If you’re going to invest in a business, you might as well invest in a good business. What makes a business “good” is open to debate. At Morningstar, we generally define a good business as one that can earn excess returns on the capital for a long time. Said differently, every dollar the company invests back into its business reaps an attractive return.

Finding companies that can do this isn’t easy. But there are some signs you can look for. Today’s post is about how to find companies with pricing power – otherwise known as the ability to increase prices without sending customers running for the hills.

This is a quality that Warren Buffett loves to see in a business.

In fact, he called it out as the single biggest difference between a good business and a not so good one. In 2010, he said this in an inverview during the US Congress's enquiry into the Great Financial Crisis: 

"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 a tenth of a cent, then you’ve got a terrible business. I’ve been in both, and I know the difference."

Pricing power has lots of perks:

  • As long as costs don’t rise by the same amount, charging a higher price for the same product will result in higher profit margins. This will also mean more dollars in profit for every dollar invested in the assets and labour needed to deliver the product. This means higher returns on capital.

  • Being able to charge your existing customers higher prices can provide a buffer against industry downturns. Even if there are fewer new customers coming through the door, revenue and profits could still rise (or at least fall by a smaller amount).

  • Companies with pricing power are better placed to navigate periods of high inflation. This is because they can pass most, if not all, of their cost increases through to the customer. 2021 and 2022 were something of an acid test in this regard.

Pricing power is likely to show up in the financial statements in the form of higher or more stable profit margins. But it is rare. Capitalism is defined by competition, and that competition will often be on price – a reality that Jeff Bezos turned into a multi-billion dollar fortune.

Nonetheless, there are a few situations where companies with this superpower are more common.

Unregulated monopolies

The law of supply and demand dictates that if there’s only one place to buy a product, the price is likely to be higher.

Buffett’s old love for local newspapers is the perfect example. Before Facebook groups and targeted online ads, local newspapers were one of the only ways for locals to keep up with news and for local businesses to reach their customers en masse. Most towns were only big enough to support one main newspaper, which could price its advertising space accordingly.

The internet broke a lot of old monopolies apart. But it has also caused new ones to form, and many of these quasi-monopolies and duopolies stem from what is known as a network effect.

A network effect arises when each new user of a product or service adds value to every other user of the product. Once this reaches a critical mass, it becomes hard for competing products to offer anywhere near the same value to customers. This can lead to winner takes all or winner takes most industries. I wrote more about network effects and three ASX stocks that benefit from them here.

An example of a network effect business with pricing power is REA Group (ASX: REA). REA isn’t the only game in town. But along with Domain (ASX: DHG) it enjoys an effective duopoly in Australia's residential real estate listings sector.

If you are searching for a property and want to see the biggest number of options, you head to these websites because they have the most listings. And if you are a real estate agent, you need to list your property on one or both portals because they have the most viewers.

Both REA and Domain Holdings have consistently raised prices at multiples of the rate of inflation, even during periods of declining property prices. Our analyst Roy Van Keulen expects both companies to keep doing so.

Effective monopolies can also come about due to industry conditions and regulation. As an example, Transdigm (NYS: TDG) designs and supplies aircraft parts. Here is how our Transdigm analyst Nicolas Owens describe the barriers to entry facing its competitors:

“Aerospace products are often made to unique designs and stringent specifications, enforced by regulatory requirements that only approved parts may be used to repair and maintain a given certified aircraft. While competing firms could theoretically reverse engineer the product to design a replacement, this is challenging because the designs are proprietary and thus never shared outright. The aircraft’s type certificate holder (usually a government regulatory body) would need to certify that the replacement part is identical to TransDigm’s.

Because TransDigm’s parts are not the most complex parts of an aircraft, and often represent a tiny fraction of the overall cost of the vehicle, we believe that it is economically prohibitive for potential competitors to create identical spare parts because the upfront expense of part certification—which may range between a few hundred thousand to millions of dollars—could exceed annual revenue for many of these specialty items.

As many components can have numerous spare parts, we think it would be prohibitively expensive for firms to re-engineer enough parts in TransDigm's catalog to meaningfully challenge its sole-source incumbency.”

Transdigm's customers, who are required to check and replace parts periodically, often have little choice but to accept TransDigm’s prices. Another source of effective monopoly can come from patent protection, which I covered at length here in this article on Big Pharma.

Products with true brand power

The value of a brand is directly proportional to the extent it helps a business compete on grounds other than price.

How might this come about?

Users might perceive a company’s products as offering far more quality or reliability than cheaper options. Or in the case of products that are readily visible to others, they might want to show off or avoid looking cheap. Meanwhile, a product’s distributor might tolerate price increases because a brand is entrenched in their sales catalogue.

