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The Fundamentals of Investing in Monopolies

Motley Fool - Sat Apr 29, 2023

In this podcast, Motley Fool analyst Mary Long talks with Motley Fool senior analyst Ron Gross about:

  • How to tell if a business is a monopoly.
  • Laser-focused companies that have fended off competition.
  • Monopolies in railroads, trash, and surgical robots.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

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Ron Gross: You could theoretically rest on your laurels, but if you do that for too long, then you run the risk of losing that monopolistic power. You probably won't lose it if you are a regulated monopoly or a legal monopoly, like a utility, but you could lose it if you're the dominant player in search, and you stopped innovating and ChatGPT isn't even on your radar for example.

Chris Hill: I'm Chris Hill and that's Motley Fool's Senior Analyst Ron Gross. There are strong companies and then there are monopolies. Mary Long caught up with Ron Gross to talk about the fundamentals of investing in monopolies, why monopolies are legal, and a few of them that are currently trading at reasonable valuation.

Mary Long: Ron, today we are talking monopolies. We will get to some specific stocks in a few minutes, but the first thing that comes to my mind when I hear the word monopoly is how I got monopolies? At least here in the US we're supposed to be illegal.

Ron Gross: I don't want to get too into the legal weeds here, but in general, it's not really that monopolies are illegal, it's the harm that can be caused to consumers from a monopoly that the government is really trying to avoid. Now way back when in 1890 Congress passed the Sherman Antitrust Act, that was the first step to limit the harm. Then we had the Federal Trade Commission Act and the Clean Act, both from 1914, so way back in the day. These are laws that the government can use to protect consumers. You may remember back in the day when the government made AT&T breakup into lots of Baby Bells at the time, that was to protect the consumer. But not all monopolies are illegal.

As you said the how, is because sometimes the government actually allows a company to operate as a monopoly and they're known appropriately as a legal monopoly. That's where companies are permitted to offer a specific product or a service at a price that is regulated by the government. They can be private companies, they can be regulated by the government. They can be government-run companies. The US Postal Service is an example of a legal monopoly, the National Football League, Major League Baseball are legal monopolies that the government actually allows. So there are certain circumstances where our government, the US government does permit a company to operate with monopolistic environment, but the main point of it all is making sure that the consumer is unharmed. We see it today with Microsoft trying to take over Activision. There's a question about whether that would harm consumers in the video gaming space. So the government, the antitrust lawyers are deep into it to try to make a decision as to whether that would be harmful to consumers or not.

Mary Long: From an investor standpoint, maybe more so than a consumer one, what constitutes a monopoly? Are we looking for just an insanely dominant market share or really something where it's the only company that dominates in a field?

Ron Gross: There's a number of definitions, and we won't go through all of them, but it can be either a company that has found its way to dominating a market. They've got WD-40. For some reason, they've decided and were able to dominate the oil and the can market. [laughs] When your door has a squeak, you're almost invariably turning to WD-40. But it doesn't appear to have harmed consumers in any way because there are alternatives. It's just that they dominate from a market share perspective. Then as we discussed, there's other types of monopolies where the government has simply allowed it to happen and put regulations on. The legal definition is a firm with significant and durable market power. It's the ability to raise prices without long-term consequences, or the ability to exclude competitors. That is where the government gets a little worried again about competition pricing the consumer. To be deemed a monopoly, there's rules of thumb. It's generally a company should have at least 50% of sales for its product or service within a geographic area. So more than half the market share of a potential industry or a potential product or service, so they're really, really dominating the market. That's when the government starts to get a little itchy and may step in if they see that.

Mary Long: Apart from the pricing that monopolies could potentially cause consumers, what encourages monopolies with that singular focus to keep innovating? Do they need to, if they're just the only player in the game?

Ron Gross: You could theoretically rest on your laurels, but if you do that for too long, then you run the risk of losing that monopolistic power. Now you probably won't lose it if you are a regulated monopoly or a legal monopoly, like a utility, but you could lose it if you're the dominant player in search and you stop innovating and ChatGPT isn't even on your radar, for example, but other search engines are coming in and innovating. If you use new drugs or vaccines as an example, without patents and monopoly power, drug companies, they'd be unwilling to invest a ton of money in drug research, because they need to know that if they get to the point of where they can commercialize a vaccine or a drug, that they will have the exclusive market in that drug for at least a period of time. If they weren't assured that, it would be very difficult to get them to spend billions of dollars to attack any one or two or three drugs. That's one example. Other examples, we keep talking about Google, Alphabet and search, they create so much money, Apple creates so much money with their dominance in iPhones that generates so much cash flow that then they can take that cash and do other things with it; new technological developments, other parts of their business, self-driving cars, whatever they want to pour their money into. So the bread and butter from the monopolistic part of the business can fund other parts of the business and new innovations.

