Price Makers, Share Gainers, and Compounding Machines: Three Quality Business Models
Published on March 31, 2021
Defining a quality business is easier said than done. We have found that the highest quality businesses either consistently exercise pricing power while maintaining market share or consistently grow market share by undercutting incumbents. A choice few companies we call “compounding machines” can both raise price and increase market share.
As high conviction, active managers we believe that owning a select group of quality companies is the most effective long-term investment strategy. In our view, fundamentally sound businesses are more likely to outperform in both up and down markets.
The challenge, of course, is consistently finding these types of companies and buying them at the right price – ideally when they are out of favor with the market or when growth opportunities are not properly discounted in a company’s valuation. Determining whether a company is truly high quality is complicated, and requires more than just analyzing financial statements, economic conditions, and regulatory issues.
In our experience, one of the most important investment criteria, and also one of the most underappreciated, is the strength of a company’s underlying business model. We spend a considerable amount of time assessing this, not only because it is difficult to evaluate, but also because we believe it has an outsized impact on returns. In general, we prefer to invest in one of the following three types of businesses:
- Price makers - companies with pricing power
- Share gainers - companies that leverage low cost leadership to consistently grow market share
- Compounding machines - companies that do both
For us to invest in a company, it generally must fit into one of these categories.
Price Makers: Companies with Pricing Power
Warren Buffett, the vaunted investor who compounded annual shareholder returns at Berkshire Hathaway Inc. at a stunning 20% from 1965-2020, has long pointed to pricing power as a key indication of business quality. In fact, he said in 2011 that:
Basically, the single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business. I’ve been in both, and I know the difference.
Said another way, companies that can charge more without losing market share have durable pricing power and thus are generally very high quality. This dynamic sounds simple, but it is relatively rare and incredibly powerful because revenues generated from price increases tend to flow straight through to the bottom line, creating higher margins even if nothing else about the business changes. Companies that can achieve this feat can therefore drive highly profitable growth for years, but these companies must offer real value. Otherwise, customers will find less expensive alternatives. Furthermore, cheaper competitors will clamor in to pick off unhappy customers.
For pricing power to remain durable, companies need to have a meaningful competitive advantage. Often this can take the form of strong network effects that create high switching costs, regulatory barriers to entry, technological differentiation, brand value, or some other structural advantage.
By our estimate, roughly one-third of our portfolio falls into the price maker category. These high-quality businesses typically are dominant within their industry and possess significant pricing power over time, have high incremental margins, and exhibit attractive consolidated return on invested capital (ROIC).
Share Gainers: Low Cost Providers With Growing Market Share
Given Buffett’s extraordinary track record and his seemingly definitive statement that pricing power is “the single most important decision in evaluating a business,” one might think that business quality is all about charging high prices. However, this is far from the full story.
In fact, some of Buffett’s greatest investments have been in businesses that consistently undercut competitors and lower prices for customers. Just consider GEICO or Costco Wholesale Corporation: these are businesses that for years have provided critical goods and services (insurance and retail products, respectively) at prices customers cannot find elsewhere. These companies are in the business of offering industry low prices to ensure happy customers who come back again and again. Notably, both companies exhibit low operating margins and do not exert pricing power, which might lead one to conclude these are low quality businesses.
What makes them high quality is that they systematically increase their sales volume by taking market share from competitors. As long as the industries they operate in are flat to growing, the companies taking share enjoy steady revenue growth at stable but relatively low margins. The winners are able to do this in a capital-efficient manner, driving very attractive returns.
To maintain durable market share growth, companies have to possess a meaningful competitive advantage. Often this can take the form of a hard to replicate operating model, economies of scale, or first mover advantage.
By our estimate, roughly half our portfolio falls into the share gainer category. These high-quality companies typically combine lower prices and operational efficiency to take market share from incumbents with less competitive legacy business models. They tend to generate attractive revenue growth through expanding market share while maintaining stable but modest profit margins and have high unit level ROIC.
Compounding Machines: Pricing Power and Market Share Growth
A rare breed of companies can both consistently raise price and take market share – we call these businesses “compounding machines.” This very powerful combination typically results in high revenue growth and even higher profit growth due to attractive incremental margins.
Few companies fit this dynamic. In our view, those that do often operate in relatively narrow sectors of the economy, provide a critical good or service to their customers, and are typically considered the premium provider in their market.
Compounding machines tend to have multiple competitive advantages. For example, they often have network effects and a proprietary operating model or a technology advantage and brand strength. This combination can ensure years of continued market share gains coupled with robust pricing power.
