Previously, I talk about the concept margin of safety and how various domains from military, engineering and investing apply the same principle because there are many unexpected things that can happen in life, albeit in different terms. Having a ‘just in case’ plan reduces the probability of unfavorable outcomes. And investing is all about protecting the downside.
We are going to extend this concept by asking – What kind of business has great demand for margin of safety? That would be where the cost of failure is extremely high. I cited parachute as an example. If you are a skydiver or someone that runs a skydiving business, you won’t want to have business dealings with a supplier that guarantees their parachutes only opens 99% of the time (low probability high fatality). So mission-critical tasks that require quality tools to perform the job without failure will have the highest demand.
Let’s say you took up an interest in cycling recently to get physically fit. You did some research online to check out what other cyclists would recommend. At the same time, you are quite price conscious as well. You just need one that is good enough to perform the job – one that allows you to ride with your kids at the park on the weekend. You don’t need something fancy as long it is durable. And considering the quality for most bicycles nowadays are good enough to last for a few years, you know you can get one for a decent price.
Now contrast this to a professional cyclist whose job is to win tournaments. They are not concerned with the price but demand the best. They want a machine they can rely on to consistently perform at peak performance during competitions without failure because the stake of failure is high. The value to price ratio is high. The value here is winning the tournament, preserve their reputation and increase sponsorships. Their concern isn’t about pricing, pricing is relative, it is about performing the job in the highest order.
This is where pricing power comes in. When a product or service has a low cost, in relative to whatever the customers are trying to achieve, ones that demand plenty of margin of safety, then there’s plenty of pricing power for it. Pricing power or price maker, as opposed to price taker, means the business has the ability to raise prices without adversely impact its sales volume. In essence, their customers are price insensitive. This should be viewed as relative not absolute. If you decide to take up a new language out of interest, you might be less willing to pay for a $3,000 language class but opt for a book or free online language course instead. But for someone that wants to master it for winning a potential million dollar business deal, that seems like a fair price. It is all relative to what the customers are trying to achieve.
Here you can imagine a horizontal line. On one end you have price sensitive customers that are buying a commodity like products or services. They are indifferent to the quality of those products such as steel, paper plates or packagings etc. They basically compete on the price factor. This happens under two scenarios. One is there’s a lack of differentiation between products, for example, customers would not care whether a slab of steel is produced by ArcelorMittal or Nippon Steel. Second is when the overall quality is good enough to satisfy the mass market that the product itself gets commoditized. The personal computer is a good example. As computer parts manufacturing process get standardized and driving cost down, thanks to competitions, the cost of owning a PC becomes affordable. The performance also improved to a point where a decent priced PC can meet the requirement of most customers. As a result, commoditization in PC industry. There’s exception of course, which brings us to the topic of markets.
In the bicycle example above, your first impression might be that bike manufacturing can’t possibly have much of a pricing power right? And as you already know, that depends on the market they serve. Take packaging. The packaging industry is a low margin business but a packaging company specialized in the food packaging market will command a higher margin compared to one serving durable goods market due to a stringent quality requirement for food safety. So again, a commodity industry doesn’t mean they are doomed to fail or bad for investment, it just means they would generally focus more on operational efficiency to control cost because they are price taker or weak in pricing power.
On the other end of the spectrum, you have businesses providing mission critical products or services that generally has the ability to dictate price, especially when those manufacturing capabilities are hard to be replicated by other companies. This comes in many forms such as network effect, switching cost, low-cost advantage etc.
Next time when you are analyzing a business, think along the line of what value is the business creating for their customers. Understand the industry and how the business adds value along the value chain. If a business can create tremendous value for its customers either through quality, low cost or a mix of both, and there’s reasonable expectation that competitions are unlikely to erode this advantage, there might be a case for paying up for the stock.
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