In my last article, I looked at one of the qualities that makes a good business, pricing power.
This isn’t the only factor investors need to consider when analysing a company’s quality. Many companies have pricing power, but that does not guarantee success.
As well as pricing power, a business must also produce something customers want and provide value for consumers. There’s no point in having pricing power if you can’t bring customers in the door.
There are two strategies companies can pursue. They can either sell commodity products at the lowest prices or unique, high-quality items that can’t be found elsewhere. Think Costco vs Tiffany as an extreme example.
I touched on this briefly in my last article. This time, I want to expand on the principle and expand on the idea.
When we look at companies and the good/service they provide to customers, it makes to look at the value they offer, as well as the uniqueness of the service. It’s relatively easy to understand the uniqueness of a product. Profit margins and return on capital metrics can be useful indicators.
What’s less easy to understand is the value proposition to customers.
One way of understanding this advantage is the Robustness Ratio, a principle Nomad Capital’s Nick Sleep described in his 2005 letter to partners:
“The robustness ratio is a framework we use to help think about the size of the moat around a company. It is the amount of money a customer saves compared to the amount earned by shareholders.”
Sleep went on to give some examples:
“In the Berkshire Hathaway annual report this year, the Chairman tells us that Geico policyholders saved $1 billion on their policies compared to the next cheapest carrier. It also turns out that Geico earned around $1 billion as well. So that’s one dollar saving to the customers and one dollar retained for shareholders. At Costco we think the customer saving is around five-dollars, compared to shopping at most supermarkets, for every dollar retained by the company.”
The higher the ratio, the harder it may become for competitors to take customers away. Peers would have to become more efficient and low customer costs. For many firms, that’s just not possible. Therefore, by keeping prices low and providing value for customers, these businesses develop and reinforce their competitive advantages.
But there could be a trade-off between a high robustness ratio and valuation. Wall Street likes profits and companies with high profit margins. Therefore, companies that want to keep customers happy with low margins may be overlooked by Wall Street.
As Sleep went on to explained in 2005:
“It is probably fair to argue that the higher the ratio, the harder it would be to compete against Costco on a like for like basis. Also, a higher ratio may imply a somewhat inequitable distribution of system rewards between customer and shareholder than a lower ratio. There is a tension here between the size of the moat on the one hand and the distribution of rewards on the other. In the last few years the pendulum has swung in favour of the customer, with the result that the stock is cheap enough to be vulnerable to a leveraged buy out.”
Of course, a cheap stock is not a bad thing. Sooner or later, someone will realise the opportunity. In the meantime, the business can continue to grow, aided by a strong relationship with customers.
Some of the most successful companies of all time have deployed this strategy incredibly well. Rewarding customers over shareholders, might not seem like a successful business strategy on the face of it, but without any customers, a business is nothing.