Investors often speak of economic moats and its importance for spotting high-quality companies . One key feature of a company having an economic moat is pricing power. The best companies to invest your money in are companies with pricing power. So let’s dive in and learn about one of the most important factors in evaluating a business – pricing power.
What Is Pricing Power?
Pricing power is the ability of a business to raise prices higher than inflation without impacting sales or losing existing customers – very few businesses are able to do this. Businesses that can raise prices, make higher profits, which means that they have more money to reinvest or distribute as dividends. If companies don’t have pricing power, they face margin challenges as costs of goods rise. Furthermore, companies with pricing power also tend to survive economic downturns and recovery quickly.
Buffett’s Favourite Metric
Pricing power is what makes businesses great and these businesses are hard to come by. Warren Buffett, in the past, has often emphasized the importance of pricing power. In 2011, at a Financial Crisis Inquiry Commission (FCIC) interview, he said:
“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.”
Speaking at a university lecture, he tried to explain it in layman:
‘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 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.’
A perfect example of this is See’s Candies – a Berkshire company, which has grown tremendous profits over the years. When Buffett acquired See’s Candies, it earned $4 million in profit on tangible assets of $8 million. Today, See’s has generated profits of close to $2 billion that required additional investment of only $40 million in this period.
Why Is Pricing Power Important?
Pricing power is often the difference between a company that succeeds and one that fails. It is important because raising prices allows the business to overcome the effects of inflation and increased costs. Without adequate pricing power, the business may not cope with higher expenses.
The higher price the business can command, the more reliably you’ll be able to maintain profit sufficiency. There are three ways in which a company can successfully gain pricing power:
- When demand for products is ever growing and price increments are negligible to the customer.
- When customers dependent on company’s products or services and there is no perfect substitute.
- When the company is a monopoly and barrier for new entrants is high.
That said, companies with pricing power are not easy to spot for the untrained eye. So I’ll show you how you can easily spot one even if you are just starting out.
The Indicator of Pricing Power
The best quantitative indicator of a company’s pricing power is Gross Margin, calculated as:
[(Revenue – Cost Of Goods Sold)/Revenue]
While 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.
One such company that has seen growing gross margins is CSPC Pharmaceutical Group (HK:01093)
CSPC was listed on the Hong Kong stock market in 1994. The production of bulk drugs including vitamin C and antibiotics had always been its major business until 2012, when it acquired the finished drugs business from Hony Capital. The finished drugs business is now contributing over 70% of CSPC’s earnings. It generated 75% of its revenue in the first six months of 2018 from finished drugs.
CSPC’s pricing power derives from its strong portfolio of finished drugs which consist of class 1 or 2 type of drugs classified by China Food & Drug Administration (CFDA).
Class 1: A drug with an innovative active ingredient or chemical structure.
Class 2: A drug with an innovative way to deliver known active ingredient
A drug classified in either class is an exclusive product. Its exclusiveness protects it from competition to enjoy more stable growth. CSPC’s range of innovative drugs helps in the treatment of fatal diseases. A drug tackling fatal disease implies it is almost necessary for the patient to take the medicine. If the number of patients is large, the demand is further warranted.
For example, CSPC’s NBP (chemical name: Butylphthalide) is a class 1 drug for treatment of acute ischemic stroke, which is a fatal disease with a large number of patients. Other drugs such as ‘Keaili’; helps with treatment of breast cancer, and ‘Duomeisu’; helps with treatment of lymphoma, ovarian cancer and malignant tumor.
In addition, CSPC’s drugs are covered by national and provincial medical insurance programmes. This means that patients’ expenditure on the drug is subsided by public medical insurance programmes. As such, patients are more willing to take the drug, which drives demand. CSPC also has a strong new products pipeline, which enables it to launch one new class 1 drug each year in 2019 to 2022 to fuel earnings growth in the long-run.
CSPC possesses strong R&D capabilities and a rich product pipeline. The Central Drug Research Institute, located at CSPC’s headquarters, is formed by a strong professional team of overseas returnees and staff with PhDs and Master’s degrees. Currently, the Group has over 170 products under research and development including Class 1 new drugs, Class 3 news drugs and exclusive TCM, with focus on five major therapeutic areas of cardio-cerebrovascular, diabetes, oncology, neurology and anti-infective. Among these drugs, 18 Class 1 new drugs are under research and development in China. With regards to overseas registrations, the Group actively participates in ANDA applications in the U.S. In addition, 2 innovative drugs of the Group are applying for clinical trials in the U.S. and EU.
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 choose to reinvest back in the business and strengthen its position in the market. This means that the business has opportunity to innovate, gain market share or expand its range of products. Establishing such an advantage is one of the most important goals of any company. In today’s world, competitive advantage is essential to business success. Without it, companies will find it difficult to survive.