Warren Buffett has a lot of great quotes. Like, a lot!
But one quote in particular has had a strong influence on the way I invest and evaluate businesses:
“Basically, the single-most-important decision in evaluating a business is pricing power”
It is an incredibly powerful quote when thinking about putting your money to work.
The quote also has fascinating origins. It didn’t come from an annual letter to shareholders. It didn’t come from an investor meeting. Instead, it came during Buffett’s 2010 interview with the Financial Crisis Inquiry Commission, which was investigating the causes of the financial crisis on behalf of the US Congress.
Buffett was discussing his investment in ratings agency Moody’s and went on to describe the role pricing power plays in his investing decisions:
“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 a tenth of a cent, then you’ve got a terrible business.”
The secret of pricing power
Some of the best performing companies listed on the S&P/ASX 200 (INDEXASX: XJO) have pricing power embedded into their business models. Companies like CSL Limited (ASX: CSL), Xero Limited (ASX: XRO) and Altium Limited (ASX: ALU) all have the ability to increase pricing with low risk of losing customers.
The true secret of pricing power is that it is a symptom of an underlying competitive advantage. A competitive advantage is what keeps customers using the company’s product even when the price rises. For example the cost, in terms of time and effort, for a company to switch from accounting platform Xero to a competitor is likely to be far more than a small annual price increase.
Companies with pricing power can more easily offset their own rising costs, can operate at higher margins and potentially compound returns at a higher rate than other companies. This can provide a powerful buffer from new competition.
Another extremely valuable competitive advantage is a low-cost advantage over competitors. Either way, I use Buffett’s quote as a valuable sense check before I add any new company to my portfolio.
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Regan Pearson owns shares of Xero.
You can follow him on Twitter @Regan_Invests.
The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of CSL Ltd. The Motley Fool Australia owns shares of Altium and Xero. 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.