Thursday, June 12, 2014

The limits of pricing power

It's human nature to extrapolate the recent past forward. When the stock market has experienced big gains for several years in a row, many people assume-- often subconsciously-- that that's the norm and expect the future to be similar.

As value investors, we know this is wrong: all else equal, if the market has gone up a lot recently then future returns should be lower. Yet many value investors make the same flawed assumption about pricing power. If a business has raised prices above the rate of inflation for many years, they assume that's an inherent feature of the business. In reality, even the best business faces limits in how much it can raise prices. Josh Tarasoff has a great quote about this:

There’s a point where you’ve raised prices aggressively because you have a great market position. There’s only a finite amount of time you can do that because eventually you’re going to run up against the value that you’re giving to your customers. No matter how great your market position is, your product or service has a finite value. Sometimes if you look at a history of large price increases, I think the normal reaction is to say, “Wow, what a great business. They’ve raised prices at 5% for the past 20 years every single year. It’s great.” But the way I think about that is they’ve very aggressively been using up whatever finite amount of pricing power they have and I’m worried that it’s ending.

Tarasoff says that investors should look for latent pricing power rather than a history of price increases:

What’s interesting is that when you look at the history, what you’re not looking for is price increases. What you’re looking for is actually lack of price increases, and that’s what really gives you the very powerful pricing power potential in the future.

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