Sunday, October 11

Week 223 - Pricing Power

Situation: Stock-picking does not appear to be difficult. There is but one task (estimate earnings growth for ~30 companies) and one scorecard (growth of the S&P 500 Index). The long-term price appreciation for each company’s stock is a simple function of earnings growth and short-term interest rates. The most efficient way to boost earnings is to raise prices, if it won't hurt sales. This can be done by convincing customers that a company’s product or service is superior to the competition’s. In that scenario, pricing power = brand power. Alternatively, a company’s managers can engage in “restraint of trade” practices. In that scenario, pricing power = monopoly power (which is illegal). But pricing power is such a strong driver of earnings growth that company managers will try to skirt the legalities “to get a leg up on the competition.” Companies discover pricing power when “Mr. Market” decides that one of its “brands” is superior to others like it. In other words, consumers may decide to pay more dearly for a particular product or service just because it is perceived as “cool.” 

Mission: Determine which companies have brands that are strong enough to explain earnings growth “surprises.” In other words, which companies have the kind of stock price appreciation that comes from pricing power related to growing brand value, instead of pricing power related to “restraint of trade” practices. 

Execution: We'll start with the list of brand values in the recently published “Global 500 2015.”  Many of those brands denote whole companies but others denote separate product lines within a company. There are 87 US brands in that list with a higher dollar value in 2015 than in 2014. For analysis purposes, we’re only interested in companies (or the parent companies) having a publicly traded stock that has been around for at least 16 yrs and has a pricing pattern that roughly tracks that of the S&P 500 Index, as analyzed by the BMW Method. We find that 53 of those 87 companies meet those criteria and have revenues great enough to warrant inclusion in the Barron’s 500 List. Given that our stock-picking scorecard is the S&P 500 Index, we excluded the 6 companies that have had lower price appreciation over the past 16 yrs than the S&P 500 Index. Those are: Southwest Airlines (LUV), Sprint (S), Morgan Stanley (MS), Time Warner (TWX), Intel (INTC), Cisco Systems (CSCO). That leaves us with 47. An additional 17 were deleted because of having an S&P bond rating below BBB+ and/or an S&P stock rating below B+/M. This leaves us with 30 stocks to consider (see Table).

You want to have a stock-picking strategy that beats the S&P 500 Index. Failing that, you need to sell your stocks and dollar-average the proceeds into the lowest-cost S&P 500 Index fund (VFINX at Line 39 in the Table) or its bond-hedged version (VBINX at Line 37 in the Table). Over the past 20 and 30 yr periods, only 6 stocks have been able to track the S&P 500 Index and outperform it with less risk of loss in a future bear market, per the BMW Method. Those 6 stocks are Abbott Laboratories (ABT), Air Products and Chemicals (APD), 3M (MMM) and 3 utilities: American Electric Power (AEP), DTE Energy (DTE), and NextEra Energy (NEE). In other words, it is almost impossible to beat the S&P 500 Index unless you take on more risk (in the hope that price appreciation will outweigh the additional risk). 

Bottom Line: We have found 30 companies that beat the S&P 500 Index over the past 16 yrs (see Table). All 30 have improving brand values. The pricing power conferred by that improvement likely contributed to the earnings growth that has driven their stock prices higher. Investors are justified in thinking that pricing power is a “necessary but not sufficient” explanation for the outperformance of these stocks. A stock-picking strategy founded on improvement in brand values may be the best strategy available to retail investors, i.e., those who work outside the finance industry.

Risk Rating: 7

Full Disclosure: I dollar-average into NKE, UNP, JPM, WMT and MSFT, and also own shares of KO, PEP and MCK.

Note: Red highlights in the Table denote underperformance vs. the bond-hedged S&P 500 Index (VBINX); metrics in the Table are current for the Sunday of publication.

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