In the past I’ve spoken about how bar owners pretty much need to stock the Jack Daniels or the Guinness rather than a cheaper alternative. It’s what the customer wants and expects. It’s also a far safer bet than stocking a less established brand.

An example I wasn’t familiar with until recently comes from ASX-listed Reliance Worldwide (ASX: RWC) and its SharkBite brand of water pipe connector in the US market.

Our analyst Esther Holloway says that SharkBite’s recognition in the US is such that it has become synonymous with the broader product category. SharkBite also has decades of sales history with no at-fault rulings. This is something Esther thinks customers are willing to pay up for. The alternative is paying less and risking a disastrous leak.

SharkBite’s has been able to utilise its brand power to extract higher prices from its key stockists Home Depot and Lowe’s. This is a rare feat as both of those companies have huge buying power.

Products with high switching costs

Switching costs are things that make a user reluctant to change provider.

Genuine switching costs can make a customer less price-sensitive and give the vendor more room to rise prices without losing business. One of my favourite examples comes from the specialty ingredients industry. Here is an excerpt from our Ingredion (NYS: INGR) analyst Seth Goldstein's report on the company:

“After a new food or beverage starts to be sold, consumer packaged goods companies rarely, if ever, replace key ingredients. This is because the replacement ingredient could change the taste or texture profile of the product and turn consumers away.

This dynamic gives specialty ingredient suppliers pricing power. For example, Ingredion raised prices to fully pass along inflation costs when crop prices and other raw materials costs hit multiyear highs in 2022.”

Business critical software can also have high switching costs.

For example, WiseTech (ASX: WTC) sells a suite of software tools, called CargoWise, to freight forwarders. Here is a snippet from Roy Van Keulen’s report on Wisetech's moat:

“Implementing CargoWise requires multiyear rollout projects as processes are mapped, technologies integrated, and people trained. Given the high upfront capital expenditure and the mission-critical nature of the product, once implemented, CargoWise customers have been reluctant to switch providers. Moreover, even after the initial launch, customers usually continue integrating deeper with the product.

CargoWise switching costs are evidenced by its industry-leading customer retention rates of over 99% per year during the past decade, despite the company implementing material prices increases for many customers in recent years.”

Mission critical but small fraction of total cost

Pricing power is more likely to arise in situations where a product’s reputation for quality is more of a concern than its price. This becomes even more likely if the product or component is only a fraction of a buyer’s cost base yet performs an essential role. Adhesives (stuff that makes other stuff stick together) offer a good example.

Adhesives represent a tiny fraction of a manufacturing company or construction firm’s total costs. Yet they are essential for delivering a safe and well-functioning product. The losses, financially or in terms of reputation, of a cheaper product letting the buyer down could far outweigh any savings achieved by being penny-wise. Meanwhile, even a large price increase in percentage terms could still be a rounding error compared to the customer's total costs.

Morningstar’s Matthew Donen noted that Sika (SWX: SIKA), a construction chemicals firm and leader in adhesives, typically raises prices 1% annually. But in 2021 and 2022 it was able to pass-through double-digit price increases during 2021 and 2022, keeping its gross margin comfortably above 50%.

Australia’s PWR Holdings (ASX: PWH), which provides engine cooling systems to every team in Formula One, offers a racier example. Every second counts in F1, and engine cooling plays a vital role in maintaining an engine’s performance and reliability. Yet PWR's invoices to F1 teams are a rounding error compared to the USD 10-15m spent building each F1 car - around 2% according to our analyst Angus Hewitt.

PWR’s other end users in the luxury and supercar space are also likely to prize quality and performance over price. PWR’s ubiquity in F1 give its notable prestige and essentially removes price from the equation. Buyers in this bracket are not going to penny pinch. They just want to drive (and talk about driving) a car powered by F1 standard parts.

Pricing power is not static

Companies with pricing power cannot sit back and relax.

If a company’s pricing power comes from a perception that their products are higher quality, the company needs to make sure this perception holds up. This will likely require continued investments in marketing and improvements to the product.

If a company’s pricing power comes from switching costs, the company needs to make sure the customer’s cost/benefit equation doesn’t turn against them. This could involve making sure that big innovations by the competition are replicated quickly.

Whatever the source of a firm’s pricing power, management need to do their utmost to keep it intact. When Warren Buffett talks about wanting his managers to focus primarily on “widening the moat”, I think this is what he means.

Further reading

Pricing power is often the result of a moat. In fact, it will often be the most visible symptom of the company's competitive advantage. To learn more about finding companies with a moat, read this article by my colleague Mark LaMonica.