There is one Buffett quote I think is more important than all the rest.
Back in 2010, two years after the financial world had crumbled into ash and dust, Warren Buffett was hauled before the U.S. Financial Crisis Inquiry Commission.
Buffett was there to answer questions on the causes of the crisis and the role played by ratings agencies, especially Moody’s which he owned (and still owns today) through his company Berkshire Hathaway.
Asked by the Commission what kind of due diligence Buffett had done before buying shares in Moody’s, Buffett replied (emphasis added):
“I never met with anyone… 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.”
Although it’s brilliantly simple I think pricing power is still commonly overlooked.
The ability to raise prices without losing customers can fiercely accelerate earnings growth and is a symptom of a significant competitive advantage somewhere in the business.
Imagine a hypothetical company that has $100m in revenue and reports $10m in profit. If the company can lift prices and increase revenue by just 1% ($1m) with no loss of customers (and no increase to costs), margins would rise and profit would grow by 10%.
This can be almost impossible to achieve for cost focused commodity producers like Santos Ltd (ASX: STO) and BHP Billiton Limited (ASX: BHP), or companies operating in highly competitive markets like insurer QBE Insurance (ASX: QBE).
Companies with pricing power seem to defy economic gravity. In dry academic terms we usually expect returns to diminish towards the cost of capital as a company grows over time. Customers don’t like to pay more, so competition floods in to steal market share and force prices down.
Pricing power allows a business to reinvest capital at the same or increasing rates of return, accelerating compounding, which is incredibly powerful.
One of my favorite examples of this is CSL Limited (ASX: CSL). In the company’s 2016 Annual Report CSL boasted compounded annual returns of 27.6% since 1994 meaning $1,000 invested on listing would have been worth $217,039 at 30 June 2016. A spectacular outcome.
How to make Buffett’s rule work for you:
To make Buffett’s rule work for you, start by looking for companies with significant competitive advantages like niche market positions, or products with few close substitutes.
Keep pricing power a priority in your investment process and review the companies you own regularly to ensure they don’t lose their edge.
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You can follow him on Twitter @Regan_Invests.
The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.