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Warren Buffett and Pricing Power

February 19, 2011 | About:
Josh Zachariah

Josh Zachariah

38 followers
Warren Buffett was quoted as saying in his testimony to the Financial Crisis Commission that “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"…. and also "The extraordinary business does not require good management. ”

This should come as no surprise.

Buffett loves firms with pricing power and specifically ones with the market power that enables pricing power. Though he neglected to say Moody’s (MCO) operates in an oligopoly which also makes its very attractive. Coca-Cola also operates in a duopoly with Pepsi (PEP) and this provides an valuable “moat” around the business.

What does come as a surprise is the history of Coca-Cola (KO) pricing. You’d think a brand such as Coke operating in a duopoly with Pepsi to be consistently raising prices, but this couldn’t be farther from the truth. Prices for a 6.5 oz of coke remained stable at a nominal price of 5 cents from the years 1886 to 1959. From then on to today, the price for a Coke has trailed the rate of inflation. This seems paradoxical as you’d think of such a prominent brand as Coke to exceed the rate of inflation.

This phenomenon is reiterated in the price elasticity of demand of Coke. This is a measure of change in demand resulting from a change in price. As the link will show Coke’s elasticity of demand is -3.8 which means a price increase of 2% would result in a decrease in demand of 7.6%. By contrast the general soft drink market is between -.8 and -1 which would indicate consumers will not reduce consumption nearly as much for a similar percentage price increase. This point should be clarified by the fact that Coke commands a much higher price than unbranded colas. Thus a 2% increase in Coke would be a several percentage point hike in an unbranded cola. But it remains that Coke does not have the ability to simply raise prices without losing customers.

What Coke does have going for it, is its significant mark-up to their unbranded rivals. And assuming a similar cost structure, even though Coke may very well have a much better one than its rivals, Coke will also have much larger margins (its latest net margin has exceeded 20%). When Pepsi was first released in 1934, they offered a 12 oz bottle for the same price as Coke’s 6.5 oz bottle. Clearly a premium existed in Coke even during its stagnant price period.

The margins also serve as a buffer. If sugar prices were to rise, the unbranded colas which have much more narrow margins would have to increase their prices at a much higher percentage than Coke would need to in order to sustain the previous margins. Coke also has the option of simply riding out cost pressures while their competitors will likely have to raise prices or watch profits (and possibility the business) disintegrate. This seems to be the strategy most consistent with Coke’s pricing history.

Josh Zachariah

About the author:

Josh Zachariah
I credit my father and Warren Buffett for molding me into the investor I am today.

Rating: 3.9/5 (19 votes)

Comments

htyen1
Htyen1 - 3 years ago


warren knows what he is talking about, i just recently read "how might warren buffett invest in real estate?" his ways not only works for stocks but also real estate!
grandpagates
Grandpagates - 3 years ago


I would like to switch the topic to whether it is time to buy MCO. (After all, the pricing power comment was in reference to MCO.)

If I remember this interview correctly from last year, Buffett revealed why he began selling MCO ... it was essentially that he re-evaluated the price of MCO because there was risk that the government would mess with its oligarchy.

Except, WEB has not sold MCO recently and it almost seems like the tempest blew over. For example, WEB sold no MCO in 4Q2010. Barney Frank passed his bill, and it is now rear view. I think some govenment pubs were not going to reference a rating agency, that's it.

I am beginning to wonder if it is time to crank up the exuberance on MCO. (It reminds me of a cartoon I saw where a little man peeped out and asked "Lord Greenspan" whether "may we resume our irrational exuberance".)

I am a little too tired tonight to track down this exact comment, but I believe it is in here:

http://c0181662.cdn1.cloudfiles.rackspacecloud.com/2010-05-26%20FCIC%20staff%20audiotape%20of%20interview%20with%20Warren%20Buffett,%20Berkshire%20Hathaway.mp3

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