Yesterday I wrote about the importance of return on equity as a key principle of Warren Buffett's investing strategy.
I listed 6 stocks which have high returns on equity, strong earnings growth, and no debt.
Building on from this, another key Buffett principle and one sign of a competitive advantage is pricing power. A business that is able to increase its prices faster than its costs can be very rewarding for investors.
Buffett has said:
"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 10 percent, then you've got a terrible business."
Of the six stocks I discussed yesterday, two stand out as having pricing power: Sirtex Medical Limited (ASX: SRX) and REA Group Limited (ASX: REA).
Sirtex sells an innovative liver cancer therapy product – clearly essential to those who need it.
Pricing power in relation to healthcare stocks can be controversial as we saw last year when the US company Turing Pharmaceuticals increased the price of one of its products by 50 times.
While most investors are not likely to want to invest in a healthcare company with exploitative pricing, a well-run healthcare company with a quality product can adopt pricing that covers the costs of its research, funds future growth, and generates a sufficient return for investors.
Two other healthcare success stories – Cochlear Limited (ASX: COH) and CSL Limited (ASX: CSL), have enjoyed pricing power for similar reasons.
REA Group has been able to increase its prices over the years while still growing customer numbers thanks to the effect of its powerful network.
The cost of using REA Group's websites still represents a small portion of the total costs involved in selling a house and is seen by many as necessary to reach the largest audience of potential buyers.
REA Group would have to increase its prices considerably in order to face a mass exodus of customers to its key competitors.
Similarly, SEEK Limited (ASX: SEK) and Carsales.Com Ltd (ASX: CAR) enjoy pricing power as a result of their powerful networks.
Who else has pricing power?
Any business which controls a monopoly asset will usually have a large amount of pricing power. This is why Buffett has said his favourite type of investment is a toll bridge style business.
An example is ASX Ltd (ASX: ASX) which operates Australia's primary stock exchange and has significant pricing power in relation to listing fees as a result. However, this could all change in the future if technology like blockchain disrupts the industry.
Similarly, Sydney Airport Holdings Ltd (ASX: SYD) and Transurban Group (ASX: TCL) are highly profitable due to the pricing power that comes from their monopoly style assets.
XERO FPO NZX (ASX: XRO) is one newer company which appears to be developing pricing power.
Xero provides cloud accounting software which is central to the operations of many small businesses. It is currently on track to hit 1 million customers by next year.
With businesses paying an average of around $30 a month, it remains a relatively small expense for them considering how integral it is to their operations.
Once a business is reliant on the Xero platform it is unlikely to go through the process of changing to a competitor in order to save what may amount to $10 a month. This means Xero is likely to be able to increase its prices faster than inflation for the next few years with few complaints.
Foolish takeaway
Pricing power is an important concept which has been central to Warren Buffett's investing success. It is clearly worth considering when deciding which companies to invest in.