By our estimate, just under a fifth of our portfolio falls into this category. These businesses tend to generate attractive revenue growth through share take, see expanding profit margins, and exhibit high unit level ROIC.
The Importance of Competitive Advantage
If we sound like a broken record on the concept of competitive advantage, it is because we obsess over this idea. Every investment we consider has to have a durable, lasting, and demonstrable competitive advantage. Understanding the durability of this competitive advantage is key to underwriting continued pricing power and/or market share growth, and we devote most of our research efforts towards this endeavor.
We frequently revisit the thesis for every company we own to test its structural advantage. Key to this analysis is monitoring pricing, market share flows, margins, and other financial information. We also carefully consider strategic transactions that happen in the sectors our companies operate in to understand if competitive dynamics have changed or could change in the future. In addition, we periodically check in with customers, suppliers, and other stakeholders to assess whether our companies enjoy the same advantages they historically have. Lastly, we closely monitor competitors and potential insurgents to understand whether new threats are emerging.
Evaluating a company’s competitive advantage is as much art as science and does not come down to a simple checklist, as companies and industries are in a constant state of evolution and change. However, by remaining fully engaged and, frankly, paranoid, we think we can maintain a solid grasp on what competitive advantage each company has and how much runway exists.
Tying It All Together
Every analysis, research project, and investing conversation on the Core Equity team revolves around competitive advantage. We always seek to quantify competitive advantage and believe that the vast majority of high-quality businesses exhibit durable pricing power while maintaining market share or operate as a low cost provider consistently growing market share in a profitable way. A rare breed of companies we refer to as “compounding machines” both exert pricing power and grow market share profitably. Our strategy seeks to build a concentrated portfolio of high-quality companies that fall under this framework at compelling valuations.
Nael Fakhry
Co-Chief Investment Officer – Core Equity
Core Equity Composite (as of 9/30/24)
In our Core Equity accounts Osterweis has the discretion to decrease or increase equity exposure in an effort to reduce risk.
| QTD | YTD | 1 YR | 3 YR | 5 YR | 7 YR | 10 YR | 15 YR | 20 YR | INCEP (1/1/1993) |
||
|---|---|---|---|---|---|---|---|---|---|---|---|
| Core Equity Composite (gross) | 3.89% | 14.85% | 30.45% | 6.42% | 12.28% | 11.53% | 9.58% | 11.15% | 9.68% | 11.45% | |
| Core Equity Composite (net) | 3.63 | 14.00 | 29.17 | 5.38 | 11.19 | 10.44 | 8.50 | 10.05 | 8.57 | 10.30 | |
| S&P 500 Index | 5.89 | 22.08 | 36.35 | 11.91 | 15.98 | 14.50 | 13.38 | 14.15 | 10.71 | 10.59 | |
Past performance does not guarantee future results.
Rates of return for periods greater than one year are annualized. The information given for these composites is historic and should not be taken as an indication of future performance. Performance returns are presented both before and after the deduction of advisory fees. Account returns are calculated using a time-weighted return method. Account returns reflect the reinvestment of dividends and other income and the deduction of brokerage fees and other commissions, if any, but do not reflect the deduction of certain other expenses such as custodial fees. Monthly composite returns are calculated by weighting account returns by beginning market value. Net returns reflect the deduction of actual advisory fees, which may vary between accounts due to portfolio size, client type, or other factors. From 1/1/2021 onward, net returns also reflect mutual fund fee waivers in certain periods.
The Standard & Poor’s 500 Index (S&P 500) is an unmanaged index and is widely regarded as the standard for measuring U.S. stock market performance. This index does not incur expenses and is not available for investment. Index returns reflect the reinvestment of dividends. The S&P 500 Index data are provided for comparison of the composite’s performance to the performance of the stock market in general. The S&P 500 Index performance is not, however, directly comparable to the composites’ performance because accounts in the composites generally invest by using a portfolio of 30-40 stocks and the S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring U.S. stock market performance.
The fee schedule is as follows: 1.25% on the first $10 million, 1.00% on the next $15 million up to $25 million, and 0.75% in excess of $25 million. A discounted, institutional rate is available.
Clients invested in separately managed core equity accounts are subject to various risks including potential loss of principal, general market risk, small and medium-sized company risk, foreign securities and emerging markets risk and default risk. For a complete discussion of the risks involved, please see our Form ADV Brochure and refer to Item 8.
The Core Equity Composite includes all fee-paying separately managed accounts that are predominantly invested in equity securities, and for which OCM has the discretion to increase and decrease equity exposure in an effort to reduce risk. The non-equity portion of the account may be invested in cash equivalents, fixed income securities, or mutual funds. Individual account performance will vary from the composite performance due to differences in individual holdings, cash flows, etc.
