How To Find A Great Stock Investment These Days

When evaluating a business, I pay close attention to the ability of the prospective business to raise prices that it is able to charge for its good or services each year. Along with improved improved technologies/lowered costs, increased sales, and share buybacks, this is the remaining element that can lead to increased profit per share.

Arguably, pricing power is the most significant factor in identifying a buy-and-hold investment because it actually is the manifestation of a competitive advantage. With share buybacks, the only requirement is that there must be cash somewhere on the balance sheet that can be used to lower the share count outstanding. With lowered costs, the competition often benefits from the same technological development, so it is rarely proprietary and/or competitive benefits to the business itself. Increased sales is closer to measuring the competitive advantage of a business, but sometimes, it could just be that a healthy local grocer is opening another location 45 miles away with a business model that is “ok” but is being rolled out across the region.

Incidentally, when Warren Buffett spoke at Notre Dame in 1991, he gave a speech when he compared the results from owning the “Hathaway textile lines” that were part of the original Berkshire Hathaway textile conglomerate that he purchased in comparison to his experience running See’s Candies, the iconic boxed candy company on the West Coast.

In particular, Buffett said that Hathaway linings for men’s suits supplied half of the men’s attire in the United States during WWII and Sear’s awarded Hathaway its “Supper of the Year” Award multiple times in the late 1940s. Buffett noted that Sears executes and Hathaway’s executives would frequently socialize and take summer vacations together.

At the time, the price of a Hathaway linen was 79 cents per yard. A few years after the War, Buffett tried to raise the cost of a linen from 79 cents to 79.5 cents. As Warren Buffett recounted, the price per linen hadn’t increased in over a decade, as Hathaway thought it would be unseemly to raise prices of any clothing during the war. When Sears received the notice of the price increase, it switched to a collection of about a dozen regional competitors that still agreed to sell Hathaway linens for 79 cents per yard. Eventually, Hathaway relented and returned to 79 cents per yard.

Warren Buffett said that selling an undifferentiated product was one of the most important lessons of his life because it taught him that high profit growth would forever be difficult to come by, as the success of the business could not escape what the nearby low bidder was doing.

In contrast, Berkshire Hathaway purchased See’s Candies in 1972 for $25 million. It’s an actual chocolate brand that sells a differentiated product that means something to customers. Warren Buffet stated that, on December 26th every year, he raises the price of its chocolates no matter what, almost always by an amount greater than inflation. This “premium pricing” becomes a form of profit capture that accrues to shareholders.

Sometimes, you hear these business stories and think they are academic and abstract but don’t exist in the real world. With See’s candies, let me show. If you go to sees.com and seek to purchase an assortment of 24 chocolates, it is going to cost you $21 to buy these See’s Assorted Chocolates. If you wanted to get your hands on boxed chocolates for a cheaper price, you certainly can. Over here at Bon Courage Gourmet, you can get your assortment of 24 chocolates per the “Taste of Europe Chocolate Sampler” for $12.95.

That extra $8.05 is pure profit that flows to Berkshire Hathaway’s shareholders as the result of owning a brand that means something to customers. Although the cost of production of the chocolate is a trade secret and is therefore not disclosed, See’s Candies has a larger distribution network than Bon Courage Gourmet and should enjoy lower chocolate production costs.

Typically, the average chocolate company enjoys 16.8% profit margins, but when it sells direct to customers, those profits are usually around 45%. My guess is that each box of chocolates costs about $11.55 to manufacture and ship/distribute to customers. With See’s, it is probably earning around 45% or about $9.45 in profit per box of 24 assorted chocolates. If Bon Courage Gourmet has the same cost structure, it is probably earning in the neighborhood of 10% for a profit of about $1.40 per box of chocolates after all costs are considered. It was only founded in 2013, and it doesn’t have pricing power, and therefore, See’s rains down cash profits in a way that Bon Courage does not.

The lesson for investors is that it is important to focus on (1) the annual price increases that are part of a prospective business’ economic model; and (2) what happens to the volume of sales when those price increases are passed on. After all, if a business raises prices 6% but loses 20% of its customers, it is not a testament to pricing power because the business is in fact proving that it does not have pricing power by losing customers when the price goes up.

For an example using a publicly trading stock, look at the example of Starbucks raising the price of a twelve-ounce tall brewed coffee from $1.95 to $2.15 over the past year. The twenty-cent hike may not sound like much, but it is a 10.26% year-over-year price increase. And what happened to sales of coffee? The volume of sales increased by 4%.

This is highly suggestive of strong pricing power–the coffee price increase was more than triple the year’s inflation rate, and still, the sale of the product increased at a low single-digit rate. It is easy to see how Starbucks’ has a fifteen-year track record of growing profits per share by 14.5% when it can raise its prices by double-digit rates and demand simultaneously increases. Hathaway linens these are not.

When you study investments to make in your own life, finding businesses that can charge more for its products at a rate that exceeds inflation each year while also experiencing volume growth is a strong signal of “pricing power” and a “dominant competitive” position. While there are some excellent businesses out there that do not have this characteristic, nearly all businesses that have this characteristic are outstanding businesses.

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