Price Makers, Share Gainers, and Compounding Machines: Three Quality Business Models

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.