Pricing power in the age of tech champions
Photo by Lopez Robin on Unsplash
Market bears point to weakening market breadth in the S&P 500 especially as a sign that things are not well, attributing to passive flows, YOLO retail options or simply irrational buying the phenomenon of the FAANG+ megacaps (including the likes of Microsoft and Nvidia) being the only drivers of the market.
We ourselves are keen watchers of market structure, and we do believe that passive flows, dealer hedging, YOLO retail options et al could very well be the reason why the FAANG+ complex continues to outperform.
But there is also a possible fundamental driver: that the stocks that are being bought are those of companies with pricing power. In the years since the last bout of serious global inflation, much has changed. And with the changing of market leadership so too do the purveyors of pricing power.
When US yields spiked in March, the “long duration” tech stocks plummeted. Most (ourselves included) believed that with higher rates, companies with no near term profit (or with most of the value in the terminal value of the famous DCF) would see a material derating as rising rates means lower future value. Simple right? Well, it was, but then rates stopped going up and went down and the “long duration” tech stocks carried on falling.
So, thinking caps on, we started to think a bit deeper.
And here is a working theory.
Blast from the past
Let’s just take a moment to think about inflation: when was the last time we REALLY had sustained, high-ish inflation?
Based on OECD numbers, the period to look at would be around 2011-2014. Arguably, the US and the EU never really got out of the post GFC growth slump, although the extent of the monetary easing from QE showed its effects all around the world, especially in emerging markets:
Without a doubt, there were countries experiencing pronounced inflation. And according to the traditional equities playbook, the trade was to seek out companies with pricing power, businesses that provided goods and services that were absolute necessities and – even better – had the ability to raise prices and pass through cost increases in the face of inflation.
The tail end of the commodity supercycle still gave commodity producers some pricing power, and real estate was arguably a good inflation hedge as rents could be hiked in line with prices (even as developers were plagued with other issues especially relating to debt), but the holy grail in almost every portfolio was formed by a collection of consumer staples names: after all, inflation or not, wouldn’t everyone have to buy soap, toothpaste and food?
The poster child of the inflation-proof business was probably Unilever: its main listing returned an average of 23% p.a. between the lows of 2009 and 2016 in USD. Its locally listed units did even better, topped off by Unilever Indonesia returned an average of 32.5% p.a. over the same period. Likewise, other global consumer staples giants like Mondelez clocked in similar rates of performance.
As always, the narrative is key – the narrative goes that aside from being largely well-run, these companies sell products that their customers simply cannot live without. As a result, they not only have a steady source of demand, but they also have a strong ability to hike prices (or decrease package sizes), passing through higher inflationary costs into a pool of inelastic demand. Inelastic demand, prices go up, profits grow disproportionately more – Economics 101 saves the day.
10 years later
Here’s our take. A decade ago, FAANG wasn’t even yet a term that was invented – Facebook wasn’t even yet listed, and Netflix at the time had just started streaming video on demand. These businesses were hardly mature at the time, and “tech” at the time was pretty much the realm of the speculative. It certainly wasn’t yet the age of “every company is a tech company” – there were still “non-tech” companies around.
They certainly weren’t things that “people couldn’t live without”.
10 years later, let’s consider what we actually cannot live without: that Amazon prime subscription that gets us what we need the next day, or even in a couple of hours; the unending supply of content on Netflix; the messaging connectivity and social networks on Facebook’s trifecta of Facebook/Instagram/Whatsapp; or even the undying aspiration of millions around the world to own an iPhone despite its clearly demanding price tag.
By the same logic of “everyone needs to eat and brush their teeth, inflation or not”, we aren’t surprised that even in the face of inflation, cancelling Amazon Prime, Netflix or Spotify isn’t a priority when it comes to “saving money”. These aren’t discretionary anymore – in 2021, these are necessities.
FAANG+ represent the new basket of necessities for life in 2021. Yes, the stuff we consume and buy from them are the real necessities, but for better or for worse, these platforms have aggregated demand from so many people that they become demand engines in and of themselves – Amazon Prime itself has 200m members, so if Amazon Prime were a country, it would be the 8th largest country in the world, behind only China, India, the USA, Indonesia, Pakistan, Brazil and Nigeria.
