Why Warren Buffett Love Pricing Power of Companies?

Warren Buffett is very choosy when it comes to stock picking. Which are the favourite companies of Warren Buffett?

It is possible for “us” to decipher the stock picking strategy of Warren Buffett?

After all Buffett is no normal human being. He is a legendary investor.

Yes it is possible. Buffett is a legend, but his investing style is more logic and less rhetoric.

Hence they are simple to understand and use. Even for common men like me and you.

Yes, the understanding about these companies are so simple.

Lets see, how the understanding is simple. Let me ask a question…

Would you like to buy stocks of companies which has more control? Yes.

What companies must have more control on? Sales and Profit.

Reasonable control on sales and profit, can make a company favourite of Warren Buffett.

In financial jargon terms we say, such companies have “pricing power” control.

#1. Having “pricing power” means what?

Suppose one has only two stocks in the investment portfolio.

One stock represents a company having pricing power.

Other stock represents a company having no pricing power.

Hold these stocks for 3 years and watch their performance. You will understand the difference.

The stock having pricing power will shine. While the other will be lagging.

What is pricing power?

It is the ability of a company, to increase selling price of their goods/services whenever needed.

How much increase is good? Increase more than the rate of inflation.

But this price increase any company can do, right? No.

For 99% companies, decision of price rise is taken over board meetings.

There is so much at risk that, lower management cannot dare up-the-price on their own.

What’s the risk?

When price rises, sales takes a hit. Why? Due to competition.

Companies with pricing power has an advantage.

Their sales do not fall with increase in selling price.

Today’s best example is telecom sector (facing severe competition).

With every price rise in “Data Plans”, customers are switching to other service providers.

Which are these companies? Reliance Jio, Airtel, Vodafone, Idea etc.

These are examples of near zero pricing power type companies.

#1.1 Ideal pricing power…

Due to inflation, product and services price will rise. This is normal.

Suppose inflation rate in car sector is 8% per annum.

It means, on an average, in one year, the price of cars goes up by 8%.

Hence the price of your favourite car rose from Rs.500,000 to Rs.540,000.

Would you still buy that car? Yes sure. Why? You will not feel the pinch of price rise. Why?

As all other car manufacturers will increase the price in the same range (8%).

Now, consider this…

Suppose your favourite food (like others), is Pizza.

If the price of Pizza goes up by 8%, will you stop eating pizza? In most probability, no.

What does it mean? It means, that pizza manufacturer has the “pricing power”.

When sales price can be increased beyond inflation, and the sales is not hampered, this is the ideal pricing power.

Such companies can raise sales price to boost profits.

This is called “complete control” in hand of the company.

“Pricing power” is symbolic of a good business.

If a company does not have it, Warren Buffett calls it “a terrible business” to invest in.

#1.2 Pricing power is not only about price…

The ability of a company to raise its prices, speaks a great deal about its business fundamentals.

Who will leave drinking Coke if its price rises from Rs.9 to Rs.10.? No one.

Apple fans will stop buying iPhone’s if it is priced at Rs.100,000? People bought iPhone X standing in queues.

Price of a Rolls Royce Phantom is Rs.7 Crore. There are still buyers for it.

What is common between Coke, iPhone X and Phantom?

They are all unique products representing a cult brand name.

Buying product of these companies has become an habit or a status symbol.

Public knows that they are expensive. They still buy it, paying a premium price.
Pricing power is the ability of company to charge a premium price.

Only those companies can do it, who has a unique and likeable product to sell.

Such a product cannot be made in a fluke.

A combination of several things working in tandem develops such a product.

What are those things?

• Vision.
• Leadership.
• Funding.
• Research and Development.
• Technology.
• Team work.
• Marketing.
• Sales and Distribution.
• After Sales Service.
• Further Improvement.

What does it mean? A unique product is not just a product.

It is result of an excellent business practice (represented by above 10 points).

A business, run on excellent principles, will have the necessary pricing power.

#2. Why Warren Buffett likes Pricing Power?

Such companies run on “excellent business practices”.

This is the “bigger” reason. But there is also a “smaller” and a more understandable one.

Companies with pricing power can raise sales-prices to boost profits.

What does it actually mean in terms of business operations?

It saves huge cost for the company. How?

Normally for any company, to boost sales and profit, it must increase its capacity and efficiency.

• Capacity increase – by executing expansion projects.
• Efficiency increase – by executing modernisation projects.
• But expansion and modernisation comes at a cost (CAPEX).

How big is this cost (Capex)? Example:

Current

• Sales Turnover: Rs.300 Crore.
• Net Profit: Rs.25 Crore
• PAT Margin: 8.3%

After 5 Years

• Sales Turnover: Rs.550 Crore.
• Net Profit: Rs.50 Crore
• PAT Margin: 9.09%

Investment required (Capex): Rs.300 Crore.

What does these numbers say?

To increase sales & profit margin, companies must invest money (Capex).

But for a company enjoying pricing power, for them Capex is almost zero.

They can just increase their sales price of the product.

Net profit and margin will automatically improve.

Increasing selling-price is a convenient way to improve profits, right? Certainly.

But unfortunately, only 1% all companies in this world enjoy this liberty (pricing power).

#3. How to identify companies having pricing power?

One observable characteristic of such companies is, “they never care to give discounts”. 🙂

Bad? But probably you would like to buy stocks of such companies.

Other more technical ways of identifying such companies are:
Look at last 10 years ROA.
Look at last 10 years PBDIT Margin.

Why ROA?

ROA = Net Profit / Total Assets.

ROA represents net profit generated by the company, per Rupee of invested capital.

What is invested capital? Total Assets of the Company.

When Company is spending on Capex plans, total Assets of a company rises.

Example: Suppose a company makes Rs.1 crore PAT. Total Asset = Rs.10 Crore.

What is its ROA? 10%.

Now, suppose this company invested in Capex and its PAT rose to Rs.1.5 Crore. Total Asset = 16 Crore.

Wha is its ROA now? 9.4%.

It means, even though the company has spent money on Capex, and its PAT has improved, but its profitability has gone down.

Such a company cannot be said to have a pricing power.

Why PBDIT Margin?

No matter what a company does, if it is not improving its margins, it is not good for Warren Buffett.

PBDIT Margin is that margin which has least provisions of manipulation.

Hence I consider taking PBDIT for evaluation.

As an investor, what we would like to see in PBDIT Margin? Continual growth.

#3.1 Example – Eicher Motors

ROA of Eicher Motors has increased from 5.02% (2008) to 28.25% (2017) in last 10 years.

PBDIT Margin of Eicher Motors has increased from 6.56% (2008) to 34.57% (2017) in last 10 years.

Conclusion…

Which are the favourite companies of Warren Buffett? Companies like Eicher Motors.

But does it mean that, one can blindly buy stocks of Eicher Motors today? No.

There are two more things that must be checked about the company:

• Moat.
• Intrinsic Value.

Warren Buffett prefers to call competitive advantage as MOAT.

What gives sufficient MOAT to a company?

• Brand name,
• Pricing Power and,
• Large market share.

Warren Buffett will never buy a stock without estimating its intrinsic value.

Have a happy investing.