Invest in Inelasticity

Invest in Inelasticity

Editor's note: A previous version of this article incorrectly referenced financial data from Time Warner Inc., rather than Time Warner Cable. The author and The Motley Fool regret the error.

A couple of recent events got me thinking about price elasticity and how a savvy investor can capitalize on producers of inelastic products. Price elasticity refers to the change in consumer demand when price changes occur. Items that are less elastic will experience a smaller change in demand when prices change than will more elastic goods and services.

Elastic goods are typically found in highly competitive industries or segments, where products are similar across different brands. Restaurants are a good example of a highly competitive industry with high price elasticity. Given the industry's lower barriers to entry, consumers have a wide variety of restaurant choices. For example, all things being equal, if Five Guys hikes its prices, customers will flock to Smashburger.

In a volatile stock market like we're experiencing, investors can gain some portfolio stability by owning shares of companies that produce inelastic goods. Investors can expect steady revenue and earnings from these companies, as well as potential expansions during market downturns.

No alternative
My local cable provider was recently purchased by Time Warner Cable , and consequently my bill has grown each month. One month my cable and Internet magically became "unbundled," and my bill went up $5. The next month, I began to get charges for some tiny receiver box I have never seen to the tune of $3.50. And so on and so forth.

This led the cheapskate in me to look for alternative cable and Internet providers in my area. But what Time Warner Cable knows, and what I now know, is that there are no alternatives in my area that provide similar Internet speed and variety of cable programming -- not a one.

Time Warner Cable can raise its price as high as it wants, and I will continue to pay as long as I want to watch ESPN on cable while researching stocks on my iPad using broadband. This monopolistic pricing may be terrible for consumers, but it can be rewarding for investors in Time Warner Cable shares.

Investors looking for steady growth in a long-term portfolio (or wishing to hedge increases in their cable bill) should consider establishing a position in Time Warner Cable. With $21.9 billion in annual revenue, Time Warner Cable is reasonably priced at a forward P/E of 14.4. Look for the company to continue growing revenue through acquisition, add-on sales, and, of course, price hikes for current customers.

Piggybacking Time Warner Cable
One company benefiting from Time Warner Cable's monopolistic pricing is Netflix . Netflix has very elastic pricing, as was evidenced by the loss of nearly 1 million customers during 2011's Qwikster debacle, which would have raised prices by 60% (from $9.99 to $15.99) for its DVD-plus-streaming customers. However, the inelastic pricing model of cable companies is the main reason for Netflix's success.

Imagine (in a parallel universe) there are a huge number of available cable companies to choose from. Because of such competition and variety, consumers have a broad choice of broadband providers and television content. Prices are low, access to content is unlimited, and price elasticity is very high. In this alternate universe, Netflix could not exist, or it would be just one of hundreds of content providers -- like our burger joint.

Back in reality, Netflix exists and excels largely because of the monopolistic pricing of cable companies. Consumers who are already paying high prices for monthly Internet and cable services choose to leverage their fixed costs by paying a low price of $7.99 to stream videos from Netflix. It is one of the few freedoms that consumers have in the world of cable and broadband. This makes Netflix a great business model and a potential growth vehicle for your portfolio.

Backed into a corner
Health care has the most inelastic pricing of any major industry. Unlike our cheeseburger example, there are only a handful of choices for most health care decisions. From major surgery to generic drugs, patients unfortunately have little ability to shop around for low prices.

Severe morning sickness can be a debilitating condition -- just ask my wife. Expecting our third child, she has been in a significant amount of pain but cannot take many of the normal pain-relief remedies due to pregnancy. Thankfully, our family doctor prescribed a generic form of Zofran for her condition: Ondansetron, manufactured by Teva Pharmaceutical Industries .

Patients like my wife are at the mercy of Teva's pricing department, paying $1,400 for a bottle of 30 Ondansetron. While this is terrible for sick patients, shareholders are smiling wide. Teva is the country's largest generic-drug manufacturer, selling generic forms of products from Augmentin to Zovirax. Teva's sales of $20 billion and EBITDA of $5.6 billion are strong and consistent, and the company also pays a 3% dividend.

Teva is a defensive stock that tends to outperform when markets are doing poorly. This is a consideration to make when modeling your portfolio, as too much allocation to defensive investments can lead to underperformance.

Cable bills and prescription drugs are nearly as unavoidable as death and taxes. Given stable earnings and growth through price increases, wise investors will follow the inelastic demand curve to a well-rounded portfolio.

The best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

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Spencer Houlihan has no position in any stocks mentioned. The Motley Fool recommends Netflix. The Motley Fool owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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