Mary Long: You'd mentioned regulated monopolies. Duke Energy is a regulated monopoly. For listeners that might not be in North Carolina, what is Duke Energy and what does that regulated monopoly status mean for them?

Ron Gross: Duke Energy enjoys a legal monopoly from the state of North Carolina. With very few exceptions, third-party electricity sales are simply not permitted under state law. Solar companies, for example, cannot sell their output directly because Duke Energy controls distribution and transmission infrastructure. In exchange for the ability to control that market, the government steps in and regulates price, and regulates the amount of profits a company like Duke Energy or another type of utility can generate. So they want to make sure that Duke doesn't use that monopolistic power to hurt the consumer and charge exorbitant prices. Duke, they're in the generating electricity business, coal, gas, nuclear plants, 45% comes from natural gas and fuel oil. Only 2% currently in hydro and renewables. One would think that would start to ramp up over time. But even nuclear is actually 35% of the business. They're relatively well-diversified across the energy spectrum. It's a $76 billion company and they also coincidentally have $76 billion of debt. A lot of debt on this company. That's because by building out a utility is expensive. They constantly need to float different types of bonds to continue to power the business to have enough money for their capital expenditure programs. Twenty-eight billion in revenue, four billion in operating income, 96 quarters of paying cash dividends, 4% yield right now. For those seeking a nice dividend and one that increases over time, Duke Energy is really interesting and it is a relatively low multiple. We're really trading or only around 17 times, probably the forward earnings, that's not necessarily special in this sector, most utilities energy companies trade around 17, 18, 19 times forward earnings. It is not unique in that regard, but it is a relatively low multiple when you compare it to other more growthier type investments.

Mary Long: When we think about multiples, we think of like other energy companies in this space. What does competition look like for Duke? They don't have competition in North Carolina, but is there competition spread out throughout the industry and other geographic areas people that they're playing against?

Ron Gross: To a certain extent, but they really do have the monopoly in their main business. When you look at valuations, you can't really look at valuations of competitors, which is something we would often do if we were doing a relative valuation analysis, not an absolute valuation analysis. So in this case, it's hard to do that because of the competition doesn't exist, but you can look at similar companies throughout the country. Other diversified energy businesses, other electric utilities. The median of those companies right now are trading at about 18 times forward earnings, Duke's trading around 17, 17.5. Right in line right there. Duke does have that 4% dividend yields. Many electric utilities also have a nice dividend yield, not necessarily as high as 4%. That's one of the nicer yields I've seen. It's not really the competition you look at, but it's similar companies.

Mary Long: Because it's the only game in town. I would imagine it operates in a really highly regulated market. Does that regulation change how we would evaluate it up?

Ron Gross: It would because it impacts the ability of the company to grow profits. They're not going to typically be able to grow profits the way a growth company would or a technology company would. There's a benefit to that in that there's somewhat more predictable because they're regulated. Price hikes are regulated, growth is regulated. You have a better idea when you look into the future, what a company like Duke Energy could potentially earn three, five years down the road. Now there's supply and demand characteristics as with any company. The demand for energy would impact ultimately their profits that they are generating. There is some variability there, but not nearly the variability of just a regular company that is producing products and services deciding what price the market will bear, hoping supply and demand works out in their favor and then growth will be whatever it will be. Duke's is much more regulated and therefore more easy to predict.

Mary Long: Let's switch over to the other coast real quick and talk about Union Pacific, which is a railroad company, one of the largest in the U.S. Railroads don't strike me as cutting edge or the industry with a lot of growth potential. Whereas maybe you could make that argument with energy. Am I missing something? Is there something cool about this that I don't see?

Ron Gross: There is nothing cool about it and our man behind the glass, Dan Boyd loves it when I bring companies to the table that have really boring and he loves to make fun of me. But you know what? Railroads are responsible for transporting 30% of the goods that we use each year. That's a big business. May not be sexy, but it's a big business. Railroads exist in a really special environment. One word there's really never even the possibility of a new market entrant, at least not a new rail market entrant. It would cost an estimated trillion dollars to reproduce the Class 1 railroad networks that are, have been built over the last 150 years. That's not even accounting for the cost of the land. It is the barriers to entry of creating a new railroad company are, they're astronomically high. So you're in a protected industry really. There's not much competition that's going to creep in. There's other types of competition. There's ships and plans and other types. But in terms of moving the 30% of goods across the nation, railroads are the only game in town, and Union Pacific is certainly one of the big biggest. It's North America, it's pretty much premiere out railroad, 32,000 miles of track. They operate in a duopoly. So two companies across the U.S. West. It's Burlington, Northern Santa Fe and Union Pacific, which make up the monopolistic companies in the Northwest. Burlington Northern is owned by Berkshire Hathaway. But Union Pacific is a really nice company, 2.7% dividend yield again. Most folks are probably looking at railroads for the dividend yield, but they've got 10 billion in operating income. They do have $35 billion of debt. Again, let's keep an eye on the balance sheet. But they've paid dividends on their common stock for 123 consecutive years. That's the stability that certainly some more conservative or older investors really look for.

