By Rupert Hargreaves. Originally published at ValueWalk.
Here Charlie Munger talks about strong pricing power . Part two of a short series on Charlie Munger’s Human Misjudgment Revisited.
Warren Buffett often speaks about the benefits of a company having an economic moat, are a strong competitive advantage which allows it to keep prices high, profit margins wise and returns to shareholders large. Strong pricing power is a huge part of a business, and for brands to have strong pricing power for a prolonged period is the Holy Grail.
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Strong Pricing Power – Thoughts From Charlie Munger
Consumers also associate price with quality, and it’s this association that can make or break a firm. As Charlie Munger explained in a talk given at UC Santa Barbara in 2003:
“I have posed at two different business schools the following problem. I say, “You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That’s what you’ve learned?” They all nod yes. And I say, “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?” And there’s this long and ghastly pause. And finally, in each of the two business schools in which I’ve tried this, maybe one person in fifty could name one instance. They come up with the idea that occasionally a higher price acts as a rough indicator of quality and thereby increases sales volumes.
This happened in the case of my friend Bill Ballhaus. When he was head of Beckman Instruments it produced some complicated product where if it failed it caused enormous damage to the purchaser. It wasn’t a pump at the bottom of an oil well, but that’s a good mental example. And he realized that the reason this thing was selling so poorly, even though it was better than anybody else’s product, was because it was priced lower. It made people think it was a low quality gizmo. So he raised the price by 20% or so and the volume went way up.
…And nobody has yet come up with the main answer that I like. Suppose you raise that price, and use the extra money to bribe the other guy’s purchasing agent? (Laughter). Is that going to work? And are there functional equivalents in economics – microeconomics – of raising the price and using the extra sales proceeds to drive sales higher? And of course there are zillion, once you’ve made that mental jump. It’s so simple.
One of the most extreme examples is in the investment management field. Suppose you’re the manager of a mutual fund, and you want to sell more. People commonly come to the following answer: You raise the commissions, which of course reduces the number of units of real investments delivered to the ultimate buyer, so you’re increasing the price per unit of real investment that you’re selling the ultimate customer. And you’re using that extra commission to bribe the customer’s purchasing agent. You’re bribing the broker to betray his client and put the client’s money into the high-commission product. This has worked to produce at least a trillion dollars of mutual fund sales.”
In his text, Philip Ordway notes that it is the investment management business that’s currently offering the most extreme example of the above. Even though passive investment management is grabbing market share at an alarming rate, investors who have already achieved success can continue to ride the wave for a prolonged period.
He goes on to say that the world of advertising still works according to these principles. Advertising is seen as the best way to build a brand name but most “advertising executives can provide no definitive proof of success or even a quantified return on investment.” Coca-Cola, for example, is spending hundreds of millions of dollars on advertising every year but how is it possible to quantify the progress that the company is making?
Still, raising prices, spending more and changing accounting tactics to show a better overall picture are commonly used tactics by companies effectively trying to show that by raising prices they can sell more volume. Enron, for example, benefited when the company changed to mark-to-market accounting allowing profits to soar, which led to praise being heaped on its executives. It’s this change Ordway argues, and change in culture that came about as a result, that laid the foundations for the company’s downfall.
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