Pricing Power Is King

Editor's note: This Weekend Edition, we're taking a break from our usual fare to share an essay by Dr. David "Doc" Eifrig. In it, he reveals one of the top qualities of inflation-resistant businesses... and shares five "ingredients" to help you find investment-worthy stocks in today's turbulent market.

It was an e-mail that would cost folks $4 billion...

Yet no one even blinked an eye. Instead, members just made sure their credit cards on file were up to date so their service wouldn't be interrupted.

E-commerce giant Amazon (AMZN) operates an amazing business – one that folks can't live without.

Earlier this year, Amazon sent out an e-mail to its Prime members telling them about a price increase. The e-mail said that as of February 18, the monthly price of its Prime membership would increase from $12.99 to $14.99. The price of the annual Prime membership would increase from $119 to $139.

Now, $20 more per year doesn't sound all that significant. But at last count, Amazon has more than 200 million Prime members...

So just with one simple e-mail, Amazon will make $4 billion – with no additional capital expenses.

And like I said, there has been no uproar from Prime members... They've neither held boycotts nor protests. I'd be shocked if there were many – or even any – cancellations.

Most folks can't live without Amazon Prime. It's integrated into our day-to-day lives.

Think about it... We've all come to expect free two-day shipping when we order online. Anything less is deemed unacceptable.

Prime Video, which is included for Prime members, has also become a streaming service we can't live without...

The service is coming out with a new Lord of the Rings series called The Rings of Power later this year. Given the popularity of the original Lord of the Rings and The Hobbit books and movies, fans surely won't cancel their memberships because they have to pay $20 more per year.

Amazon could send out another e-mail in a few months saying that it's raising prices again... and there would likely be a similar reaction (or lack thereof). Customers would be fine with it.

This is what's known as "pricing power."

This is a company's ability to raise prices without reducing demand for its products.

This is hard to find. Most companies can't afford to raise prices frequently because their customers would just walk – or click – over to their competitors.

Amazon doesn't have that problem. Its customers are "sticky."

Companies that have pricing power are the ones you want to own today.

They are the ones that can survive inflation. And it's no secret that inflation is running wild today.

When the cost of raw materials or wages goes up, margins go down. That hurts companies' bottom lines... and that's why inflation can be so deadly.

The best businesses, however, can simply pass those costs onto the customer without much, if any, backlash. They raise prices and that keeps margins high. Then the company is able to keep rewarding its shareholders by paying dividends, buying back stock, and reinvesting in the business.

With inflation running at 8.5%, you need to own stocks with pricing power.

Most economists believe that we're likely close to peak inflation today. And I tend to agree with that. But that doesn't mean inflation is just going to go away...

In fact, I believe we're on the cusp of the next stage of inflation – what I call the grind.

That means there will still be intense inflationary pressure on the economy, but less than the recent 8.5% level. That doesn't mean 1% or 2% inflation... at least, not for a while. My estimate is that we'll see inflation of about 4% or 5% for a few years.

That's still significant... And it's why you need to look for businesses that can help you survive these difficult times.

In his 1977 Fortune essay titled "How Inflation Swindles the Equity Investor," legendary investor Warren Buffett detailed how to identify "inflation resistant" businesses. So today, I'm going to summarize his key points...

The true underlying return for stockholders comes from the business's return on equity – earnings compared with the book value of the business (the firm's total assets minus its liabilities).

From 1945 through the time of Buffett's 1977 essay, stocks managed a consistent return on equity of about 12%. As he wrote, "It shows no signs of exceeding that level significantly in inflationary years (or in years of stable prices, for that matter)."

The trick is, while earnings may go up due to inflation, so does the value of assets on the books. This keeps the return on equity flat.

It doesn't happen all at the same time... If inflation strikes and a business raises its prices, that can boost earnings today. But as it starts to invest and replace assets, those prices are higher. The carrying value of equity rises, so the business earns the same return on equity.

When the market is heading into an inflationary period, it's critical that you only own shares in businesses that can sustain a high level of return on equity.

That's why Amazon should be a good investment in the face of inflation. It has a historically high return on equity... Plus, as I said, it can keep raising prices without losing customers.

Pricing power aside, Buffett writes that businesses have five ways to improve earnings. In his essay, he saw most of these as unavailable to the businesses of the time – and that's largely true today as well...

1. Increase turnover. To boost return on equity, businesses need to earn more sales relative to assets on their books. Of course, any business would like to do this at any time... It's just tough to do.

(One exception: Businesses that derive value from their assets – like gold mines or timber companies – can do better during inflationary periods because of their assets. So a high asset value isn't a liability for those businesses like it would be to a manufacturer with an expensive portfolio of factories and equipment.)

2. Cheaper leverage. Businesses can earn higher profits by paying lower rates on their debt. In the 1970s, Buffett noted that this couldn't happen because interest rates would rise to choke off inflation. We're seeing the same thing happen today.

3. More leverage. If you borrow more, you can potentially report higher earnings on the same amount of equity. Buffett noted that American businesses were already highly levered – and it's even more true today.

4. Lower taxes. This is outside of the businesses' control – but we already have historically low rates after former President Donald Trump cut corporate taxes to 21% in 2017.

5. Wider operating margins. Again, this is what any business would like to do... But it's always a challenge.

Buffett reviewed these criteria with a view on the entire market and concluded that stocks would struggle. And the situation appears to be the same today.

But there's another way to look at this analysis...

You can also view these criteria as a blueprint for the exact kind of stocks that can outperform in an inflationary market.

While the market as a whole will struggle to drive its return on equity higher, some individual businesses can – and those are the ones you want to own.

Here's what you need to look for...

  • High asset turnover – you want an "asset light" business that doesn't have a lot of factories and capital equipment on its books. This will keep it from seeing inflation in its book value. (Again, not counting gold mines.)
  • A strong balance sheet – so that it can increase leverage if it chooses.
  • Rising operating margins – a company that can raise prices more than it sees its costs rise.
  • A market-beating return on equity.
  • A fair valuation.

Putting these "ingredients" together, there are plenty of businesses that you could be buying today. These are companies that will preserve your wealth... and even help you make terrific returns during environments like we're seeing now.

Here's to our health, wealth, and a great retirement,

Dr. David Eifrig

Editor's note: Thirty-five years ago, Doc discovered an investing strategy that has protected him from every market crash since. This approach can help both novice and seasoned investors make money in floundering markets... And RIGHT NOW is the perfect time to start using it in your portfolio. Click here for more details.