I hear the phrase “that stock’s got real pricing power” a lot. But what does it mean? And how do you identify the stocks to buy with real pricing power?
Does McDonald’s (NYSE:MCD) have real pricing power? Probably not. What they have is a duplicatable system. That’s equally important. However, when you can own a stock that has both, you’ve hit the investment jackpot.
What about Netflix (NASDAQ:NFLX)?
Its stock’s getting pummeled as I write this, down 12% over the past five days of trading. Shouldn’t a company with pricing power resist market corrections?
Not a chance. Investors get nervous. Stocks go down. That’s especially true for those up 75% year to date as Netflix was before this week’s selloff.
But back to pricing power.
Warren Buffett’s partner Charlie Munger gave a speech in 2003 to a group of business students at the University of California Santa Barbara in which he described how a friend who had a product that was selling poorly despite being the best on the market. He raised the price by 20%, consumers began to value it more, and sales went way up.
The stocks to buy with real pricing power are those that can raise prices almost with impunity. Here are the seven I think you’ll want to consider.
Stocks to Buy for Real Pricing Power: Netflix (NFLX)
While it’s true that Netflix stock has gotten a haircut in recent days, every investor would love to have its three-year annualized total return of 45%.
It got that kind of returns, in part, because of its pricing power.
“What’s less talked about is the strong pricing power Netflix has shown over the past 5 years since announcing its first price increase in May 2014, growing pricing globally at a 5% clip (7% in the US) since,” Arif Karim, senior investment analyst at Ensemble Capital, stated in a must-read October article in Intrinsic Investing. “Despite this increase in prices, it has continued to show very strong momentum in signing up new customers for its service around the world.”
Since 2011, Netflix has grown subscribers by 30% compounded annually. In Q3 2018, it increased paid memberships by 5.4% from Q2 2018 and 25% year over year.
While the U.S. growth has slowed, international streaming grew by 39% year-over-year with plenty of the world still to cover.
Figuring out how to keep growing at this kind of pace is a nice problem to have if you’re Reed Hastings.
Stocks to Buy for Real Pricing Power: Amazon (AMZN)
Warren Buffett, like Charlie Munger, is a big believer in owning companies with pricing power.
“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,” Buffett stated in 2011. “And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
You can always count on Warren for a good quote.
Amazon (NASDAQ:AMZN) is a classic example of a business that can raise prices without losing business.
Whether it be through an increase in its Prime membership — in 2014, Amazon upped the annual fee by $20 to $99 and in 2018, it raised the monthly fee by $2 to $13 — or by using artificial intelligence to find products that customers are less resistant to price increases and promoting the heck out of them.
The reality is that pricing power isn’t just about being able to raise prices with impunity, it’s also about getting your best customers to spend more.
Prime customers spend $1,700 annually, more than double the number ($700) for non-Prime members. As long as it keeps adding Prime members and gets them to spend more on an annual basis, little incremental price increases here and there will add up to significant revenue and profit growth.
Stocks to Buy for Real Pricing Power: Apple (AAPL)
I wasn’t sure whether I should put Apple (NASDAQ:AAPL) on the list of stocks to buy with real pricing power.
I get that people like Warren Buffett are investing in the company because they believe it has real pricing power, but one has to wonder how much customers will be willing to pay in the future to own an iPhone.
Here in Canada, the most expensive iPhone, the 512GB version of the XS MAX, is CAD$1,999. Not a chance in the world I’m paying 2K for a phone.
However, Buffett sees it differently.
“I have a plane that costs me a lot, a million dollars a year or something of the sort. If I used the iPhone — I use an iPad a lot — if I used the iPhone like all my friends do, I would rather give up the plane,” Buffett said on CNBC in August. “Now it’s got competition so you can’t push the price, but in terms of its utility to people and what they get for a thousand dollars…you can have a dinner party that would cost that, and here this is, and what it does for you, it’s incredible.”
He’s a lot smarter than I’ll ever be, so I’m going to accept his opinion that pricing power entails more than just an ability to raise prices; it also speaks to the power of Apple to keep its buyers addicted to its products.
Stocks to Buy for Real Pricing Power: Sherwin-Williams (SHW)
Morgan Stanley analyst Vincent Andrews talked up Sherwin-Williams’ (NYSE:SHW) pricing power in February 2016. Trading around $255 at the time, he had a 12-month target price of $305, which it hit precisely one year later.