As an aside, some food for thought for observers of market structure in this instance. “Market breadth” measured by the number of advancing/declining stocks can also be misleading. Consider the old days where defensive sectors like utilities and telcos comprised multiple operators that were separate companies but remained highly correlated with each other as a result of their business nature - would 5 telcos moving in lockstep look like greater “market breadth” than one mega telco? Yes it would. Yet the nature of today’s internet platforms decrees that there can be only one Amazon. Would it make everyone feel better if there were 10 mini Amazons, 5 Netflixes for regional broadcasting or 1 Mercadolibre equivalent per Latam country to make the market breadth measure look nicer? Perhaps, but if that were true, it would be highly economically inefficient and unprofitable for everyone.
All of these platforms make competition global, and adopting the strategies of the department stores of years ago, they’ve demolished the value of individual brands: from private labels (e.g. Amazon Basics, Netflix originals) to allowing competition from smaller producers (of both physical goods as well as content etc) that have lower brand premia, including user generated products and services (e.g. marketplaces and UGC); to absolutely dominating infrastructure – try surviving without using Microsoft Azure, AWS or Google Cloud, for example. Even Nvidia, a recent inductee into the “+” section of FAANG+, has exhibited outstanding pricing power with its chipset sales.
In such an environment, does pricing power really still reside with consumer-facing brands? In some cases (e.g. Nike Sneakers), yes, but in most cases, especially with commoditised products like shampoo, toothpaste or other staples, pricing power lies with the platforms – the coming of age of all of these platform businesses and the dominance they promised.
No surprise either that the prior champion of pricing power, Unilever, this week announced a 1H profit warning, attributed to none other than rising costs. You can swap from Cif brand detergent to some random, white-labelled cleaning fluid for a 30-50% saving in cost, but whatever you choose, you’ll probably be browsing, comparing prices and buying it from Amazon.
The pricing power that used to characterise these companies has now shifted, and likewise the aura that used to shine upon “defensive” consumer staples now shines upon the new necessities of the day: FAANG+
Oh, and yes, inflation is coming. Unilever basically told us so with that profit warning. And believe us, if there’s anyone in the world that has bargaining power over supplier pricing, it’s Unilever, so when they say costs are hurting, we tend to believe them.
Defensives on the offensive
We certainly do not intend to throw shade at the market technicians that warn us of the worrying dynamic of what seems to be a bull market in the headline indices with very little market breadth, effectively having the FAANG+ stocks “carrying” the market on its uptrend (for now). By any measure, that is a metric that everyone needs to be watchful of.
Yet perhaps the narrow nature of this “bull market” in this case should not be entirely attributed to market structure quirks that tend to mean revert. Perhaps there is a perfectly sensible, fundamentally-driven justification for narrow breadth – that these are the only obvious candidates in the market that command pricing power. In fact, if one looks a bit deeper one can see that stocks like Sea Limited with budding dominance in Southeast Asian ecommerce or Latam’s Mercadolibre which has perked up of late as well as a host of others have begun to join the FAANG+ cohort.
Perhaps, in the end, the squeeze higher is a flight to safety, a rotation into the highest pricing power names in the market. It only so happens that these also are the largest market capitalisation companies in the world and as these entities aggregate more and more demand, it is the rest of the pack (the majority) that suffers to protect their margins.
We started this note with Inflation, and so we end with an assertion on the same topic: that in the face of inflation, regardless of what the Fed or any central bank does, an equity market that distrusts the idea of “transitory” inflation (even as the definition of “transitory” creeps from weeks to months to years) will naturally seek solace in pricing power.
Pricing power in 2021 sits with the Tech giants that comprise FAANG+, along with other platform businesses that have established footholds around the world which importantly have the ability to maintain or even grow margins in the face of inflation. Unfortunately, given recent regulatory action, we’d exclude Chinese e-commerce platforms from this definition – we’d point readers to our notes on the DiDi incident and on Alibaba for more context.
Moral of the story: seeing the S&P 500 and the Nasdaq squeezing higher may not be just another market quirk, nor should it be mistaken as a leading indicator of rate expectations (down), nor a proxy for another “numba go up” rally in profitless, YOLO stocks. Likewise, rising rates, if they come through, may trigger a selloff in these names – but to expect them to crash like a profitless, long-duration earnings stock, is likewise a dangerous conclusion to make.
It’s been a long time since the last bout of serious inflation, and much has changed – tech isn’t the speculative gambling den it used to be. It’s grown up now, and it’s time for us to recognise that.
History doesn’t repeat, but it often rhymes, and the rhyme is one of pricing power.
That’s what we really need to look for.