Mary Long: After 123 years of consistent dividends, I would imagine Union Pacific spends a lot of its cash flow on those dividends. At the same time, many railroad companies we've seen in the news, Union Pacific included have run into talent and some safety issues. What's the story with UNP's capital allocation? And what do you think of their current strategy?

Ron Gross: Well, first of all, the industry, in general, has to clean up this barrage of safety issues that have really just popped up in a pretty big way of late. That's primarily both for safety reasons and because we don't want the transportation of goods across our country consistently disrupted. But I think mostly for the safety. Let's be careful out there. In terms of capital allocation, they returned about $10 billion to investors last year, seven billion dollars through stock buybacks and about three billion through dividends. The dividends, I'm fine with the stock buybacks are always a little bit tricky because you want to make sure that they're purchasing stock, especially at that level, at prices that are attractive to the shareholders. They're not just trying to lower the earnings per share, boost the earnings. I would have to dig in a little bit more to see if seven billion is the right number. That seems perhaps like it's a little bit high. They made a need to pull back on that and up their CapEx spending, especially to address some of these safety issues as we discussed. It'll be interesting to see what they do. There is an activist investor in that stock who primarily is calling for the CEO to be replaced and therefore all the things that flow from that, which is improving operating metrics and improving the business in general. It'll be interesting to watch if they're successful as well. This is another relatively low multiple company trading at 17 times forward earnings, but again, not unique. Other rails CSX is at 16 times, Norfolk Southern 15 times, Canadian National 20 times. They're all in that 15 to 20 range. Not really high, but the Union Pacific is not necessarily unique.

Mary Long: This may seem like a bit of a departure from energy, electricity, rail, freight, and transportation, but Intuitive Surgical could also probably be considered a monopoly. Yet out of the other companies that we've discussed, this might be the one that's more unfamiliar to listeners. What is Intuitive Surgical do and why do we consider it a monopoly?

Ron Gross: This one is totally different because it has nothing to do, really the least directly with government regulation or being a legal monopoly. It's a company that has innovated to the point where their product, which is a robot-assisted minimally, easy for me to say, invasive surgery robot that can perform quite a number of different types of surgeries. Their product is really the best one out there and it's gotten traction over the years. That has really allowed it to rise to by far the leader in terms of market share, they have about 80% share in the surgical robotics market. Not necessarily a monopoly by definition and except for the fact that it is over 50%. But we don't currently see them harming consumers in any way or trying to charge prices that would somehow hurt the consumer or the hospitals and eventually the patients. But it's a very strong company. It's this classic razor or razor-blade model where you buy the robot, but then you always have to then buy the instruments that go with the robot for each subsequent surgery so you have that recurring revenue stream alongside the purchase of this relatively expensive robot, which I've actually had the opportunity to use, not on an actual person, but in an operating room, just trying to pick up and move things around and it is pretty cool, I will not lie.

The only part of this business that is regulated, if we want to call it that is, the FDA is big into anything having to do with surgery or medicine or medical devices. This was approved, I was going to say only back in 2000 I guess that's 23 years ago [laughs] at this point. But it seems recent because the robotic market is not that old, quite frankly. They're doing great. The pandemic put a lot of elective surgeries on hold and they've gone through a little bit of ups and downs there. But this company has crushed the market since its inception. Crushed the market over the last five years. It is a company that Motley Fool growth investors have done quite well in David Gardner, our Chief Rule Breaker, really discovered this company very early on as he is so good at doing. I'm a conservative investor. So for me, that kind of growth and that kind of unknown into the future always makes me a little nervous. But this company has done incredible and really incredibly well.

Mary Long: Well, and it seems like they've really tapped into an industry that I would think lots of other medical device companies or people in, or companies in that field would want to tap into. You hinted at this by saying that they've got the best technology out there. But what is stopping another company from trying to catch up to Intuitive Surgical? What kind of moat have they carved out for themselves?

