The Real Power Of Pricing

One of Warren Buffett's key investment tenets relies on identifying companies that have an ability to raise prices. Certainly pricing power is a characteristic of quality earnings potential. It may also go deeper into the DNA of a firm as well. Something as seemingly mundane as a company's pricing philosophy may indicate whether it has the vision, culture, and business model to become a long-term success. And more importantly, whether or not it is good for investors and consumers alike.

A few years ago, I was at Southwest Airlines' headquarters for a talk led by Herb Kelleher. When he founded the company, his goal was lofty but simple: he wanted to democratize air travel and bring it to the masses. As a result, Southwest (LUV) built the most low-cost, efficient business model in the industry to profitably support their low fares. They priced based on cost and could care less what others were doing. And to this day, they continue along the same path. Still no bag fees. Have you ever compared fares between Southwest served cities and non-Southwest cities? Every industry needs a Southwest Airlines.

Similarly, Wal-Mart (WMT) continues to bring low prices through efficient operations and a singularly focused mission. It has resisted the temptation to boost margins despite its size with tactics such loss-leading prices common in the industry (have you ever wondered why a gallon of milk costs so much more at Wal-Mart?). I was at a meeting recently with a mid level executive who proudly explained that Wal-Mart would rather sell "10,000 items for $1 than 1 item for $10,000." Certainly Sam Walton’s motto continues to ring true deep into the heart of the organization.

Cheaper, however, is not always best. The first dot com bust was a disaster and probably set internet commerce back several years. Remember the days of CDNow and Pets.Com that would sell anything for a loss in order to build traffic and chase lofty valuations? Amazon (AMZN), in certain respects, still subscribes to this notion (see Amazon's Strategy Problem). Diapers.com may have been forced to sell to Amazon a few years ago because of its predatory pricing tactics. It seems the industry is still evolving as there has yet to emerge an industry leader to rationalize the marketplace.

What is more interesting on this topic are those areas that affect us in an important way. For example, how much should big pharma companies be allowed to charge for new blockbuster drugs? On the one hand, the absurd prices during the patent years encourages investment in R&D, but on the other hand, this shuts out many of the most needy patients who cannot afford to use them. It's a good thing generic firms are gaining more market share to counterbalance the incumbents.

Principle-based companies generally employ clear pricing tactics and the highly successful ones use their power to generate profits, sustain the industry, and solve a real need for consumers. Industries that lack these quality leaders tend to face erratic pricing and significant turnover in the players. There are many industries that have yet to be rationalized like our healthcare system that still lacks the visionary leaders to effect cost structures and outcomes in the long run. But for now, at least we can enjoy an Abilene to Houston flight for $99.