With several companies announcing price increases in their recent earnings reports, one could be forgiven for thinking that many companies have pricing power. However, real pricing power goes beyond simply raising prices – not all companies can raise prices without eroding demand.
To determine pricing power, we generally focus on companies with high and stable gross margins, but we also consider several macroeconomic factors. Porter’s five forces can be a useful guide in this analysis. Each force below serves as a guideline for assessing an industry’s competitive dynamics and ultimately determining its potential pricing power.
1. Competitive Rivalry: Using sports as an analogy, the key questions here are: how many teams are in the league, and how many of them can actually compete with the strongest franchise? If the answers are both “a lot”, it is safe to assume that it will be more difficult to win the championship. Similarly, an industry’s ultimate pricing power is limited when there are a large number of competitors, as firms compete for market share by lowering prices. Conversely, an industry made up of a small number of firms with a competitive advantage will produce higher pricing power.
2. Authorization of the supplier: In the traditional sense, supplier power relates to the ease with which a firm’s suppliers can raise their prices. Generally, if suppliers offer a unique product that is hard to find elsewhere, they have a better ability to raise prices. In a broader sense, supplier power can be linked to pressure on input costs. For example, in a tight labor market, labor suppliers have more bargaining power, and price increases may be offset by higher wages in labor-intensive industries.
3. Purchasing power: The power of the buyer is the reverse of the power of the supplier. If there are only a few buyers and the purchasing power is high, a company must be cautious not to lose them. This effectively reduces a firm’s pricing power. When there is a large pool of potential customers, a business generally has more leeway to raise prices, or even price discriminate.
4. Threat of Substitution: The ability to substitute one product for another is an indicator of the elasticity of demand for a product. Inelastic demand indicates that consumer demand is less sensitive to price. Products that have few substitutes have relatively less elastic demand. Branding can help protect against the threat of substitution, at least partially. Some products have multiple substitutes, but a strong brand image or higher quality product can evoke brand loyalty, making consumers more loyal and pricing power higher.
5. Threat of new market entrants: The term “natural monopoly” is used to describe companies or industries that benefit from an “economic gap”. This means that barriers to entry lead to high start-up costs, which makes it extremely difficult for new competitors to enter. Companies that operate in industries with high barriers to entry tend to enjoy higher pricing power, but there are exceptions. For example, regulations may exist to prevent natural monopolies from price-gouging.
There is no universally accepted or perfect way to quantify these five forces, but they are important to consider in today’s economy. There are, however, a few notable risks that investors should be aware of. First, companies with a high market share risk being subject to antitrust scrutiny, especially when inflation is high. Second, and perhaps most relevant given current market conditions, is the stock list’s natural underweight to energy companies. Subject to the dynamics of global supply and demand, energy companies generally lack pricing power as we define it. This sector underweight has detracted from relative performance so far this year. Nonetheless, we believe that companies with pricing power have an advantage in this market environment and should be better able to protect their margins as volatility persists.
Main Contributor – Michelle Laliberte
The content is a product of the Chief Investment Office (CIO).
Read the original blog – Pricing power: it’s not all about priceMay 12, 2022.