Pricing Power

"We like buying businesses with some untapped pricing power. When we bought See's for $25 million, I asked myself, 'If we raised prices by 10 cents per pound, would sales fall off a cliff?' The answer was obviously no. You can determine the strength of a business over time by the amount of agony they go through in raising prices. 

A good example is newspapers. The local daily paper controlled the market and every year they raised the ad rates and circulation prices – it was almost a big yawn. They didn't worry about losing big advertisers like Sears, J.C. Penney or Wal-Mart, or losing subscribers. They increased prices whether the price of newsprint went up or down. 

Now, they agonize over price increases because they worry about driving people to other media. That world has changed." - Warren Buffett at the 2005 Berkshire Hathaway Annual Shareholder Meeting

Collectively, the earnings of the companies in the S&P 500 will be down 30-40% compared to the peak in 2006. As a group, the earnings of the companies in the S&P 500 is slightly down (5-15% depending on estimates) compared to 5 year ago.

It's a different story for those companies that have pricing power.

Consider the following.

We are in a severe recession yet the earnings of KO, PEP, JNJ will still be -- give or take -- basically flat compared to a year ago. No real earnings erosion in an environment like this? A more than slight decline in such an environment would be completely acceptable, yet these businesses are so good that they can still grind out similar earnings year over year. What's possibly a bit underappreciated though is that while the aggregate earnings of the companies in the S&P 500 is down a bit compared to five years ago, all three of these company's earnings this year will be 50% higher compared to five years ago.

This earnings resilience comes from the pricing power of each company's high quality brand portfolio, distribution strength, and the stability of demand for their products.

The earnings of all three should also continue increasing solidly over time.

Great franchises produce above average returns on capital through pricing power.

They are price setters not price takers.

Price setters are those companies that dictate the price its customers pay for goods and services.
Price takers are those companies that cannot dictate their prices. Their prices are dependent on the supply and demand within the market (commodities).

If a business doesn't have pricing power, it consistently has to be the low cost producer in the industry to get above average returns.

Adam

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