1 Important Reason Why Smart Investors Would Shun These Shares

Famed investing legend Warren Buffett once gave some insight on how investors could find great businesses. This is Buffett on the topic in a 1991 lecture he gave at the Notre Dame Faculty (I found this courtesy of a transcript which investor Whitney Tilson had produced):

“A couple of fast tests about how good a business is. First question is “how long does the management have to think before they decide to raise prices?” You’re looking at marvelous business when you look in the mirror and say “mirror, mirror on the wall, how much should I charge for Coke this fall?” [And the mirror replies, “More.”] That’s a great business…

…The ability to raise prices – the ability to differentiate yourself in a real way, and a real way means you can charge a different price – that makes a great business.”

In a nutshell, it is a business’s ability to raise prices and not lose customers in the process which can help point out great businesses. If you’re a long-term investor (and I think everyone should have a long time horizon in investing), this is an extremely useful tool-kit to have in your investing arsenal. It’s also good to point out that a company’s ability to raise prices is also a very important business trait which Buffett looks out for when he invests.

But just as useful as it is to pick out shares which are likely to possess pricing power, it can also be very useful for investors to think about the shares which don’t have the ability to raise prices. As Buffett’s long-time business partner Charlie Munger is fond of saying, “Tell me where I’m going to die, that is, so I don’t go there.”

So, what are some local companies which have trouble raising prices? Commodity producers and traders come easily to mind – and that includes blue chips like Golden Agri-Resources Ltd (SGX: E5H), Wilmar International Limited (SGX: F34), and Noble Group Limited (SGX: N21).

For the third quarter of 2014, palm oil producer Golden Agri saw its quarterly revenue climb by 17% year-on-year only for its EBITDA (earnings before interest, taxes, depreciation & amortisation) to drop by 9% on the back of “weaker average CPO [crude palm oil] prices.” As you can see, the movement in commodity prices (CPO prices in this case) can affect the company’s EBITDA-margins significantly, and that’s a sign of a lack in pricing power.

Elsewhere, Wilmar International, which has business interests in palm oil, oil seeds, consumer products, and sugar, saw its third-quarter revenue drop by 2.7% year-on-year despite experiencing a 3.9% increase in sales volume. It was a very similar dynamic for Noble; the commodities trader saw its revenue for the first nine months of 2014 step up by only 4% even though its sales volume actually surged by 19.3%. These are strong signs that Wilmar and Noble have a distinct lack of pricing power in their businesses as they couldn’t translate volume growth into more-than-commensurate top-line growth.

A Fool’s take

In investing, there are many roads which lead to Rome (so long as the road’s paved with the intentions of looking at shares as pieces of a business!). The likes of Golden Agri, Wilmar, and Noble may attract certain investors because of say, their very low valuations; at current prices, the trio are valued at a price-to-sales ratio of 0.59, 0.37, and 0.06 respectively.

But, for investors who are focused on finding great businesses to hold on for the long-term, they might very well just shun the three shares because of their lack of pricing power.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any companies mentioned.