By Vivek Bajaj
Inflationary pressures can reduce corporate profit margins and, as a result, investor returns. This is because businesses suffer from inflation in addition to consumers, as higher costs on everything from raw materials to logistics and energy bills eat into profits. Ideally, Companies would prefer to pass on the cost to customers by raising the price of their products or services, but doing so risks decreasing demand. So, they need a competitive advantage that ensures that even if they charge more, their customers – in B2C OR B2B – will pay up, which signifies that they have pricing power.
Companies with substantial and long-term pricing power will be able to protect their margins by passing on the cost to customers with little resistance. As a result, they are better equipped to deal with a high inflationary environment. According to the renowned investor Warren Buffett, “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 an excellent business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
A perfect example of this in the Indian Context is Page Industries (Jockey) and Vedant Fashions (Maanyavar) — both are affordable luxury brands aspirational by the youth in the textile business, which have grown tremendous profits over the years. These companies have huge brand loyalty from their customers despite no discounts given to their customers.
Why is pricing power important?
In his recent shareholder letter, Terry Smith, the founder, and CEO of Fundsmith, said one of the reasons poor returns can persist is because companies with many competitors lack ‘control over pricing.’ In contrast, he said: ‘Good businesses find ways to fend off the competition — what Warren Buffett calls “The Moat” — strong brands; control of distribution; high spend on product development, innovation, marketing, and promotion; patents and installed bases of equipment and software which are troublesome to change for example.’ Pricing power is significant because raising prices allows the company to overcome the effects of inflation and increased costs. With adequate pricing power, the company may cope with increased expenses.
The higher the price the business can command, the more consistently you will be able to maintain profit sufficiency. A company can successfully gain pricing power in three ways:
- When product demand constantly increases, price increases are insignificant to the customer.
- When customers rely on a company’s products or services, no perfect substitute exists.
- When a company has a monopoly, the barrier to entry is high.
- However, companies with pricing power are difficult for retail investors to identify.
How do you identify companies with pricing power?
‘Revenue from Operations is the first place ideally an investor should focus, and during the earnings calls, the management will sometimes refer to volume and price. Quite often, they will refer that they have grown sales by a certain amount, some of which is price. ‘You will see analysts/ investors analysing the revenue growth in terms of price and volume, and when you have businesses generating revenue growth solely through price, that’s pricing power.
The best fundamental indicator of a company’s pricing power is Gross Margin, calculated as:
[(Revenue — Cost of Goods Sold)/Revenue]
While the gross margin is also influenced by other non-price factors such as volume, cost efficiency, product mix, and channel mix, it is natural that companies with strong pricing power should see their gross margins grow over time. A rising trend in gross margins could indicate one of three things:
- The company better manages its input costs, such as bargaining with suppliers.
- The company is raising prices for end users.
- The company is selling more products.
Pricing power gives a business an edge over competitors; a business with pricing power tends to generate more profits. With more profits, the management may reinvest in the business and strengthen its position in the market. This means that the company has an opportunity to innovate, gain market share or expand its range of products. Establishing such an advantage is one of the most important objectives of any company. In today’s world, competitive advantage is essential to business success.
With it, companies will find it easier to survive. When companies have such pricing power, then that will be reflected in their operating margins and Return on Capital Employed. As a result, such companies will always command a high PE in the market. For example: – Nestle displays consistent margins and growing ROCE due to its pricing power in key products like Baby Food Cerelac.
However, pricing power is not the end-all and be-all fundamental analysis. End-user industry dynamics, competition scenario, management quality, capital structure (whether the company has manageable levels of debt versus equity), and valuations are all important parameters to consider before investing. However, as we enter a macroeconomic scenario characterized by continued high inflation and potential interest rate hikes, it may be beneficial to seek out and stick with businesses with a proven track record of pricing power.
(Vivek Bajaj is Co-founder of StockEdge. The views expressed are the author’s own. Please consult your financial advisor before investing)