Pricing Power and Inflation
“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.” – Warren Buffett
With the Consumer Price Index (CPI) hitting 7.5% in January – a 40 year high – inflation is on investors’ minds, and rightly so. Most investors and business operators today have little experience in such environments.
Companies and investors alike have increasingly pointed to “pricing power” to explain how they’re protecting margins in this environment, so it’s important to clarify what that does and doesn’t mean.
First, let’s address what pricing power doesn’t mean. Pricing power doesn’t mean raising prices in an inflationary environment. When consumers expect higher prices on their regular purchases, companies with and without durable competitive advantages can raise prices without much concern for losing business.
Pricing power – the kind we’re interested in as long-term investors – is something different. Riffing on the Buffett quote that started this post, pricing power is the ability to confidently raise prices at times when your competitors need to have a prayer session before they would consider raising theirs.
Most importantly, we want to see companies taking price in a sustainable manner that is respectful of all stakeholders and is focused on long-term value creation. In some scenarios, companies press their competitive position too hard and raise prices on customers to the point where it “mortgages their moat.” We don’t want to own companies that employ that strategy.
We do, however, want to own companies that delight their customers, are reliable long-term partners, play a critical role in their customer’s operations, and otherwise offer tremendous customer value. Companies with these characteristics tend to have little trouble raising prices if they choose to, regardless of the macro environment.
Here’s an example. Less-than-truckload (LTL) carrier Old Dominion Freight Line’s (ODFL) long-standing pricing approach has been to “deliver superior service at a fair price, while also diligently controlling cost.”
ODFL looks at the cost of managing each account and considers its need to reinvest in its network to ensure it can deliver on its promise to the customer for years to come, then it adds a spread.
ODFL’s been able to do this because it offers a superior value proposition. Its customers have come to understand when they put something on an ODFL truck, it gets there on time and isn’t damaged.
By communicating with its customers that in order to continue its superior service it needs to maintain a spread over cost, ODFL has grown revenue per shipment at a 5% annualized growth rate while cost per shipment grew 4% over the period.
Source: ODFL Filings
Historically, this pricing discipline has been rare in the LTL industry. Competitors often used price in response to capacity shortages or oversupply. When there was a lot of spare capacity, competitors dropped prices to bring in more volume. And when capacity was tight, they’d jack up prices to capitalize.
While ODFL’s competitors may have taken temporary share by dropping prices, the long-term results are miles apart. As the chart below illustrates, over the last 16 years, the LTL industry’s revenue per shipment grew at just 1.7% annualized versus ODFL’s “slow but steady” approach growing at 5% annualized.
Source: ODFL Filings, Bloomberg. Indexed to 2005 = 100
ODFL’s superior outcome was possible because of its superior value proposition. It stayed focused on the long-term opportunity of building out an extensive network of service centers and delivering goods with exceptional quality standards. Over years and decades of consistent performance, both shippers and receivers of the goods came to understand ODFL’s value proposition and saw the company as a vital part of their own operations.
That’s pricing power.
Some of our strategy holdings, such as Mastercard, Landstar, and First American Financial, charge a percentage of transaction values as part of their revenue stream. So as prices for goods and services, trucking, and houses rise, so does the revenue for these companies. Other companies, such as Costco and Fastenal, help their customers solve for higher inflation by reducing overall costs by sharing their scale advantages. This, in turn, attracts more traffic to their businesses.
We’ve been asked recently how our companies will manage through this period of high inflation – however temporary it might be. And while high inflation, all else equal, is a headwind for security valuations, we can say with confidence that from an underlying business perspective, our competitively advantaged companies can manage through it.
The fact that many of them are raising prices today to offset higher input costs doesn’t tell us much about their “pricing power” across a business cycle. We’re more focused on the value the business will create for all stakeholders over the next ten years and beyond. As long as our companies continue to deliver superior customer value propositions, we have no concerns about their pricing power or ability to manage through challenging economic times.
For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.
While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.
Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. The opinions expressed within this blog post are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. All opinions are subject to change without notice and due to changes in the market or economic conditions may not necessarily come to pass. Nothing contained herein should be construed as a comprehensive statement of the matters discussed, considered investment, financial, legal, or tax advice, or a recommendation to buy or sell any securities, and no investment decision should be made based solely on any information provided herein. Links to third party content are included for convenience only, we do not endorse, sponsor, or recommend any of the third parties or their websites and do not guarantee the adequacy of information contained within their websites. Please follow the link above for additional disclosure information.