Pricing Power

1 · Why raising a price is different from every other way to make money

Most ways to grow a business require selling more. More volume usually means winning customers from a competitor or finding new ones, which takes selling, time, and often a lower price to compete. Raising the price, however, needs no new customers. It only requires that the customers you already have cannot or will not easily leave.

Where the extra unit costs almost nothing to produce, as with software, data, or a required standard, nearly all of any increase reaches profit, and the temptation is strongest.

Management has to balance using this pricing power, which rewards shareholders, with keeping it. If prices rise too fast or too far and draw attention to the position, customers, regulators, suppliers, or competitors start to push against it. If pricing power is never used, investors may push for new management.

2 · Earned advantages and granted ones

A granted advantage can look stronger than an earned one for years, because it produces the same high returns without the business having to keep earning them. It also depends on someone else continuing to agree, which an earned advantage does not.

3 · The years the numbers look best

Picture a business whose product is required at a checkpoint everyone has to pass. It raises the price many times over in a few years while the product stays about the same. Almost all of each increase lands in operating income. Margins rise, returns on capital rise, and earnings per share rise faster still because the extra cash buys back stock.

Every number an investor is taught to watch gets better at the same time. The financial statements do not warn you, because from the inside nothing has gone wrong. The business is doing exactly what it did last year, at a higher price.

4 · When customers push back

In the 1870s, a wheat farmer in Illinois or Iowa usually had one way to get his crop to market, and that was the railroad running past his land. There was no second line and often no river nearby. The railroads knew it and set their rates to match. A farmer on a single line could pay more to ship his grain a short distance than a shipper in a city with several railroads paid to ship much farther.

One farmer could do nothing about it. But thousands of them were paying the same high rates for the same reason, and that gave them something to organize around. Many joined the Grange, a farmers’ association that grew quickly in those years, and took their complaint to their state legislatures. Several states passed laws limiting what railroads could charge. In 1887 Congress passed the Interstate Commerce Act, which put railroad rates under federal oversight for the first time.

Nothing about the trains had gotten worse. The railroads had charged enough, for long enough, that farmers who had never agreed on much found a reason to act together.

The same thing can happen to a business today. When customers have no alternative and prices keep rising, they start comparing notes, and competitors, middlemen, and regulators all find reasons to take their side. The rule protecting the business is rarely repealed outright. More often, whoever controls it makes the alternative easier or cheaper to choose, and the protection fades. The faster prices rise, the sooner that happens.

5 · What the company would say

A company that raises prices this way usually has a real defense. Its product may be better than the alternative. It may keep only a small part of what the customer finally pays, with most of the cost added by others along the way. Some of its loudest critics may have interests of their own. Even if every one of those points is right, the result is the same: prices that rise this fast give the people who can change the rule a reason to change it.

6 · Businesses that lower prices instead

Nick Sleep, a British fund manager legendary among a small group of value investors, ran a concentrated investment partnership for more than a decade and looked for companies that did the opposite of flexing their pricing power. He found companies that grew their competitive advantage, their “moat,” by growing larger and cheaper to run while passing the savings to customers as lower prices. That held margins, and the other measures investors watch, down for a while, but it made those businesses harder to compete with every year.

Customers whose prices keep falling do not organize against the company. Nobody writes to a legislator about a bill that keeps getting smaller. Keeping the savings as profit produces better numbers now and more opposition later, and the choice management makes tells you if it is running the business for this year or for the long run. Evaluating Management covers how to read that choice.

7 · What to watch

8 · The investor’s mistake

A high valuation on a business with real pricing power is often deserved. Many of the businesses the market has called compounders earned their premiums for years. The mistake is assuming the price increases that produced those years can keep coming at the same pace.

Investors are part of the pressure on management. They reward it for raising prices, bid the shares up as each increase arrives, and then pay a valuation that only works if the increases continue. If the response comes, the valuation can fall much further than the business does, because the price had already paid for years of increases that may not happen.

The Direction of a Moat asks if a moat is getting stronger or weaker. Here the moat looks stronger than ever while it is being used up.

Where this lands

Pricing power is worth a great deal, and using it has to be balanced against keeping it. A business that raises prices in step with what it gives customers can keep doing so for a long time. A business that raises them faster can report excellent results for years while shortening its own runway, and the financial statements will look the same in both cases. What tells them apart is where the advantage came from, who could take it away, and how quickly the price increases are giving someone a reason to.