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In today’s episode, we speak with Kathrin Forrest, an equity investment specialist with Capital Group Canada, about pricing power. We asked how she identifies sectors and companies with pricing flexibility, the names of some extraordinarily powerful pricers, and we started by asking why pricing power is such a key attribute in the current market.

Kathrin Forrest (KF): Yeah, inflation has become an important topic in recent months. As companies face higher costs, their profit margins, earnings, and ultimately returns for investors are put under pressure. That is unless they can raise prices without meaningfully impacting demand for their products. And that is what pricing power refers to. We see this in certain pharmaceuticals, where supply is protected by patents. Another example are luxury goods, where brand recognition and exclusivity can limit customers’ price sensitivity. And then companies within specialized skill sets or technological advantage may also have more pricing flexibility. We see this for certain companies in the semiconductor manufacturing space. And, you know, when I take a step back, what is interesting here is that there are certain sectors where pricing power may be more prevalent, but we can really find opportunities across the broad set of industries, and that is a good way to stay diversified.

How she identifies companies with liberal pricing authority.

KF: I would highlight three important considerations. The first one is high margins. That would suggest low level of competition. The second consideration would be stable margins. Lower variability would suggest higher pricing power. And that takes me to the third point, the sustainability of pricing power. I would consider that in the context of resilient demand, what’s the nature of the product, is it a necessity, what’s the desirability of it, is there structural growth in the industry, and what is the risk of disruption.

Names of power pricers.

KF: A really good example is the Dutch chip manufacturer ASML. The story of pricing power in the semiconductor industry is pretty simple. It’s a case where soaring demand is meeting quite limited supply, and it’s left a few dominant players such as ASML with potential pricing power in specialized areas of the market. Taking another example in a different industry, we look at UnitedHealth Group. Historically, U.S. health insurance companies have passed on rising healthcare costs to their customers through higher premiums. Managed care companies like UnitedHealth group are focused on reducing inefficiencies in the U.S. health care system. By delivering more value, UnitedHealth can maintain its pricing power while it also helps tackle a long-term problem in the U.S. health care system.

The limits of pricing power.

KF: That’s a really important point, and it goes back to how resilient demand is. What you want to think about is your customers. How much of a necessity is the product that you’re providing, what’s the broader competitive landscape, is there risk of new entrants and emerging substitutes. If you want to express it in economic terms, it’s around how elastic demand and supply are, both over the short term, as well as over the long term. Just to bring this to life, when we look at Netflix, the company increased subscription rates four times since 2014. And that was in an environment where they saw robust subscription growth globally. They’ve seen more limitations to that subscription growth more recently. Another example could be providers of soft drinks that might have brand recognition and pricing power to a degree, but ultimately there is an ability for customers to switch to other products if they feel they’re not getting value for their money. High profitability in certain cases attracts new competitors. So, there is risk of disruption if the nature of the product allows new entrants to participate in the market. And, of course, there’s consideration of regulation as well as legislation to limit market power for certain companies in the interest of consumers.

Finally, what’s the headline?

KF: The headline is “Time to be selective.” Some companies are much better positioned to navigate higher inflation. Inflation is not the only issue that we’re facing now. So, while we continue to look at pricing power, resilience more broadly has moved very much into the spotlight for us. And the idea here is that in order to protect and grow capital in real terms, including pricing power as well as strong cash flow, balance sheets, and capital allocation, and experienced management can help companies thrive in the years ahead.

Well, those are today’s Soundbites, brought you by Investment Executive and powered by Canada Life. Our thanks again to Kathrin Forrest of Capital Group Canada. Visit InvestmentExecutive.com, where you can sign up for our a.m. newsletter and never miss another Soundbite. Thanks for listening.

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