Like other important concepts in business and investing, the term “pricing power” is often-used, but less well understood. Speaking to the Financial Crisis Inquiry Commission in February 2011, Warren Buffett stated that “The single most important decision in evaluating a business is pricing power.” According to Buffett, “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.” In search of more insights into the concept of pricing power, I had the pleasure of speaking to Josh Tarasoff, general partner of Greenlea Lane Capital Partners.
My conversation with Josh Tarasoff revealed many insights into the concept of pricing power: the different kinds of pricing power, the necessary and sufficient conditions for a business to have pricing power, how not to look for pricing power, and of course, how to generate investment ideas based on the concept of pricing power. Throughout the conversation, which is available in full in The Manual of Ideas Members Area, Josh Tarasoff managed to combine an intellectual mastery of the concept of pricing power with an exceptional ability to relate the theory to investing practice. I’m pleased to share below an excerpt from my conversation with Josh Tarasoff and trust that you will find his insights on the subject as illuminating as I have found them to be.
Josh Tarasoff on Pricing Power
Says Josh Tarasoff:
“Pricing power, like the term “great business,” is a term that’s used a lot but very seldomly defined. There are different kinds of pricing power, just like there are different kinds of great businesses. And it’s so important to think carefully about it. For example, I think I mentioned Dun & Bradstreet [DNB] before, and I shouldn’t pick on a particular company, but I actually have an investment in that space, which is why it’s on my mind.
There’s a point where you’ve raised prices aggressively because you have a great market position. There’s only a finite amount of time you can do that because eventually you’re going to run up against the value that you’re giving to your customers. No matter how great your market position is, your product or service has a finite value. Sometimes if you look at a history of large price increases, I think the normal reaction is to say, “Wow, what a great business. They’ve raised prices at 5% for the past 20 years every single year. It’s great.” But the way I think about that is they’ve very aggressively been using up whatever finite amount of pricing power they have and I’m worried that it’s ending.
My biggest investment mistake was a company called Ambassadors Group [EPAX]. I made a lot of mistakes in that investment thesis, and only one of them was that it had overpriced its product in the marketplace. I looked back and I saw that it was actually raising prices at double-digit rates over the past five years when I made the investment. And it was a great product and all that. But what I did not recognize is that their overpricing their product was exacerbating problems that they later had. So, now when I think about pricing power, I think of it very differently.
Let’s just go back to the fundamental idea of pricing power. There’s nominal pricing power, and then there’s real pricing power. Nominal pricing power we can define as the ability to raise your prices with your cost inflation to offset your cost inflation. Even that is often talked about as a key strength; this company can offset cost inflation. If you can do that in real-time as opposed to on a lag basis, that’s much better. Overall, if that’s all you can do, that’s good, but it’s not that great because if you can’t do that, you’re in a really bad position. It’s hard to imagine how your business is attractive if you can’t offset your cost inflation. So, it’s almost just a prerequisite; it’s not this great thing. It’s a prerequisite, and it’s not something that I get really excited about.
But real pricing power is different. Real pricing power we can define as the ability to raise prices in excess of your cost inflation. You’re taking a little bit more of the earning power of your customer every year, and that is very powerful and valuable because it results in margin expansion. The math of that is very compelling. If you have 5% operating margins and you raise prices by 1% in excess of your cost inflation, that 1% is 20% of 5%. So, you’re taking only 1% of your customer’s earning power extra, but you’re increasing your operating income by 20%. That’s really, really great. Ironically, the best situations actually have big real pricing power and low margins, so that has implications for when you look at things.
So, real pricing power is very powerful, but it’s very rare and very unusual. Why is it unusual? Well, it’s because I think companies are pretty good at taking what they can get for their products. Over a long period of time, they sort of figure out how to extract from their customers what they can get and no more and no less. It’s a competitive product market, and the existence of underpriced products might be considered inefficiency. Just like in the securities markets, there are inefficiencies, but they’re not the norm. But they exist.
One interesting thing to do is to look for where there might be inefficiencies in product markets with respect to the pricing of products like you do look for inefficiencies in securities markets. You might look for a company that has been actually a non-profit organization for a lot of its history. A non-profit organization doesn’t have a profit motive in a traditional sense. So maybe it hasn’t sought to extract all the revenue it can extract.
A good example of that is a company called Verisk Analytics [VRSK], which began as an insurance cooperative pooling data for insurance companies. This is going back a long time ago into the early 1900s. Insurance companies would pool their data for the purpose of a better actuarial analysis, and they would collectively own the cooperative. Verisk existed in that form until it converted to a for-profit, I think, in the late ’90s, and then it went public. I think it converted to a for-profit corporation in 1997. It’s funny; in that conversion, the employees took 15% of the company. They took 15% of the equity. Some of the members, the owners, who are the big P&C insurance companies were really against it, but eventually they relented because they were worried about their reliance on this organization. They didn’t want to create acrimony with this newly independent organization, which is just a very good indication of the power this organization has.
Verisk went public a couple of years ago, and if you look at the gap between the price and value, it’s enormous. Their estimate is that for their most value added products, the return on investment of their customers is 30x; and for the least value added products, it’s 5x. That’s that gap between price and value of a product and service that is indicative of pricing power. What’s interesting is that when you look at the history, what you’re not looking for is price increases. What you’re looking for is actually lack of price increases, and that’s what really gives you the very powerful pricing power potential in the future.
Another example is railroads. Real rates in the railroad industry declined by about half since deregulation. And then the industry consolidated and in 2004 they started to raise rates. That was a great moment for the railroad industry. If you looked at the history, you were actually seeing real rates declining for a long period of time. So, I think that’s what you really want to look for when you’re looking for pricing power.”