Business

Pricing Power Adds Pep To Equities

Pricing Power Adds Pep To Equities by Mark Phelps and Dev Chakrabarti, Alliance Bernstein

It’s hard to find companies that can reliably increase earnings while global economic growth remains subdued. In this environment, pricing power can help investors identify companies that are capable of delivering sustainable growth.

There are two components to earnings growth: the top line, represented by revenue, and the bottom line, driven by margins. For many companies, the best way to boost margins is to increase volume. Selling more of what you already produce typically generates economies of scale that improve profitability.

Demand Is Hard to Find

This is easier said than done. With China and emerging markets slowing down and fragile recoveries from the US to Europe, it’s difficult to find sources of new demand.

In a low growth world, pricing power can unlock higher profits. But with inflation stuck at very low levels—0.5% in the US and about 1.0% in the euro area—it’s not easy for companies to raise prices. So what should investors look for to identify companies that can lift prices? We think there are three keys to pricing power:

  • Innovation
  • Competition
  • Cost and inflation dynamics

Paying More for Innovation

Innovation is a great enabler of higher prices. Of course, technology companies that can create products or services that never existed before can command higher prices. The same can be said for drugmakers who develop new treatments.

Marketing is another way to innovate. By adding a “new and improved” label on detergents, a consumer goods manufacturer can try to charge just a bit more per item. But investors need to assess whether consumers will really be willing to pay more—and whether regulators won’t intervene if exaggerated claims are made. Marketing can only take you so far up the pricing ladder.

The pricing structure itself can also be innovative. For example, a company that operates theme parks can offer a package deal with a deep discount to a second attraction in order to drive up volume.

In global markets, currency movements also create pricing risks and opportunities. Caterpillar of the US is feeling the pinch as falling commodities demand undermines sales of massive earth-moving equipment. And its leading Japanese rival, Komatsu, benefits from a weaker yen, which allows it to reduce its price in US-dollar terms and increase volumes.

The Competition Factor

Pricing power is often a function of the competitive environment. Take the supermarket industry, where brand perception determines pricing. In the UK, discount supermarkets such as Aldi and Lidl have cut prices so low that they are creating big problems for giant rivals like Tesco and Sainsbury. And premium brand supermarkets today can’t really use their usual tactic of regularly raising prices slightly in a world without meaningful inflation. This same logic can be applied to other industries where low-cost providers have taken market share, from airlines to finance.

When assessing a competitive environment, pay attention to the regulatory threat. When Hillary Clinton pledged to combat high prices of prescription drugs if elected, she created a perception of potential regulation that makes it very tough for pharmaceutical manufacturers to raise prices. Similarly, telecom providers need to beware of activist regulators blocking their ability to raise prices at will.

Control is the issue. The degree of control that a company exercises over its industry is a key determinant of its pricing power. Historically, OPEC has been able to control supply to maintain high prices. However, over the last 18 months, as it perceived a threat from US shale rivals, it exercised its control of supply to keep the oil price down aggressively in an effort to drive out capacity.

Cost Dynamics Matter

In a low inflation world, cost dynamics are crucial. Consider a company like Ecolab, which makes chemicals for cleaning that are derived from oil-based products. With oil prices at extreme lows, Ecolab’s input prices have dropped dramatically. So even without raising prices, profitability can increase.

In the global agri-tech sector, companies such as Syngenta of Switzerland or Monsanto of the US have created bio-engineered seeds and traits for crops such as corn and soybean, hoping that farmers would pay a premium for higher-yielding products. However, their ability to sell these products at higher prices is constrained because underlying prices for crops like corn have stayed low, so farmers have been unwilling to move up the price pyramid.

Pricing power is always an important component in the fundamental analysis of a company’s business model and earnings prospects. Today, with big challenges facing top-line growth across an array of industries, we believe that understanding pricing power is essential to developing high conviction in specific stocks.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorized and regulated by the Financial Conduct Authority in the United Kingdom.

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