SIMON BROWN: Margins: the key rules of pricing power

The ability to raise prices is important to all businesses, not just to keep up with inflation but also to improve profit margins. Few businesses have real pricing power, but when they do, it’s a magical thing for both the business and investors.

Let’s start with those that have very little or even backward pricing power: food retailers. A tin of beans is the same everywhere you go, so raising the price above your competitors will just lose you sales. Instead, you put pressure on the supplier of the beans, getting them to drop the price you pay. You charge the customer the same, but it’s at higher profits. This is why I don’t like food producers as a rule — they have no pricing power and are always being squeezed.

Clothing is different, because you can always claim your T-shirt is better, hence more expensive. But that’s not real power. It’s more marketing trickery.

A business with a locked-in client has some pricing power if the switching costs are high. I’ve written before about switching costs, as customers will stay — but only within reason. The recent outage at cybersecurity company CrowdStrike* will serve as a great test case for this example.

One area of pricing power is where demand outstrips supply, such as we’re seeing with AI chips from Nvidia*. But can this last forever? Nvidia certainly has the tech, but it needs to keep innovating, as the competition is always trying to catch up. So this pricing power is more likely for a limited period, even if that is measured in years or even decades.

Short-term insurers have strong pricing power. Every few years some natural disaster such as floods or fires cripples profits. But the following year these insurers just re-price the risk and increase everybody’s rates. Sure, you can try to switch to another insurer, but it has likely also increased rates, so you’ve got nowhere to go. This is important to remember, as the sell-off on poor results often offers opportunity.

Real luxury has great pricing power, as we see with Ferrari, and pharmaceuticals is another sector — until the patent of a product expires.

The best pricing power is where you have no competitors. But if it’s a profitable sector competition will certainly come in time, as the JSE has seen with the introduction of new exchanges offering cheaper transactions.

This brings me to legislative pricing power. For example, the SABC used to enjoy a monopoly, thanks to legislation (as did the JSE in years past). But here again, that’s not likely to last, and often it’s just more of a moat, such as in the case of banking. Anybody can apply for a banking licence, but they’re handed out cautiously.

Pricing power matters and is great, but truthfully, few have it and often today’s pricing power may fade in time. So investors need to keep a close eye on those margins to spot when it starts to fade.

The writer holds shares in Nvidia & CrowdStrike