Why pricing power matters when it comes to picking stocks

Back in May, this column looked at how to test whether a forecast dividend payment from a company was safe or potentially at risk of a cut, in the form of a check-list of financial ratios (see here).

But such research needs to dig deeper still.

We will now look at the operational characteristics of those companies which have the most consistent dividend growth records over time because, as legendary investor Warren Buffett once noted: “Management and owners need to remember that accounting is but an aid to business thinking, not a substitute for it.”

By this, the Sage of Omaha was pointing toward the one thing he focuses upon more than any other – a firm’s competitive position and its ability to charge the prices it wants to charge rather than the prices customers will pay.

Quite simply, a company’s competitive position drives pricing power, which drives profit margins, which drive cash flow. And it is cash flow that funds dividends.

That is why Buffett argued in one of his ever-useful Letter to Shareholders (all of which can be accessed for free on the Berkshire Hathaway website): “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% then you’ve got a terrible business.”

The rest of this piece will look at sources of pricing power and how investors can test whether a company has them and whether they will be durable or not, to the long-term potential benefit of investors looking for reliable dividends, capital gains or both.

Five forces

There are many possible ways of persuading a customer to pay for a product or service but ultimately it needs to meet a need, solve a problem or both. And it is all the better if it is hard to find the solution anywhere else.

In four books written between 1980 and 1990, Michael E. Porter of Harvard Business School devised a clear method investors could use to assess the competitive strength of and market position of a company.

The first of the quartet, Competitive Strategy: Techniques for Analysing Industries and Competitors, outlined his Five Forces model, which analyses structural differences in supply and demand from industry to industry, and thus any given business’ pricing power and profit margin potential.

Porter’s Five Forces – a fundamental part of company research

Source: Michael E. Porter, Competitive Strategy: Techniques for Analysing Industries and Competitors, 1980

Using the Five Forces framework, investors can assess a number of factors to decide whether a firm has pricing power or not. Key questions that should be asked include:

• The bargaining power of buyers. What range of choice do buyers have? How many buyers are there? Are the buyers bigger and stronger than the suppliers? What would the cost be to a buyer of changing a product supply source? How easily can a buyer change supplier?

In this example, think about the pain the big supermarket chains can inflict upon smaller suppliers or how easy it is for a customer to buy luxury goods they desire from more than one supplier.

• The threat of new entrants. What are the barriers to entry? What routes to market are there? What geographical factors are at play?

Here, think about the carnage wreaked in the supermarket industry by the arrival of the new entrants Aldi and Lidl. Conversely, try to find out how many alternative suppliers leading face-cream and beauty providers for certain key oleochemicals, other than the FTSE 100’s Croda.

The arrival of new competition totally changed the outlook for the big supermarkets

Source: Thomson Reuters Datastream

• The threat of technological change. Can fashion and trends work against a supplier? What is the risk of technological obsolescence? Could legislation interfere to erode returns or a competitive position? What alternatives could there be to a product in terms of price and quality?

Think about the market share scrap between Sky, BT, TalkTalk and Virgin for broadband and telephone and TV customers, with the ITV and BBC in the mix – and that is before the arrival of Amazon Prime and Netflix. Eleven years ago the iPhone was just a glint in Steve Job’s eye. And the internet was only just getting going two decades ago. We tend to underestimate the rate of technological change. Will online and fintech firms eat the Big Banks’ lunch?

The UK’s broadband suppliers are locked in a brutal scrap for market share

Source: Thomson Reuters Datastream

• The bargaining power of suppliers. How strong are a supplier’s relationships with its customers? How strong are a supplier’s brands? What is the supplier’s reputation for product excellence and supply reliability? How does a supplier access a market? What geographical reach does it have?

Brands are massive here. Retailers like to sell them as they can attract customers. Companies want to build them as they can differentiate a product and enable them to charge a premium price – Burberry and Diageo’s portfolio of drinks and spirits are a good example here, as is the luxury goods industry overall. The attack on brands posed by the shift to plain packaging on cigarettes is a future challenge for the tobacco giants BAT and Imperial Brands, while last year’s battle between Tesco and Unilever over the price of Marmite was a key test for both firms.

Luxury goods providers have historically generated strong returns for investors

Source: Thomson Reuters Datastream

• Competition within an industry. How many players are there within an industry? How big are they? Is supply fragmented or concentrated? Do suppliers have mainly fixed or variable cost bases? How quickly is the target market growing?

Tobacco is a heavily consolidated industry after a wave of takeover deals and just six firms now dominate over 80% of the market – China National Tobacco, Philip Morris, BAT, Japan Tobacco and Imperial Brands. That is one reason why big tobacco has been a consistent payer of big dividends for a very long time.

Six characteristics

To make it harder for investors, none of these pressures is static – as shown by how companies’ fortunes, profits and share prices ebb and flow.

Brands are a good example. As the old saying goes, they take a long time to build but very little to ruin and even if a company maintains its good reputation it can still be overtaken in terms of price, technology or market share.

The annual BrandZ survey from WPP outlines this. Each year the analysis lists what it thinks are the world’s most 100 valuable brands. A quick glance at the top 20 from 2007 and 2012, and a comparison with the latest result, shows how hard it can be to stay at the top. Investors should bear this in mind when they pay a very high multiple for a stock, as they extrapolate from what they see now and assume it will last for a very long time.

How the identity of leading global brands has changed in just ten years

Source: WPP

The odds are it may not, because if a company is doing really well and generating high margins and high returns on capital then one of three things is likely to happen

1. More competition turns up
2. If that fails, customers rebel and look for a substitute or simply go without
3. If that fails, the regulator or the Government get involved and tackle what they portray as excess profiteering (quasi-monopolies such power, water and telecom utilities are used to this and don’t forget that even that bastion of free-market economics, America, broke up Standard Oil all the way back in 1911).

To see if a firm really has a deep competitive position, a quick summary of Porter suggests investors should be looking for the following:

• Does the company have strong brands?
  
• Does the company provide a product or service that is essential to someone else?
  
• Is there a regulatory driver to a product or service, which means customers and clients have to buy it whether they like it or not?
  
• Does the company provide high quality products and services? In other words does it make things better (which can be sustained with hard work) or does it merely rely on doing things more cheaply (an edge that is harder to keep)?
  
• Does the company have a powerful market share (but one that is not so powerful that it upsets the regulator)?

If you find one or more of these facets, you may have found a good business – one that doesn’t need Buffett’s prayer session after a price increase. Investors must then still assess its financial performance, balance sheet strength, management acumen and valuation to assess its merit as a portfolio pick.

If you don’t find any of these, you may be looking at a commodity business, such as steel, paper, pulp, oil or metals. Cost and price are the key differentiators here and that is why these companies’ profits can swing around so much, taking their share price with them. This is not to say these shares should not be owned at certain stages of the economic cycle. But investors need to be aware of the likely higher volatility, the greater danger of a dividend cut at some stage and the need to pay lower multiples to price in the additional risks.

Russ Mould, AJ Bell Investment Director