Pricing Power for Dividend Payers

As editor of Morningstar DividendInvestor and manager of our income model portfolio, I'm obliged to pay close attention to inflation trends. Investment returns are properly understood as income plus income growth, but from that nominal return we need to subtract inflation--the steady erosion of purchasing power. In the long run, it's only the real return that increases income and wealth.

We can't know for sure where inflation is headed, but regardless of what happens, we'll be better off owning the stocks of firms with pricing power than those without.

The Income Portfolio Perspective
Long-term bonds (save Treasury inflation-protected securities, or TIPS) don't have a "growth" component to their income stream, making them unattractive in the face of accelerating inflation. Stocks with rising dividends provide much better protection from inflation.

But not all stocks offer equal protection from inflation. What we seek in our Dividend Portfolio is an ability to keep pace with inflation using two methods:

1. Increases in operating costs must be passed along to customers, preserving profit margins.

2. Expected dividend growth will accelerate in an inflationary environment, protecting real total returns.

Pricing Power Needs a Cause
Not every type of company or industry has the ability to raise prices and pass along cost increases. Consider the present plight of packaged-food companies--even huge firms with well-known brands, like  Kraft Foods (KFT), are unable to pass along all their commodity cost increases through the retail channel and on to consumers. Profit margins take the hit instead.

Our first line of defense is an economic moat. Our moat ratings convey our expectations for a firm's ability to earn superior returns on investment over time. The same types of characteristics that create superior profits often--but not always--allow for rising prices as well.

Better yet, we can evaluate each type of firm on its moat characteristics to see evidence of pricing power. I've identified several types that, I'm pleased to report, appear to cover virtually all our Dividend Portfolio holdings.

Floating-Rate Financials
In normal times (when short-term interest rates aren't at record lows), the biggest cost for a lending institution will be its own cost of funds. Some operators--say,  Annaly Mortgage Management (NLY)--are geared toward borrowing short and lending long and won't be able to recover an increase in funding costs. But if the institution is geared toward variable-rate lending, as most retail and commercial banks are, then any increase in the cost of funds should be passed along to borrowers in short order.

Note, too, that inflation represents growth in the money supply, meaning an increase in the quantity of dollars in circulation. Who will hold and lend those inflating dollars, earning an interest spread on higher and higher nominal balances? Banks.

Research & Development Leaders
In the goods-based economy (as opposed to services, financials, or information), retailers and consumers have been trained to reject price increases out of hand. No one will pay more for yesterday's mousetrap.

Ah, but there is a way out of this headlock: a better mousetrap. Just as banks can reprice their variable-rate loans, innovative firms like  3M (MMM) and  Johnson & Johnson (JNJ) can "reprice" their existing lines with replacing them with new technologies and products. As long as these firms remain effective innovators, they're up to the inflation challenge.

Customer Switching Costs
When it's very expensive for customers to switch suppliers, chances are that 1) the supplier will be able to charge premium prices, boosting profitability, and 2) it will be able to raise prices further in an inflationary environment.

For instance,  Microsoft (MSFT) users may grumble about prices, but are they really going to switch to inferior systems--at tremendous implementation and training expense--just to save a few bucks? Will depositors switch banks and spend weeks or months changing their payroll transactions and bill-pay services? Will propane distributors like  AmeriGas  and  Suburban Propane (SPH) lose customers when they own their customers' tanks? In all likelihood, no--and that gives these firms a window to at least keep pace with inflation, if not exceed it.

Regulatory Cover
There are two basic types of profit-regulating schemes: rate of return and price cap. Your basic electric, natural-gas, or water utility works on the rate of return plan: It's allowed to earn a certain return on equity--usually something like 10% or 12%--over its asset base. Operating costs (most notably fuel) are eventually passed through to customers. However, it can take years to recover increased costs through rate cases; in the meantime, cash flow suffers. (Utilities stocks are also notoriously sensitive to interest rates; if you think inflation is on the rise, you won't want to own utilities.)

By contrast, pipelines like  Kinder Morgan  and  TEPPCO Partners  run under price caps. The operators are allowed to charge a certain rate based on the volume and distance of oil, gas, or refined products transported, but the allowed rates are indexed to the Producer Price Index. If inflation rises, so will rates, revenue, and payouts to investors. This much simpler regulatory regime, plus higher payouts, makes pipeline partnerships more attractive than utilities, in my view.

Hard Assets
Putting pipes in the ground, setting up hundreds of propane distribution centers and digging salt mines involve big up-front costs. Once a provider is established in a particular area, there's little incentive for a new competitor to set up shop. And when operating costs increase, they tend to increase for all competitors equally. In the absence of new options, customers have little choice but to pay up.

 Compass Minerals' (CMP) assets in particular would be very hard to replicate. It already owns the two largest rock salt mines in North America and the largest mine in the United Kingdom. Duplicating Compass' scale and cost advantages would be all but impossible at any cost. Thus Compass and its existing peers are free to raise prices without much backtalk.

A lack of ready substitutes also benefits these firms. Pipelines compete with trucks, but pipes will always be cheaper. Propane competes with natural gas, but the reach of gas utilities' pipes goes only so far. As for deicing salt, there are very few opportunities to substitute other minerals, and in almost every case the replacement would be more costly, not less.

The Awful Truth
Even the shares of firms with pricing power can and probably will suffer in an inflationary environment. The 1970s were terrible years to own stocks. Though dividend growth for the S&P 500 accelerated from 4%-5% to 11%-12% during the decade, investors required higher and higher yields up front--again, placing a premium on the bird in the hand versus the dividend growth in the bush.

There is a silver lining, however. Businesses whose pricing ability permanently enlarged their earnings during the decade benefited greatly as inflation fell. The overall market tripled between 1982 and 1987, and yields fell by half as investors caught up with a decade of unrealized value creation.

We cannot predict the path of stock prices should inflation increase. However, we can and will focus on firms that will create and store real value whatever happens.

This article is from a recent issue of Morningstar DividendInvestor, our monthly newsletter dedicated to helping investors find dividend-paying stocks with superior long-term return potential. To review a risk-free trial issue of DividendInvestor and receive three free investing reports, click here.

This article originally appeared online on Dec. 30, 2005.