There is an easy starting point if you want to invest like Warren Buffett: dedicate a large part of your time finding companies with exceptional pricing power.
In Buffett’s own words “the single most important decision in evaluating a business is pricing power”.
This is because companies that can raise prices without losing customers can grow at increasing returns and rapidly compound wealth.
So let’s look at three companies I rate as having exceptional pricing power.
CSL Limited (ASX: CSL)
Specialty blood product company CSL Limited gains its pricing power largely through the ownership of intellectual property over its superior research and development.
Intellectual property rights protect the company’s high margins from competing products and also generate revenue from royalties and licencing to other companies. This contributes to CSL’s almost 50% return on equity, which it has held consistently for the last few years.
Xero Limited (ASX: XRO)
Xero’s cloud accounting platform links small businesses to its key bank partners, customers and accountants, quickly setting the support structure of a small business’s operations.
Switching to a competitor becomes an unpleasant prospect, so price increases can be pushed through with less risk of customer churn.
In 2015 and 2016 Xero rolled out increased pricing for many of its subscription plans as the platform evolved. Since then Xero has continued to grow customers rapidly, while the churn rate of revenue between 2016 and 2017 decreased from 1.2% in 2016 to 1.15% in 2017.
SEEK Limited (ASX: SEK)
The pricing power held by Seek comes from the self-reinforcing ‘network effect’ where the value of the service grows as more people come together to use it.
Once a company becomes a known market place for a particular product, or in Seek’s case a service like advertising job vacancies, it can be incredibly hard for new competitors to steal customers and prices can be raised with surprising ease.
It is important to remember that pricing power is always at risk of erosion so must be reviewed constantly. Xero for example may get out-competed by a rival over time, or Seek may come under pressure from the Linkedin if it starts to achieve critical mass.
However if you really want to build and compound your wealth, start by putting companies with strong pricing power at the top of your investment list.
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The Motley Fool Australia owns shares of Xero. The Motley Fool Australia has recommended SEEK Limited. 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.
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