Geoff’s Mental Model #1: “Market Power”
“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 percent, then you’ve got a terrible business.”
– Warren Buffett
A business with market power is a good business. A business without market power is a bad business. In that quote, Buffett gives a clear definition of market power when he says: “if you’ve got the power to raise prices without losing business to a competitor” you’ve got a very good business. Basically, if you’ve got the power to raise prices without losing business to a competitor, you’ve got market power.
Market power is not an internal advantage. It is not a technological advantage, a better corporate culture, or a process improvement your competitors have yet to figure out. Market power is external. It is a strong bargaining position versus those folks a company must sit across the negotiating table from.
Market power is the ability to make demands on customers and suppliers free from the fear that those customers and suppliers can credibly threaten to end their relationship with you.
Market power is often misunderstood as being an advantage one competitor has over another. That’s the wrong way of thinking about it. Businesses don’t squeeze profits from competitors. Businesses squeeze profits from customers and suppliers.
Often, competitors engage in rivalry that undermines each other’s bargaining position with customers and suppliers. In such industries, customers can play one competitor off against another. By doing this, they can negotiate for higher product quality, lower prices, longer payment terms, etc.
However, there are industries free from that kind of rivalry.
As investors, those are the industries we want to focus on. The best businesses in the world are in the best industries in the world. And the best industries in the world are those where the rivalry between competitors does not undermine the market power these businesses have over their customers and suppliers.
Dependency: Mini-Monopoly
All publishers have a mini-monopoly over each title they publish.
In children’s books, if you’re a bookstore that wants to carry Harry Potter – you have to pay Scholastic (SCHL) whatever Scholastic wants to charge for that title. Scholastic is your sole source of Harry Potter books. The only power you have in the market for Harry Potter books is to either accept or decline a take-it-or-leave-it offer from one seller. There are no competing offers you can consider.
In videogames, if you’re a gamer who wants to play World of Warcraft – you have to pay Activision-Blizzard (ATVI) whatever monthly fee Activision wants to charge for that MMORPG. Blizzard is the sole source for your WoW fix. The only power you have in the market for World of Warcraft access is to either accept or decline a take-it-or-leave-it-offer from one seller. Those who decline the offer are usually not dependent on the product. They don’t truly “need” a Harry Potter book or access to World of Warcraft. However, there are cases where some buyers of a “mini-monopoly” are truly dependent on the product.
They “need” it.
While researching John Wiley (JW.A), I met a buyer of Wiley’s academic journals who believed that his job literally depended on his continued access to John Wiley titles. If he failed to subscribe to these titles, he believed he’d be out of a job.
This university librarian had a limited annual budget granted by his school. He used this budget to pay for subscriptions to academic journals that the students and professors at this school would then have access to. I asked him: what would he do when one of the big publishers – like Reed Elsevier, John Wiley, Springer, or Informa (Taylor & Francis) – raised the prices of their subscriptions faster than his university increased his budget?
He said that happens almost every year.
And when it does, he cuts titles from other publishers.
You read that right.
When Elsevier, Wiley, Springer, etc. raise prices on their products – he stops buying products made by their competitors.
Why?
Because the way this university librarian decides which journals to subscribe to is by first making a “wish list” of all the journals he would like to subscribe to from his top priority journal down to his lowest priority journal. He then allocates his budget to subscribing to as many of these journals as possible by starting with his top priority journal and then moving as far down the wish list as his budget allows. If the number one academic journal in a field raises its price – and Elsevier, Wiley, Springer, etc. tend to publish the most number one journals in their fields – he doesn’t consider cancelling his subscription to that journal. Instead, he cancels his subscription to the fourth or fifth most cited journal in that field to pay for the higher price of the subscription to the most cited journal. His budget is not flexible. And his need to subscribe to the most cited journal in each field isn’t flexible either. As a result, the publisher of the most cited academic journal in a field has market power. They get the price they demand.
Dependency: Entanglement
Ad agencies are some of the best businesses on planet earth. The economics of the ad agency business are amazing. However, they are also pretty simple. Almost everything that makes an ad agency great comes from one fact:
Advertisers almost never fire their ad agencies
If you changed that one fact about the advertising business, everything else would change too.
For example, ad agencies have “float”. Basically, an ad agency buys space from a media outlet using client money. I say this because the agency’s client usually settles its bill for this ad space in cash with its agency about two weeks before the ad agency settles its own bill for this ad space with the media outlet. So, imagine Coca-Cola (KO) is buying a 30-second spot on a Twenty-First Century Fox (FOX) TV show. Coke pays its agency the $500,000 for this spot on May 1st. But, Fox doesn’t receive the $500,000 till May 15th.
Where is that money in between?
It’s at the ad agency.
That means an ad agency always has about four percent (2 weeks / 52 weeks in a year = 3.8%) of its annual billings on hand. Which means an ad agency can be funded by clients instead of shareholders. Which means ad agencies have nearly infinite returns on equity.
Is this a fluke? Is this a quirk of the business that no one has figured out?
No. It’s a result of market power.
In 2015, Coty (COTY) initiated a review of its $1.07 billion account for media buys in the U.S., U.K., and Ireland. Ad agencies generally record about 20% of billings as revenue and turn about 15% of revenue into profit. So, winning a $1.07 billion account would boost an agency’s revenue by about $215 million and would add about $32 million to pre-tax profit. In the ad industry, the life of a client relationship is extremely long. So, new account wins should probably be capitalized at no less than 10 times pre-tax profit. In other words, winning this $1.07 billion Coty account – if investors believed you were going to keep it – should have added about $320 million to the market cap of the victorious ad agency. So, how aggressively did the world’s biggest ad agencies bid for this business?
Answer: they didn’t.
Coty asked the agencies pitching for this account to agree to a 150-day time lag between when Coty was going to be billed and when Coty had to settle that bill in cash. Most advertisers pay their agencies faster than 120 days. So, when Coty held a pitch session for this $1 billion plus account – the biggest U.S. ad agency (Omnicom), the biggest U.K. ad agency (WPP), and the biggest Japanese ad agency (Dentsu) – all decided to stay home.
The founder and CEO of WPP, Martin Sorrell, explained why his company doesn’t want to win such business:
“We have basically taken the position, as you know, that we are not a bank. We said that a long time ago and that we are not in a position to act as a bank and fund clients. The bank should do that.”
You can’t get your client to fund you unless you have market power. And you can’t keep market power if you and your competitors bid on the basis of ceding that advantage to an especially big customer in exchange for earning a bit more profit this year.
In most industries, the rivalry between competitors leads to decisions that prioritize the short-term self-interest of each competitor over the long-term common interest of all the competitors in the industry. In truly great industries, like the ad agency business, that doesn’t happen.
Why doesn’t it happen?
Because the rivalry between ad agencies isn’t intense enough to force them to compete away the market power they have over their customers and suppliers. Why not? Omnicom’s CEO, John Wren, said it best:
“We’re invited to new business pitches…we can’t create them…we can’t cause somebody to put their account in review.”
One ad agency can’t take a client from another ad agency. The first agency has to lose that client by screwing up in the first place. That keeps rivalry low. And keeping rivalry low lets ad agencies preserve the market power they have over their clients. It lets them insist that clients pay them in cash before they themselves have to pay for ad buys in cash.
Market power is what gives ad agencies near infinite returns on equity.
So, the next time you are considering which industry to research next – remember Warren Buffett’s words:
“The single most important decision in evaluating a business is pricing power…”