than it was to run the candy company.'
Untapped pricing power
Buffett also introduced the concept of untapped pricing power. This is the ability of a very rare group of companies to improve returns just by raising prices and they haven't done it yet. In other words, think of it as unused pricing power. Buffett explained this concept in Berkshire Hathaway's 2005 shareholder meeting.
'We like buying businesses with some untapped pricing power. When we bought See's for $25 million, I asked myself, 'If we raised prices by 10 cents per pound, would sales fall off a cliff?' The answer was obviously no. You can determine the strength of a business over time by the amount of agony they go through in raising prices.'
How to identify companies with pricing power in India?
One of the simplest ways to search for pricing power is to look at gross margins. Companies with pricing power are able to extract higher gross margins. We calculate gross margin as:
(Revenue - cost of goods sold)/revenue
Let's take the example of paints major, Asian Paints. Asian Paints' gross margins have averaged at 36.5 per cent in the last decade. The graphic shows Asian Paints gross margins at times when crude, the source of its primary raw material, titanium dioxide, moved from close to $150 per barrel to the lows of $40 per barrel levels a few years back. During this period of volatile input price, Asian Paints gross margins moved up in eight out of 10 years. This was thanks to the many price hikes the company made between April 2010 and April 2017. During this period, Asian Paints hiked prices a phenomenal 21 times.
Do such companies exist in India?
We set about looking for companies that reported increases in gross margins every year in the last decade. Out of the top 1,000 listed companies, we searched for companies that reported higher gross margins in at least seven out of the last 10 years. The table below lists out such companies. These stocks are not an automatic buy recommendation but provide a fertile hunting ground to get you started on companies with pricing power.