How The Pricing Power Index Identifies Market Leaders

During their recent episode, Taylor, Carlisle, and Steve Hou discussed How The Pricing Power Index Identifies Market Leaders. Here’s an excerpt from the episode:

Tobias: You’re at Bloomberg Indices. What do you do at Bloomberg Indices, and what is Bloomberg Indices as opposed to the Bloomberg TV or the monitors or whatever?

Steve: Yeah, thank you for asking, [chuckles] giving me a push, and an excuse to justify to our folks at Bloomberg Wire. Come on. Bloomberg Indices, so we basically started this business– Bloomberg Indices essentially came from the acquisition of the Lehmann indices, which became the [unintelligible 00:07:46] indices. The Ag, right? That’s the bond index. And then, we also have the Bloomberg Commodities Index that came from initially a collaboration with UBS, and now it’s become whole owned.

And then, I came on to the scene in 2020. At that point, we were thinking about completing our offering by building out the equity’s indices. So, we have all of the benchmarks, passive market-cap weighted benchmarks, but we also building out– So, we filled out style indices. So, when I came on, my first job was to actually build out a family of vanilla style-factor indices with only your typical value, momentum, quality and so on. So, that’s what Bloomberg Indices is. You can go on to bloombergindices.com, and you can find all of our products and our various research insights. The basic stuff we’ve actually built up more things, leverage and Bloomberg data as well.

Tobias: How does your value index deviate from other value indexes?

Steve: There are two types. There is the benchmark type, and then there is the strategy product that becomes licensed as some investment product. For a benchmark, typically, when people just want to track and evaluate their value investment strategy, that construction is not very unusual at all. We try to be as generic and as plain vanilla and explainable as possible using the most commonly used description– [crosstalk]

Tobias: Book. Suppose a book.

Steve: A price to book, book to market or price to earnings, sales, price of the cash flow, and you can find how we weight them and so on. It’s part equal weighted with some typical treatment of [unintelligible 00:09:49] and combination of different descriptors. So, nothing unusual there.

And then, if we want to come up with a value index that is to be tracked by an ETF, let’s say to invest, only then we probably do it in consulting with the client and our own thought process of trying to do it a little bit more thoughtfully with a little bit more of our own ingredients of what we find to be most applicable, especially in the modern context.

Tobias: You’ve created an index, the purchasing power index, can we go through that?

Steve: Yeah.

Tobias: What that involves and how that’s performed?

Steve: Yeah. So, I created a pricing power index. This was like a year and change ago. I recently did a reading of the index white paper with Idea Farm. And the ticker is EPP US index on the terminal. Essentially, this was 2021, I think 2022, we were thinking about how to actually– Everyone was talking about concept of pricing power. Companies with strong pricing power would do well in the inflationary regime. But then, there’s not like a very clear, explicit way people are thinking about pricing, how do you define it?

You can define it by go out and collect a whole bunch of data on all the public companies out there in terms of their market power, market share, and so on and so forth. That’s very onerous. You probably can’t really get a lot of data. So, what is actually a reasonable, sufficient statistic? People will think about profitable companies, maybe ones that have pricing power– But actually, if you look into, it turns out companies that have very high profit margins are not necessarily the ones with pricing power, because the margins can be eroded.

Now, what is interesting is that you can actually make a simple twist. And instead of looking at the level of margin, you look at the stability of margin, in particular, if you look at the stability of gross margin. Now, why gross margin? Gross margin is basically one item away from revenue, the top line. You just subtract more or less the variable cost, that includes your raw materials, that also includes your hourly wages, if you are Chipotle. That basically captures all of the ways in which you can pass through the variable costs.

The idea is that if a trailing five-year gross margin of a company is not varying very much at all, is probably a very good indicator that this company has got very strong pricing power. So, that’s the individual motivation. We built an index using this concept. We’ll go into the detail of how we construct the index in the white paper, but that’s the idea. It has actually done quite well, and we have learned some interesting things along the way.

Tobias: What have you learned?

Steve: You go onto the internet, you go onto Yahoo Finance, you search pricing power, and there’s pricing power ETF. And it’s got things like Nvidia, Tesla, Apple, and all your famous companies in it. I won’t comment on how is it done, but all I want to say is that– What we’ve found in our research, it turns out the companies with the strongest pricing power, not necessarily the ones that are glamorous that you hear a lot about, correct? Apple, for example is a very famous company. People casually think it’s got very strong pricing power. But if you look at the price tag of the flagship iPhone, it’s actually not changed very much for a few years now.

Steve: Now, you can wonder why that is, but it probably has something to do with between competitor and regulator. What we find in our portfolios is that you find companies– A good example I like to refer to is Cadence Design Systems. Have you heard of the company?

Jake: No. I haven’t.

Tobias: [crosstalk] heard.

Steve: Cadence Designs Systems, what do they do? They design software for designing microchips. There are about handful of those companies. Ansys is another one. It’s been acquired by Synopsys. There are like four of them, and one of them is acquiring another one. The private companies with pricing power are ones that are suppliers in niche industries that you don’t ever think about. There’s basically B2B suppliers. They managed to have pricing power and retain pricing power, because you don’t think about them, so competitors are not being drawn to the industry very easily and regulators are not catching their attention. Regulators very often either. So, you’ve got something like a Cadence Design System that’s designing software for manufacturing or designing microchips.

Microchips is all the rationale, and that’s a highly cyclical sector. But you can never imagine a microchip manufacturer to say, “Oh, business is terrible. I’m going to cancel my software for designing my microchips.” You’re still going to subscribe. Same thing with Adobe. So, you’re talking about that type of company, and they tend to show up a lot in our index.

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