For those who have followed our Dividend Portfolio letter for a few quarters or more, you’ve probably seen us refer to “pricing power” as one of the key elements we look for in our portfolio companies. In this quarter’s note, we unpack this term, provide some examples for what we’ve seen this year, and attempt to look into the future to see how the cycle may evolve from here.
Pricing power is defined by Investopedia as the “effect of a change in a firm’s product price on the quantity demanded of that product”.
The term is a paraphrased version of an economics concept called “price elasticity of demand”. This tells us a company can have very strong pricing power (price has very little impact on demand) OR very little pricing power (price has a very large impact on demand).
The nature of an inflationary environment like we’ve seen in 2022 means that the cost of products is usually growing at a faster rate than the incomes of consumers. This creates a situation where consumers have to make trade-off decisions about what goods and services they wish to continue to purchase. So, when consumers are put in a pinch and forced to choose, what do they still buy?
In the stock market, firms that have prospered this year generally have had at least one of two traits:
- Their product or service is “non-discretionary”, meaning rather than a luxury that would be nice to have, the product is required for daily life.
- Their product or service is perceived to have very few substitutes of similar quality.
Unpacking the first category, products that are generally considered “Non-discretionary” include those that we use in our everyday life. This can include food and beverages, medicine, energy, shelter, and personal care products. A quick peak at Year-to-date returns for the S&P 500 Consumer Staples (Food, Beverage, and Personal Care), Energy, and HealthCare sectors have handily outpaced the broader market over the last year (CNBC).
The second category of companies listed above references those for which price may impact the amount of the product you buy, but generally you’re unlikely to “trade down” to a competing product. There are a litany of companies that fit this area, but the most common element among them is the power of their Brand. Consider a few examples listed below:
- Coke and Pepsi vs. their competitors
- Disney or Universal vs. other Theme Parks (or attractions in general)
- Apple iPhone vs. other cell phones
- Microsoft Office vs. other operating systems.
- Name Brand Cereal (Lucky Charms, Frosted Flakes etc.) vs. the generic.
- Visa & Mastercard vs. Merchants requiring cash only
Notably, companies can still have strong pricing power when there’s more than 1 dominant product. In fact, academic literature has argued that some of the least price competitive markets are where there are 2 or maybe 3 competitors that control nearly all the market (airplanes, payment processing, soft drinks etc..)
Over the last 18 months, the raw cost of goods for nearly all companies (labor, raw materials, transportation) have skyrocketed. The primary determinant of success this year has been how well companies have been able to pass through these costs to their end-customers.
In our Dividend Strategy, pricing power and cost pass-through are important because we expect our companies to raise dividends each and every year. This means even when costs are rising we need our companies to be able to fund their payouts to shareholders. Even more importantly, we need this cash flow to come from the profits of their business rather than issuing debt to pay dividends. In years such as this not all are up to the task, but this is the role of ongoing research for new potential purchases as well as firms we may liquidate from portfolios.
Where do we go from here?
Our Investment Committee, and a growing number in the Financial Media, believe the likelihood of a recession in the next 12 to 18 months has increased meaningfully. We also believe that inflation should subside and has already begun to come down. That being said, we expect pricing power to remain vital to investing success.
While companies like Chipotle or Coca-Cola aren’t likely to continue increasing prices by 10% a year moving forward, we believe the better question looking ahead is: If we have a recession, which companies can maintain their (now-elevated) prices, and which will be required to cut them?
It is to answer questions like these that we continue to work; turning over investment ideas and companies across the markets in order to find a diversified collection of the highest quality, best managed, and strongest positioned companies to own on behalf of our clients.
If you have any questions about our Dividend Growth Process, market outlook, financial planning, or anything else please let us know. It’s a privilege to serve as your financial advisors.