Only One Thing Matters When Investing in a Company

That you must identify good businesses and invest in them for the long term to become a successful investor is what we discussed yesterday.

The most obvious question you might have now is – “How do I know which businesses are good?”

Well, there are several rules that successful investors like Warren Buffett follow to separate good businesses from the bad ones.

But the one rule that stands tall amongst them is…a company’s ability to increase prices rather easily without fear of significant loss of either market share or volume sales.

Let’s understand this with an example.

Assume a Company A, which sells 100 bottles of hair oil for Rs 100 each, and has a market share of 50%. The market for hair oil is very competitive and there are several companies selling similar type of oil.

Now, if Company A were to raise the price of its hair oil to say Rs 120, consumers will automatically shift to buying the product from a competitor who’s still selling the oil at Rs 100.

What this means is that just because Company A has raised its prices by 20%, its volume sales (number of bottles sold) will drop as less number of consumers will buy from it and most will shift to competitors.

This will subsequently reflect on its market share, which will also come down if it were to maintain a high price of Rs 120 per bottle.

Note that the decision to raise price to Rs 120 could have been driven by any factor – like rise in the company’s raw material costs, or an increase in general production costs. But consumers aren’t bothered about that.

Their decision to shift to competitors is purely driven by price.

What this means is that Company A doesn’t have a ‘pricing power’ – or the power to raise prices without negatively impacting its market share and volume sales.

We see something similar like this in the Indian telecom space, where companies were recently fighting a price war just to grow their volume and thus their market share.

However, since all telecom companies cut their prices, no one was better-off.

Why so much hoo-haa about pricing power?
Buffett, the world’s most successful investor ever, says that he rates businesses on their ability to raise prices and sometimes doesn’t even consider the people in charge.

He says…

“The single most important decision in evaluating a business is pricing power. 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 10 percent, then you’ve got a terrible business.”

Why is Buffett so gung-go about companies that have the pricing power?

This is simply because without pricing power, a company isn’t in charge of its business. Its competitors are.

And why should you buy the stock of a company that is not in charge of its own business, and its own future?

On the other hand, a company that can afford to sell its products even after increasing its pricing, and in a competitive market, is a company totally in charge of its business.

Whenever it finds the need to raise prices, it is easily able to do that without hurting sales and market share.

Now the question you may have is…

“Where do I find companies that have the pricing power?”
Well, it’s difficult to find companies with pricing power in the fast-growing and thus highly-competitive Indian market. But a few opportunities still exist.

Without naming any company, let me say that you can look at a company (or companies) whose products you like a lot and find that there’s no other company that makes such products.

The product should also be such for which you’ll be willing to pay up even if the company were to raise its price.

A hint: You might find such companies in the FMCG, pharma, newspaper, toll roads, premium retail, and branded food retail spaces, but never in telecom, banking, automobile, metals and real estate. 🙂

So the tip of the day is: Before buying a stock, raise these questions with the company’s management:

1. Do you command a leadership position in your industry?
2. Does this give you the flexibility to raise product prices?
3. If you raise prices, do you risk losing market share?
4. Do you have to have a prayer session before raising your prices?

A ‘Yes’ to the first two questions and ‘No’ to the next two would mean that you’ve struck upon a brilliant business opportunity.

And if such a stock is available for cheap in the stock markets, it would make for a brilliant investment opportunity.

Just grab it with both hands. You’ve struck gold!