Book review/thoughts
Price setting by Truman F. Belwey
In general I avoid value investing books these days. Many suffer from survivorship bias and are not very interesting. Or they are self promotion books. But when I saw Price Setting by Truman F. Belwey my interest was piqued as he heavily draws from real world data that is not easy to get through chatgpt or a google search.
Curiously the exact mechanisms of pricing power is a very underdiscussed subject in value investing. But it is extremely important for obvious reasons. It’s something that Buffett heavily focuses on when discussing any business with management. A significant edge can be gained in value investing if you can guess how profit margins will evolve over time, or if there is latent pricing power/economies of scale in a business. You would think a large amount of value investing books were written on the different pricing mechanisms and game theory behind it yet that is not the case.
What Belwey did is talk to insiders and managers in many different industries over a period of more than a decade and summarize the findings in this book. Interestingly it also got me thinking and gave me a realization that there are different types of pricing power (on the way up and on the way down).
I can identify roughly 4 different pricing mechanisms between a company and a paying customer:
Pure commodity price taking. Like Lumber (somehow it feels wrong to not write Lumber without a capital L) oil, copper etc. Zero pricing power. Almost no differentiation. Often very liquid and global. Prices feel more like the result of some Moloch nobody controls than the agreement between two parties. The only way to make money is to sit at the bottom of the cost curve. Low cost advantages often come from geography (like oil) and not pure scale, as pure sizing related economies of scale industries usually morph into oligopolies/duopolies.
Auctions. Set apart from pure commodity price taking by lower liquidity and assessment of bidders ability to execute. Where the lowest bid doesn’t always win. Usually seen in construction and government contracts.
Formula based pricing. Price is set with a formula by companies with some input from customers/suppliers. Where the formula can be renegotiated periodically.
Cost plus pricing like in low value add manufacturing (textiles) or retail
When combined with longer term contracts where end product could be a commodity, but inputs are unique and require huge upfront investment (gas pipelines and LNG terminals)
High degree of bespoke/custom manufacturing where plenty of alternatives exist, but switching costs are high after a company chooses a supplier. Renegotiating prices on a regular basis could risk painful business disruption.
Usually more common in more illiquid markets, or when cost volatility increases.
Monopoly/Oligopoly pricing power. Companies have a larger degree of freedom to just set a price without much input from their customer, and the customer is forced to pay it as there are few or no alternatives. Usually:
Luxury products
Very high value added products with no alternatives (Intel in its glory days).
Industries with very large economies of scale that form into oligopolies/duopolies over time (memory chips after they consolidated)
Companies that operate in extreme niches.
New industries that do not have a lot of competition yet with a few first movers.
I always find it amusing how macro economists think that economic agents make decisions on stats that usually only economists care about, the author was quickly disabused of that notion:
“One might expect in a study like this to read about negative productivity shocks and Federal Reserve Bank inflation targeting or forward guidance, because these topics are much discussed in macroeconomics. Neither topic ever came up spontaneously, except when a few respondents mentioned the effects of drought on agriculture and of low water levels on river and lake shipping. I occasionally brought the topics up, but eventually desisted, because respondents implied they were irrelevant to pricing.”
The main things I learned while reading this book (not necessarily all explicitly mentioned):
Two forms or pricing power:
The kind where it is easy to raise prices
The kind where it is hard to raise prices, but where price stickiness is fairly high (in a recession or when a shortage goes away). This is why some companies in Covid supply shock managed to keep elevated margins above their historical average even when bottlenecks went away. But were not able to accomplish these price increases without an external supply shock.
Value-added manufacturing creates switching costs. For example custom packaging for consumer products. Pricing stickiness is a function of how high the switching costs are and how volatile demand is.
A recurring theme in the book is that purchasing managers think the more value add there is, the less they want to lower prices in a recession as price becomes a weaker and weaker signal to potential customers, but quality and reliability is. So switching costs work in your favor but also make it harder to poach competition by lowering price just a bit, you would have to lower it a lot. This is true for competitors as well, so they are less likely to lower their price as well (for the same reasons) so this keeps pricing stable even in weak demand.
Purchases that are spaced more widely have the potential to increase pricing power vs regular made purchases. As customers wont remember what they paid last time. I don’t think this counts for big ticket fairly undifferentiated items like automobiles though. I’m actually a bit sceptical of this as often regular purchases are made by a distributor even if the end customer buys it sparsely.
Suppliers (like clothing manufacturers to clothing brands) often are given higher margins in high growth phases when the brand wants their suppliers to have ample capital to grow with them. This process can reverse when growth slows down as the buyer is going to renegotiate contracts with its suppliers as margins become more important. So beware of this when investing in suppliers exposed to higher growth industries (like for example Chinese textile manufacturers). Both growth and margins could collapse at the same time (and often why these Asian manufacturer companies trade at lower multiples).
Lowering prices could cause a company to lose their distributor customers as it would lower their inventory value. This is a bit counter intuitive to me. But it makes sense if distributors/retailers enjoy significant network effects and market power. In general I think the role of middle men (and potential removal of them) is under appreciated in the pricing power discussion.
More on the role of distributors, if they have put a lot of material out there with their prices, then changing it suddenly is a pain. So to maintain good relationships in some industries pricing is set only once a year.
If a product is a component in a larger piece of equipment that is sold to multiple distributors and manufacturers before reaching the end customer, it is easy to see how increasing price can create significant complications for customers downstream and is more difficult vs when selling directly to the end customer through perhaps only 1 distributor layer.
Highly differentiated products tend to have a clientele who know about that product and know less about substitute products (quote by an executive in the dental industry).
Increasing automation potentially increases fixed cost % as machines cannot be fired. Which makes prices more rigid.
Despite enjoying reading most of it (the section about lumber/grain pricing wasn’t interesting to me and I skipped most of it, and retail also doesn’t interest me a great deal) I think the book fell short in several ways. First I think the author should have been more granular per industry. I would have loved to see how industry consolidation, customer concentration affected price negotiations. The book presents a lot of quotes from sales people/CFOs/purchasing managers, but little information around it about potential moat of the business and more detailed industry dynamics. Since the author collected data over more than 20 years it would have also been interesting to study how industry consolidation gives companies more pricing power, and what it looks like on the ground when deals are made.
The book was published in 2025 which made me disappointed it did not cover the effect of inflation. I would have loved to learn how this affected pricing negotiations and how margins did stay elevated even after some of the bottlenecks (like shipping, chip supply) went away. Overall I felt like the author would have benefited from consulting with some value investors as he would have been able to ask more pointed questions. I think he came at this too much from an ivory tower macro economist angle. I think it is a great shame how economists seem to show so very little interest in what agents who make the market efficient have discovered.
Overall though the book is only about 200 pages and worth at least a skim if you found this interesting.