Charlie Munger (Trades, Portfolio) had famously asked this question to business school students: “Under what circumstances the correct answer for raising product volumes is to increase the price.” Very few students came up with luxury goods – higher prices indicate higher quality which in turn, leads to great sales.
Munger then revealed another trick – when the end customer is not involved directly in the purchasing decision, then the increase in price can be used to bribe the purchasing agent to generate higher profit and sales volumes.
I didn’t identify Munger’s trick when I first read about it. But as I progress along the ignorance removal journey, I started to appreciate the power of what I call the “Bribing the Purchasing Agent Model.” Businesses that fall into this category often have superior margins, higher return on capital and the resultant long term total shareholder returns. In order for this to happen, a few conditions need to be present:
1. The existence of information asymmetry – the customers are ignorant about the technicality and quality measurement standards of the product or the service, whereas the providers and the intermediary possess in-depth knowledge that cannot be easily learned.
2. The end customer is not involved directly in the purchasing decision.
The combination of these two factors creates favorable mere association bias – higher price is associated with better quality, as well as the authority bias – you are more likely to seek help from the authority figure, such as the purchasing agent.
3. Higher price benefits both the provider and the intermediary so that there is powerful incentive for them to form an alliance.
4. The existence of monopoly, duopoly or oligopoly in the market. Again, the incentive bias is favorable – fewer dominant players will help keep price rational.
5. High barrier to enter due to brand name association, technological uniqueness, patent, regulatory burden, etc.
6. The existence of a price-insensitive payer for the products.
A good example is the medical device industry. Varian Medical Systems (VAR, Financial) and Intuitive Surgical (ISRG, Financial) both have created enormous values for shareholders. Here VAR and ISRG are manufacturers/providers, we can think of the hospitals as intermediaries, and the patients are end customers. Let’s walk through the model for Varian in the fee-for-service payment environment:
1. Information asymmetry – although it seems like the physicians are the customers, the real end customers are the patients ultimately. The patients know little about Varian’s products such as linear accelerators, brachytherapy afterloaders, treatment simulation and verification equipment. But of course Varian (VAR, Financial) and the hospitals such as HCA (HCA, Financial) through their surgeons, obviously know a lot about the products.
2. Obviously the patients are not involved in making the purchasing decision. The government actually picks up the big chunk of the expense as hospitals justify on the ground of better quality care and savings from less post-discharge care need.
If you are a cancer patient and someone else is paying for most of the care, you go with the more expensive ones.
3. In the fee-for-service world, higher prices, of course, benefit both Varian and the hospitals as Varian gets higher margins and the hospitals are paid on a cost plus percentage model.
4. In the radiation oncology market, Varian, Elekta, and Accuray (ARAY) account for more than 90% of the market.
5. The barrier to entry is extremely high due to the combination of technological uniqueness and related patents protection, regulatory requirement, and knowledge and experiences requirement.
6. Very often, the U.S government is the actual payer of these expensive medical products because the reimbusement rate incorporates capex.
As a result, historically Varian has rewarded shareholders handsomely. I think the “Bribing the Purchasing Agent Model” has been a critical factor that is rarely appreciated by investors.
While this is a powerful model, as investors, we have to watch any disruptions in technology as well as the distribution channel. Any change in technology, payment model, or the relationship among the supplier, the agent, and the end customer, may break the model. This will be discussed in the next part of this article series.
I may have missed a few points in the discussion and I look forward to hearing feedback and suggestions from our readers.
Start a free 7-day trial of Premium Membership to GuruFocus.