References to specific companies, market sectors, or investment themes herein do not constitute recommendations to buy or sell any particular securities.
There can be no assurance that any specific security, strategy, or product referenced directly or indirectly in this commentary will be profitable in the future or suitable for your financial circumstances. Due to various factors, including changes to market conditions and/or applicable laws, this content may no longer reflect our current advice or opinion. You should not assume any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from Osterweis Capital Management.
Holdings and sector allocations may change at any time due to ongoing portfolio management. You can view complete holdings for a representative account for the Osterweis Core Equity strategy as of the most recent quarter end here.
Flexible Balanced Composite (as of 9/30/24)
| QTD | YTD | 1 YR | 3 YR | 5 YR | 7 YR | 10 YR | INCEP (10/1/2010) |
||
|---|---|---|---|---|---|---|---|---|---|
| Flexible Balanced Composite (gross) | 3.75% | 12.73% | 24.69% | 5.72% | 9.61% | 8.87% | 7.87% | 9.52% | |
| Flexible Balanced Composite (net) | 3.54 | 12.05 | 23.69 | 4.92 | 8.76 | 7.99 | 6.98 | 8.59 | |
| 60% S&P 500 Index/40% Bloomberg U.S. Aggregate Bond Index | 5.61 | 14.80 | 25.98 | 6.63 | 9.78 | 9.42 | 8.89 | 9.64 | |
Past performance does not guarantee future results.
Rates of return for periods greater than one year are annualized. The information given for these composites is historic and should not be taken as an indication of future performance. Performance returns are presented both before and after the deduction of advisory fees. Account returns are calculated using a time-weighted return method. Account returns reflect the reinvestment of dividends and other income and the deduction of brokerage fees and other commissions, if any, but do not reflect the deduction of certain other expenses such as custodial fees. Monthly composite returns are calculated by weighting account returns by beginning market value. Net returns reflect the deduction of actual advisory fees. Net return calculation:
- Prior to 1/1/2020, the composite net return is calculated using actual advisory fees with the following exception: one member of the composite was a mutual fund portfolio whose fee was partially waived at some point due to an expense limitation agreement. The composite net return shown during this period does not reflect this waiver and is therefore lower than the actual return.
- From 1/1/2020 onward, the composite net return is calculated using actual advisory fees.
- Our fees may vary between accounts due to portfolio size, client type, or other factors.
The 60/40 blend is composed of 60% Standard & Poor’s 500 Index (S&P 500) and 40% Bloomberg U.S. Aggregate Bond Index (Agg) and assumes monthly rebalancing. The S&P 500 is widely regarded as the standard for measuring large cap U.S. stock market performance. The Agg is widely regarded as a standard for measuring U.S. investment grade bond market performance. These indices do not incur expenses and are not available for investment. These indices include reinvestment of dividends and/or interest.
Source for any Bloomberg index is Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg owns all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
The fee schedule is as follows: 1.25% on the first $10 million, 1.00% on the next $15 million up to $25 million, and 0.75% in excess of $25 million. A discounted, institutional rate is available.
Clients invested in flexible balanced separately managed accounts are subject to various risks including potential loss of principal, general market risk, small and medium-sized company risk, foreign securities and emerging markets risk, default risk, interest rate risk, inflation risk and liquidity risk. Additionally, there is a risk that we do not manage the asset allocation strategy successfully. For a complete discussion of the risks involved, please see our Form ADV Brochure and refer to Item 8.
The Flexible Balanced Composite includes all fee-paying separately managed accounts and mutual funds that are invested in a dynamic allocation of equity and fixed income securities as well as mutual funds and cash equivalents. OCM has discretion over individual investments as well as the discretion to increase and decrease equity exposure within the range of 25% to 75%. Individual account performance will vary from the composite performance due to differences in individual holdings, cash flows, etc.
References to specific companies, market sectors, or investment themes herein do not constitute recommendations to buy or sell any particular securities.
There can be no assurance that any specific security, strategy, or product referenced directly or indirectly in this commentary will be profitable in the future or suitable for your financial circumstances. Due to various factors, including changes to market conditions and/or applicable laws, this content may no longer reflect our current advice or opinion. You should not assume any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from Osterweis Capital Management.
Opinions expressed are those of the author, are subject to change at any time, are not guaranteed and should not be considered investment advice.
Holdings and allocations may change at any time due to ongoing portfolio management. References to specific investments should not be construed as a recommendation to buy or sell the securities. Current and future holdings are subject to risk.
Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g. depreciation) and interest expense to pretax income.
Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period.