Stocks you can’t do without: The stayers in a slowdown

When an economy goes into slowdown, the stocks that usually perform best are those that have pricing power. So how do you pick them?

It’s not the only thing to look for, of course, but deliberating on pricing power often leads to a deeper understanding of the dynamics of many companies. Pricing power means the ability to “give” rather than “take” the price for the goods and services it provides. Iron ore companies such as Rio Tinto are confident of achieving at least a 65% increase in iron ore prices this year. That’s pricing power.

Traditionally brewers were the classic defensive stocks because consumer demand would not be affected by moderate price rises.

But these days Foster’s and Lion Nathan are being put under tremendous pressure by Woolworths. And so my first “price power” company is Woolworths and, as we saw in the latest interim report, Woolworths is now increasing its margins – partly through better pricing, increased offerings of house brands and because it delays payment to suppliers. The threat of being removed from the Safeway shelves is so powerful that very few Australian suppliers are prepared to risk it.

Of course Woolworths also increases its margins via its investment in supply chain, store refurbishment, stock management and IT. Woolworths senses that its opponent Coles is going to have a difficult two or three years as its operations are reconstructed while being housed in Wesfarmers’ high-debt balance sheet.

And so Woolworths is planning an enormous store expansion and refurbishment program to substantially increase its footprint in Australia and greatly enhance its pricing power. Very few of its suppliers are so important that Woolworths must have them on the shelf. A standout is Coca-Cola.

In the 1980s, Coles Myer removed Coca-Cola products from some of its shelves and customers stopped coming. In its latest interim report, Coca-Cola Amatil looked a far better company now it has sold its South Korean operation. Through Pacific Beverages, the company is thrusting into premium beer and other beverages. It will need to be careful that it does not expand too rapidly in areas where it does not have pricing power. Among Foster’s brands, Victoria Bitter beer does have pricing power but the company is so deep into wine, which has no pricing power, that Woolworths has the upper hand.

If Lion Nathan and Foster’s could trust each other they could use their strong beer brands to turn the tables on Woolworths. But there is no trust and the emergence of Coca-Cola Amatil in the boutique drinks area will make it even harder. Two other products that have pricing power in supermarkets are Arnotts biscuits and, perhaps, Colgate toothpaste. But both brands are foreign-owned. The people who have least pricing power are fruit and vegetable growers.

The Woolworths plan to enhance pricing power has similarities with Telstra. Three years ago Telstra had little mobile phone pricing power and was caught in a vicious price war while its base product – land line phones – was in sharp decline.

The Telstra board removed its chairman and chief executive and appointed Sol Trujillo who, as part of his revolution, invested huge sums in a new 3G network, which enabled the company to charge a higher price and regain pricing power in mobiles. Trujillo was also appointed to stop investing on low returns to please government and refused to make a massive investment in Web 2.0 infrastructure (fibre-to-the-node) unless it could gain high returns through better pricing power. The new Government is prepared to spend $4.7 billion on the project. The global shortage of capital may enhance Telstra’s position.

Most of the companies that provide infrastructure are limited in their ability to lift prices. Perhaps the best-placed are the toll road operators that have long-term price escalation contracts. Road users, like beer drinkers of old, keep using the product despite the higher prices. The trouble with infrastructure providers is that they are highly leveraged in a world where the cost of capital is rising.

My next selection of companies with pricing power will surprise many. In recent years banks have not had pricing power and there has been severe competition for business and personal accounts. But much of that competition stemmed from the availability of overseas wholesale funding. Those overseas lenders have been savaged by the sub-prime/monoline debacles so now have less money and are very nervous. As a result, the availability of funds for Australian lending outside the banks has been constrained, which has boosted the business flow to the big banks and most now are beginning to look for extra capital.

The banks – ANZ, Commonwealth, NAB and Westpac – have yet to fully use their pricing power but are capable of increasing their interest rates on loans across many areas of their business and resist consumer outrage. In theory, if a couple of banks lifted rates or charges then clients could go to a rival, but in the current environment all the banks are limited in the amount of money they can lend so could not accommodate a big slab of another banker’s business.

Of course any bank that increased its interest rates sharply would damage their customers and might suffer substantial bad debts. So for practical purposes the bankers’ pricing power will need to be exercised with skill and all bank shareholders need to realise that in the economic slowdown that is ahead, bad debts will rise.

The global hedge funds conducted “a dress rehearsal” for their raid on ABC Learning when they borrowed huge chunks of Australian bank scrip from superannuation fund managers and index funds and then slashed the share prices of banks to the detriment of the long-term holders whose scrip had been loaned without their knowledge.

Now hedge funds have repeated the exercise in ABC Learning, it has become one of Australia’s great scandals and our regulators have been caught out. But in the case of banks it means that the shares now represent better value, provided bad debts do not rise too far. Of the bank chief executives over the past five years, David Morgan of Westpac was the most conservative so Westpac should have the smallest increase in bad debts.

On the international arena, CSL gained pricing power in plasma products by a very clever program of global acquisitions. The buyers of its product are diverse and its rival Baxter also likes to enjoy better margins.

In the 1990 economic downturn, Boral was minced because not only did it suffer lower turnover but there was a vicious price war in building products. This time around, in the US and Australia, there are far fewer competitors and in most areas the remaining competitors still remember what happened two decades ago. So in Australia and the US the company has been able to edge up prices in areas where there is lower turnover and is prepared to shut plants rather than trying to gain market share by lowering prices.

Westfield’s dominance of big shopping centres gives it pricing power over smaller enterprises in Australia but not in the US or Britain. As Woolworths becomes more powerful some of that Australian pricing power may erode.

I have saved until last Australia’s companies with the most spectacular pricing power advantage: the iron ore and coal producers. In this case supply has fallen behind demand and the whole dynamics of the industry has changed.

Most other metals are also enjoying big price rises. But longer term none of the companies have embedded pricing power. Once demand exceeds supply the game changes. Longer term, coal maybe affected by curbs on carbon but iron ore producers believe that the good times will roll on for a long time. Others say that the BHP–Rio Tinto merger plan will cause the Chinese to look for other suppliers, as the Japanese did when Australia became too powerful in the 1970s. In Australia the two companies that are benefiting most from the boom are BHP and Rio Tinto.

The above stocks are by no means an exhaustive list of those with pricing power. But it is a question all share investors should ask as they evaluate their stock selections in the coming year.

This article first appeared in The Eureka Report