Late last year Steve Hou, PhD, of Bloomberg Indices, released a white paper on the significance of pricing power. You can find the link to it here. Being an aficionado of the stuff, I enjoyed the paper greatly. Some of the takeaways were informative and even novel for me. While I whole-heartedly agree with the premise and research provided in the paper, I do have a slight issue with the practical implications. More on that later.
Premise:
With inflation rising to the highest levels in four decades the concept of pricing power has once again become top of mind for investors. Pricing power or a company’s ability to raise prices and maintain profit margins amidst increasing costs or competition is one of the most important dimensions for evaluating the value of a business. Yet, a simple and robust measure for pricing power remains elusive. In this article, we propose such a measure for capturing corporate pricing power.
Despite the frequency of these mentions, many struggle to provide a clear definition for the concept of pricing power, let alone an easy way to measure it. In this article, we present a straightforward framework to capture pricing power. We argue that the stability of gross profit margins is a simple and robust metric for identifying companies with the ability to raise prices.
The premise that the stability (or the positive expansion) of gross margins is a proxy for pricing power is not a new idea. The first place I came across this idea was a talk given by Richard H. Lawrence in 2015, where he proposed that the most appropriate metric in identifying pricing power was the Cash Gross Profit Margin. He also proposed that this metric should have low variability - or stability as Hou mentions.
This assumption, irrespective of how original it is, is intellectually sound. Naturally, in an inflationary environment, the first place a company will see increasing costs is in its inputs, hence a degradation in Gross Margins will indicate that a company does not have the ability to pass those costs along to customers. The very best position to be in, however, is to have a fixed asset and/or cost base with relatively few (if any) input costs, and in such a scenario a company can experience expanding margins with the addition of more business.
As an aside, it appears that the research done by Hou found little variation in results between the use of Gross and Operating Margins as metric to measure pricing power. I find this a little surprising. It isn’t all that common, but I can think of a couple of notable exceptions of firms that have had declining Gross Margins and expanding Operating Margins (Alphabet for a time). In any event, my preference is for both to be expanding.
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