A Nice, Wide Moat Helps Keep Competitors at Bay

I love the game Monopoly, especially when I’m confined to my home with family for weeks on end and there’s nothing we haven’t seen on Netflix or anything else left on this planet to do. That said, it’s still quite invigorating to watch one of your opponents land on your fully developed property. I find those pleas for mercy invigorating, especially when they’re from a son who’s already bankrupting us by going to college.

Some of the best-performing stocks in recent history are or were what analysts would call natural monopolies. Those companies didn’t take over an entire market through unfair competition; they simply built protective moats around their business that competitors could’t overcome. Power, gas and water utilities are expensive to build and maintain, so once they are built competition becomes less likely. Those firms are highly regulated to ensure they don’t abuse their market position through price gouging or withholding services to potential rivals. Thanks to this regulation, utilities and railroads should be expected to earn a reasonable rate of return but because there’s little risk, not an excessive one.

On Everyone’s Play list

Then there are monopolies that arise from having the right product at the right time. Apple’s domination of streaming media through iTunes and iPods allowed it to negotiate revenue sharing with record labels and application developers with a “take it or leave it” stance. Many artists had little choice but to accept Apple’s terms of distribution, since the only other way fans would access their music was through pirating the songs for free. Apple tried to apply that same strategy to television content providers, but they held out, reasoning that if they surrendered distribution to Apple, their negotiating position would eventually dwindle to nothing. That initial dominance in music, however, provided Apple record-setting cash flow that allowed it to carve out new niches via the iPhone and the iPad.

Amazon is another company that follows the monopolist’s playbook. In its online retail business, it discourages competition through its highly efficient warehousing and distribution. Though AMZN rarely has a majority market share in any product segment, it rarely competes on price. Instead, it competes for wallet share. Now that Amazon has established itself as the first site online shoppers go to research products, it has been prioritizing in-house brands, which are presumably more profitable, but also crowd out other vendors who might find themselves ranked lower on Amazon product searches. That will lead to a virtuous cycle for Amazon: It will face fewer competitors and be able to raise prices on its in-house products.

There’s a sweet spot for growth investors where a company is growing rapidly and wielding its market position to insulate itself against competition. You’ll know this to be the case when the company has a long history of being able to consistently raise prices and maintain sales volume and profit margins. The stock price should skyrocket as the company continues to sell more product at higher prices and increasing profit margins. It’s a growth investor’s dream come true.

The Dictates of the Marketplace and Regulators

Unfortunately, there’s also some risk to these natural monopolies. First, consumers’ tastes can change. Cruise ships are a very capital-intensive business. No matter how aggressively a company buys out competitors to reduce competition, if travelers decide en masse to go on hikes instead of cruises, those ships will rot in their berths while interest expenses pile up.

The other risk is harder to anticipate and much more dramatic when it takes its toll. Regulators may decide to step in and curb the monopolistic behavior to encourage competition. Microsoft’s dominance of the web browser market led to regulators demanding Windows include other browsers as options. Microsoft’s market share for web browsing dropped from an estimated 95% of the market in the second quarter of 2004 down to 8-9% as of March 2020.

Any Mythical Creatures Out There?

These politically driven actions can come up with little warning. A company can maintain a dominant position for years. That reliability leads to high price-earnings multiples. When new regulation hits, the stock multiples will shrink while their market share begins to decline, creating a double whammy. Investors’ only protection against these events are diversification and cycling out of companies that are beginning to catch regulators’ eyes and condemnations. Alphabet is another regulator target, especially in the European Union.

Investors love the stability and pricing ability of monopolies. The optimal time to own one, of course, is well before everyone recognizes its dominance. If you are fortunate enough to catch one of these unicorns, enjoy the ride and know that eventually there will come a time to hop off and start searching for the next one.

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This article was originally published in the April 2020 issue of BetterInvesting Magazine.

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