Here’s what he had to say on the subject:
“We expect Sherwin-Williams to exhibit pricing power as we continue to move through a period of sustained raw material deflation. Sherwin retained price in 2015 so as to drive +280bps of incremental gross margin gains, and we expect the company to benefit further in 2016 as the coatings raw material environment remains similarly accommodating,” Andrews suggested at the time. “Sherwin’s pricing power relates to its control of its own distribution, as well as its outsized leverage to professional painting contractors. The contractor-serviced architectural paint market has historically been characterized by robust levels of pricing power.”
While inflation has crept into raw material prices reducing Sherwin-Williams’ ability to expand margins by 2-3% annually, I do think the second portion of the argument remains intact.
In the quarter ended September 30, SHW was able to increase prices. However, because of higher raw material costs, its gross margin improved by just 30 basis points and over the first nine months it declined by 270 basis points to 42.6%.
Ultimately, I think its purchase of Valspar will turn out to be a good one, providing it with some level of pricing power in the future.
Stocks to Buy for Real Pricing Power: Cinemark (CNK)
Movie theater stocks like Cinemark (NYSE:CNK) haven’t had an easy go of it over the past five years. Cinemark’s annualized total return of 7% is 437 basis points less than the S&P 500.
Pricing power hasn’t been the problem.
Instead, poor content has contributed to lower attendance, combined with a desire by some consumers to enjoy alternative experiences.
I believe people will always crave an occasional in-theater experience. Attendance tends to be something that goes in ebbs and flows. One year it’s way up and the next it’s way down. Content is the most significant influence on those numbers.
As for pricing power, movie theaters like Cinemark have it in abundance. You wouldn’t see average ticket prices rise every year if they didn’t.
Cinemark is in the process of raising prices to cover the cost of seating upgrades it’s made.
“Our average ticket price also increased 3.7 percent to $8.08, largely as a result of inflation, incremental pricing opportunities associated with recliner conversions, and favorable adult-versus-child ticket type mix,” said Chief Financial Officer Sean Gamble.
The fact is, if you’re a movie theater and you’re not raising prices, you’ll likely be out of business sooner rather than later.
Stocks to Buy for Real Pricing Power: Altria (MO)
The beauty of cigarette makers like Altria (NYSE:MO) is that despite a declining global customer base there are always those die-hard smokers willing to pay almost any price to get their fix.
I wouldn’t own a cigarette stock, but that doesn’t mean you shouldn’t. Cigarette makers are incredible generators of free cash flow, in large part, because they CAN raise prices almost at will.
Altria is said to be raising the price of a carton of Marlboro cigarettes by $1 — or 10 cents a pack. That’s the second increase of the year. In March, it raised prices by nine cents a pack.
“We believe pricing will remain a critical driver of revenue and earnings growth, particularly as manufacturers realize almost 3 times the leverage on earnings from a point of pricing than a point of volume,” Wells Fargo analyst Bonnie Herzog said in September.
If you’re an income investor and can wrap your head around owning a stock that manufactures “death sticks,” the 5.1% yield — it’s the highest level since 2012 — is enticing.
Stocks to Buy for Real Pricing Power: Costco (COST)
Like Amazon, Costco (NASDAQ:COST) relies on its membership fees to generate significant revenues for the warehouse retailer.
Here’s what I had to say about Costco in 2012.
“Many people think Costco is in the business of selling products at low prices. While its prices are indeed low, that’s not its ultimate goal. Its real business is selling memberships at $55 a pop or more. As long as it keeps providing great products (the chicken is awesome) at good prices, it will continue to increase its membership.”
At the time, Costco was generating about 75% of its operating income from membership fees. Today, it’s around 69%, which is still an unusually high number. Yet, it’s only raised its membership prices once (2017) since 2011.
How’s that pricing power? Well, directly, it’s not.
However, what Costco does well, like Amazon, is getting more people to join who then spend more money each year, driving up the annual revenue per customer.
Meanwhile, Costco constantly pushes its suppliers on prices, passing its cost savings to customers, who benefit from lower prices.
Keep your customers happy, and they’ll ultimately spend more as the years pass.
Costco doesn’t need to raise prices because its profitability is solely built around its membership fees.
It’s a brilliant business model.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.