Pricing Power Lends into Concentration – Series 2

In an unpredictable world, one constant challenge that companies grapple with is the consequence of rising commodity or raw material prices on their profit margins. Whether it’s the cost of metals, agricultural goods, or other essential raw materials, fluctuations in costs can place strain on a company’s financial health and margins, making it harder to maintain profitability.

In the fallout of the 2008 financial crisis, Warren Buffett famously told the inquiry commission, “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.”

But what exactly is pricing power and why do we as investors consider it imperative?

Pricing power is not merely about charging high prices for goods or services. Rather, it epitomizes the equilibrium between value creation and perceived worth. Businesses with strong pricing power possess the capacity to adjust prices in response to market conditions, consumer preferences, or changes in input costs – without significant loss of demand.

Managing the impact of rising commodity costs requires a delicate balancing act. On one hand, they must absorb some of the increased costs to remain competitive and retain customers. On the other hand, passing on the entire burden to consumers risks pricing them out of the market and dampening demand

An illustrative display of pricing power that comes to mind would be Asian Paints. Over the last decade, while the paints industry grew at a ~7% compounded rate, Asian Paints grew their sales at ~12%. Their perceived premium category combined with sticky distribution reach, aided in their growth and ability to maintain margins.

Fig: Asian Paints has maintained Gross Margins despite crude price fluctuations

Over the last 12-year period, crude oil, a key commodity used in the manufacture of paints, has fluctuated between $45/barrel to $115/barrel. Despite the same, Asian Paints has been able to maintain their gross margins by passing costs to a consumer. Furthermore, when the business expanded while maintaining gross margins, it lends itself to operating leverage as costs scale at a slower pace than topline growth.

Fig: Asian Paints grew EBITDA margins in the last 12Y period

While pricing power can be a potent asset, it is not immune to erosion. Changes in consumption pattern or competitive intensity can undermine even the strongest of pricing strategies. As Jeff Bezos aptly expressed, “There are two kinds of companies – those that work to try to charge more and those that work to charge less. We will be the second.”

To strengthen their pricing power, organizations must constantly innovate and invest in brand development to give them an edge over their peers. Characteristics of a business that lends itself to pricing power can differ. For example – Nestle or Coca-Cola maintain customer loyalty and pricing power through their robust brand recognition. Or businesses offering unique, differentiated products can command prices due to the perceived value-add. Technology firms like Adobe would fit this bucket well.

How Pricing Power helps to concentration?

So far, we have determined that businesses with pricing power have the ability to maintain margins even during a downturn, where external factors may affect growth. But this extends us to question, how can we use the ability to pick these businesses, ultimately to generate returns leading to concentration.

Investing in industry leaders who have demonstrated the capacity to sustain margins during a downturn, should have the ability to grow margins and consequently generate returns, all the while protecting downside (measurable through drawdowns) lower or comparable to the most reliable benchmark we could index ourselves to—Nifty.

To illustrate this, let us look at three businesses in distinct industries and their corresponding business cycles. In each case – given their strong positioning and pricing power, HUL, Pidilite, and Page Industries were able to sustain their margins during times when their peers were having difficulty. It is interesting to note that these businesses expanded their margins, at a time their respective industries recovered.

Fig: EBITDA Margin expansion during an upward business-cycle

Fig: Cumulative Returns and Drawdowns compared to the benchmark (Nifty)

Additionally, the margin expansion led to significantly higher returns than the benchmark over the same period, while drawdowns were on average were lower than Nifty – already among the best of indices at protecting downside. Over time, these businesses would their return on capital, leading to higher re-investments into the company.

It is crucial to emphasize that owning businesses during the times when the corresponding industry cycles are favourable to growth is equally as significant as investing in companies with indications of pricing power. During the given industry cycles, as these companies continue to compound at higher return than the benchmark or industry peers, this would often lead to growing market share for the businesses and concentrated positions within our portfolios.

One key learning from Charlie Munger and Berkshire, is that concentration over time builds wealth. “The big money is not in the buying and selling, but in the waiting.”

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