By Robert McConnaughey, Columbia Management
Recent oil and commodity price declines have raised concerns about global deflation and price stability. While the circumstances around oil’s precipitous decline are unique, many industries have built up capacity in recent years to serve a level of global growth that is not likely to reappear in the intermediate future.
Sluggish developed market growth and a dramatically slowing China have undermined the demand projections used to justify those capacity adds. Further, extremely low global interest rates (supported by a growing number of central banks) serve to keep that capacity in place by lowering the “pain” threshold of sub-par financial returns on investment. And even in areas where capacity and investment have been restrained, so too has the R&D budget.
Areas with pricing power deserve a premium, and as with any merchandise when it is increasingly scarce, that premium can become substantial. So, where do we see pockets of pricing power opportunity?
- Areas with high natural barriers to new supply. Last year’s $2 billion sale of the Los Angeles Clippers served as clear notice that a globally relevant brand with hard barriers to new entrants can grow its multiple of earnings to extremely lofty levels. Beyond the franchises themselves, the economics of U.S. major league sports in general has thrived as a key pillar of pricing strength within an increasingly fragmented and competitive media market as it is the very rare form of entertainment that commands live viewing. Perhaps a less obvious example of sturdy barriers to entry driving healthy pricing is long haul trucking in the U.S. New supply has been limited by regulation and a lack of qualified drivers willing to endure the difficult working conditions . As a result, pricing has been solidly positive.
- Real patent protection and innovation. A fairly pure example of high barriers to entry exists in biotechnology. When a new product demonstrates unique or significantly differentiated ability to combat fatal, debilitating, or even simply expensive-to-treat diseases and conditions, it has significant ability to command high prices. Combine that ability with the difficulties associated with manufacturing biologics and strict patent protection, and you have an environment with very healthy pricing power (albeit with occasional noise on the political front). An unprecedented era of research pipeline productivity from the sector has driven exceptional returns in recent years and we continue to see significant opportunities.
- Monopoly (or at least duopoly/oligopoly). Competition is for losers according to legendary entrepreneur/venture capitalist John Thiel. He is referring to natural monopolies such as Google’s stranglehold on search (at least in markets where it is allowed to operate freely). Nevertheless, Thiel’s point is relevant in simpler examples such as the Mexican beer market where an effective duopoly exists that has survived many challenges over the years. With two players effectively controlling the supply to the market, longer term demand growth from a burgeoning consumer class allows for very healthy pricing dynamics.
It all sounds so simple, but what about the risks? Obviously, one has to be vigilant for “barbarians at the gates,” driving challenges to the barriers protecting an industry. A couple examples:
- The government giveth, and the government taketh away. When the barriers to entry for a business are provided by the government, they can be sturdy, but are subject to changes in political sentiment. An example is casino gaming in Macau. With casino gaming illegal in mainland China, Macau’s casinos have an enormous semi-captive audience for Chinese guests who do not want to travel outside of greater China. However, a series of government actions have adversely affected gaming revenues in Macau over the last year. Looking forward, one must bear this in mind for Chinese monopolies such as Baidu. Today they face valuable protection from foreign competition, but might the growing power of the monopoly search engine eventually attract greater government intrusion?
- State-subsidized strategic players. The semiconductor industry has a long history of dealing with irrational “national champion” competition undermining rational pricing. However, in recent years, market disciplines have prevailed with resulting healthier industry dynamics and rising multiples. We are monitoring closely whether that discipline will persist. It is quite possible that a Chinese company will make a major U.S. acquisition in the interest of growing a strategic national interest and we would be wary of what that might portend for competitive dynamics.
- Emerging disruptive technologies. Market history is filled with dominant franchises that became buggy whip factories with surprising speed in the face of new technologies. We have great respect for human ingenuity and the power of that creative impulse in attacking the most successful businesses (and their fat profit margins) and challenging current wisdoms and our own assumptions. Generally, big moats repel challenges more durably than the market fears, but the exceptions are painful enough to be worth avoiding.
Finally, it is worth noting a completely different form of pricing power, the kind that comes when supply/demand imbalance washes out prices in a sector to levels at which embedded capacity is clearly unprofitable. Incremental new supply is withdrawn and existing capacity is often shuttered. Pricing through the recovery from these painful down-cycles can be durable and consistently surprise a skeptical market. While we do not yet see a clear path to such a case in battered oil or base metal markets, we do find ourselves asking how long the bottoming will take more than whether the downside in commodity prices from here remains significant.
Overall, we are diligently focused on areas of underappreciated current pricing strength and solid businesses unfairly painted with broad brush fears of sector-wide pricing weakness. Whatever one’s investment style, we believe the chances of success are greater when your investment’s business prospects for pricing power are strengthening and underappreciated.