HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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July 19, 2020

Pricing Power Matters & Innovation is Difficult

Pricing Power Matters

Pricing power is the polite term for a business’s monopoly status. While economic theory suggests excess returns get competed away over time (see Mean Reversion in a later post), the ability to defend market position via a patent, brand, know how, government regulation, network and scale effects can all help build a defensive moat around a business, and so defend against the prevailing competitive forces. Understanding how these moats operate and how effective they are at allowing pricing power to persist is a key component to equity investment.

Gross Margin

The best indicator that a business has pricing power is a high and sustained level of gross margin. The things that happen below the cost of goods line are important, and in particular the amount of profit that is turned into free cash flow, but it is the gross mark up a company can extract from its direct inputs that is the vital indicator of the value it creates.

Not surprisingly companies with high gross margins predominate in certain knowledge intensive sectors such as technology, healthcare, media, communications, consumer, financial and business services, particularly software services.

Precondition for Compound Growth

Pricing power matters because it delivers returns that give the best prospects of beating the impact of inflation, but it also increases the likelihood that a company can return net cash back to the balance sheet year after year. If this is matched with a high return on equity (low levels of capital employed and attractive working capital dynamics), then we have the critical ingredients of a serial compounding equity with a high reinvestment rate. If these attributes can be combined with a large addressable market, a credible commercial strategy and a Board that is focused on shareholder interests (preferably with large insider ownership), then we are describing the gold standard of equity investments.

Innovation is Difficult

A common precursor to pricing power and high gross margin is innovation. However, real game changing innovation is rare and difficult to monetise. Ben Horowitz said that innovation is almost insane by definition: most people view any truly innovative idea as stupid, because if it was a good idea, somebody would have already done it. So, the innovator is guaranteed to have more natural initial detractors than followers. This partly explains why innovation is uncommon, but it also explains why when it is apparent, it creates a special mindset and culture.

Insurgent Mind Set

As another successful investor, Peter Thiel, describes it, great innovators know a secret about the world that others don’t share. Every successful start-up is a conspiracy against the established order and its followers become similar to members of a cult. The main difference is that a cult is fanatically wrong about something the rest of the world believes or knows, while a successful start-up is fanatically right about something the rest of the world has missed.

The resultant mindset of insurgency and conspiracy these small groups of believers engender is a valuable asset for the truly innovative business, as it binds people together and drives a strong collective will.

Known Headwinds

However, natural entropy and organisational phase transition are strong negative countervailing forces that innovation must overcome to be successful. Serendipity often plays a more important role in successful innovation than history typically acknowledges.

The pharmaceutical and technology sectors (among others) are littered with heroic failures, where good ideas and their champions prove incapable of overcoming opposing forces. Early pioneers often fail, as the saying goes, the second mouse gets the cheese. Right place and right time is often critical in determining who makes the real money.

Henry Ford was not an innovator in the technical development of the motor car, Mark Zuckerberg did not pioneer the social network and Brin and Page were not the inventors of the search engine. Preceding all these great innovators and stories of huge business success were a flurry of over hyped ventures (bubbles) that boomed and then bust with multiple business failures, mal-investment and mis-allocation of capital on a grand scale.

Bubbles

But bubbles serve a purpose, they guide investors to where the opportunity lies. The dotcom boom ultimately spawned the FANGS, the 19th century railway bubble spawned consumer goods and the concept of mass transportation, and even the Dutch tulip mania signalled a major breakthrough in horticultural technology for which the Dutch remain renowned, to this day.

This is a valuable lesson of innovation, whether of a new product type innovation (such as the mobile communications), or a new strategy type innovation (such as low cost airlines). The market (humans) tend to overestimate the impact of innovation in the short term, but underestimate its impact over the long term. This is in part due to the fact that we live in a linear world and tend to underestimate the impact of geometric growth. The key point is that by the time the winners emerge, there will usually remain plenty of time to benefit from the resultant high margins and compound growth effect.

Matt Ridley has pointed out in The Evolution of Everything and his more recent, How Innovation Works, that innovation evolves based on shared knowledge, open data systems and practical trial and error. Small but persistent applications of innovative techniques and practices can deliver sustainable business advantage sometimes in the most unlikely settings. An investment process that seeks out these hidden opportunities will often yield greater value than elephant hunting for the new next big thing.

Finding innovative businesses with pricing power and the ability to compound returns is not easy, nor direct (see Success is Often Oblique in a upcoming post), however, when you do find them it is important to stay the course. Compound growth needs time to do its work.

This communication is provided for information purposes only, and is not a solicitation or inducement to buy, sell, subscribe, or underwrite securities or units. Investors should seek advice from an Independent Financial Adviser or regulated stockbroker before making any investment decisions. Progressive Equity Research Ltd (“PERL”) does not make investment recommendations.

Opinions contained in this communication represent those of PERL and/or our affiliates at the time of publication and PERL does not undertake to provide updates to any opinions or views expressed. PERL does not hold any positions in the securities mentioned in this communication, however, PERL’s directors, officers, employees, contractors and affiliates may hold a position,  and/or may perform services or solicit business from, any of the companies or related securities mentioned.

Any prices quoted in our research are as at the previous day’s close.