Ron Gross: The main thing would be the cost, the R&D research and development to develop a cutting-edge robot. Now, there's plenty of companies with plenty of money out there. So that's not impossible. But you would have to develop that and it would take years to receive FDA approval, and then you would also have to then get into the relationships with the hospital systems and convince those hospital systems to move away from Intuitive's da Vinci robot, which is the name, and to something else when the da Vinci probably is operating perfectly well. So once you get entrenched with your clients and your customers, it is very difficult for another company to move in. It happens all the time with easy things like soft drinks or restaurants or different retail products for something that requires FDA approval and is so important because it's performing surgery that becomes a lot more entrenched, and it's hard to usurp and kick them out. That's not to say over time, there won't be other robot surgery companies, but Intuitive has a really, really big lead.

Mary Long: Yeah, the common theme among all of these companies is seems to be really high, expensive start-up costs. Whether that's laying the groundwork for utilities, for railroad tracks or for robotics with it. Like robotics within a hospital seem to be now like a utility for the hospital.

Ron Gross: Yeah, that's interesting way to think of it, but yeah, the classic barrier to entry, and one of those is extremely high start-up costs or R&D expenses, and that can provide a moat in certain circumstances.

Mary Long: What is Intuitive Surgical trading at, right now? What do you think of its valuation, and what do you keep an eye on moving forward?

Ron Gross: So this is a growth company through and through, always has been and will be for quite some time. So it is trading at multiples that imply significant growth or maybe not, imply is not the right word, require significant growth in the future. So it's probably trading at around maybe 70 times current earnings. But let's look at forward the next 12 months, almost 50 times forward earnings, 50 times when the market right now the S&P 500 is trading in the low 20s around 22 times or 18 times forward. So comparing apples-to-apples, the market is trading 18 times forward earnings. Intuitive circle is trading at 49 times forward earnings more than double the market. That's because investors assume or project that this company has a very large growth runway and will continue to grow well into the future. If they don't do that then investors are not going to fare very well because the stock is in that sense, very highly priced. So whenever you invest in a company with high multiples that have a lot of growth built into the current stock price, you are hoping, you are projecting that growth in the future will materialize if it doesn't, that's when the stock gets hit.

Mary Long: We've got one more quasi-monopoly on our list of stocks to talk about and its Waste Management, which I found out recently rebranded to WM because they're more than just a waste management company.

Ron Gross: Sure. Sure they are.

Mary Long: That's what they'd like you to think. Over the past five years, Waste Management stock price has surged like 95% or just about that. Those are the best numbers out of the four companies that we've talked about today. So what is so sexy about trash?

Ron Gross: Well, garbage ain't going away anytime soon. They are one of two or three only games in town, and that's because they control the landfills in the United States. I want to say Waste Management owns about 260 landfills and 340 transfer stations around the country. Republic Services is the second-largest. Waste Connections is the third, but that's it. I mean, everybody else is tiny. So they control this business, and as I said, we're producing as much trash as ever, and even recyclables is a big part of this business too. So the ownership of those landfills really is the barrier to entry. This is a highly regulated business in the sense that anything having to do with waste or trash or recycling does have regulations on top of it, but it is not protected by those regulations. You do need permits for these landfills and they're not given them out like candy anymore. So again, they're pretty entrenched here. You know, they generate $20 billion in revenue, three billion in operating income. They've increased their dividend for 17 consecutive years.

The yield is about 1.7% right now, which is not astronomical. That's probably around the yield of the S&P 500 right now, but still pretty good, and as I said, they increase that dividend every year. It's a relatively safe investment. It's a relatively recession-proof business because even in the heart of the pandemic, we were still producing plenty of garbage, wasn't nearly as much because people weren't in the offices as they were in. The commercial business was rough. But it's relatively recession-proof because in good times and bad times, we're still producing all that garbage that needs to be picked up and transported and dealt with. So it's a really interesting one, not as cheap as the other utility companies we mentioned, this trading around 27 times forward earnings to Republic Services is 26 times forward earnings. So right there together. So there is some growth built into that price too again, trading higher than the S&P 500. In general, a pretty great business that will be consistent over time.

Mary Long: More than just a waste management company.

Ron Gross: There you go, yeah.

Mary Long: So when we think about all these monopolies if we want to call them that stocks that we've talked about today, how might investors think about these four companies and other monopolies or companies that look like them when it comes to their portfolio allocation?

Ron Gross: When I think of allocation, I'd never think of monopolies as being one of those allocation categories, but I do think of mature, steady companies that pay dividends, that have a moat, that have barriers to entry, that have what we call a competitive advantage sometimes because of legal regulations or restrictions. So that I like and that would be probably in my more conservative bucket in my portfolio. I think most portfolios can have some growth, some more conservative, some dividend payers, some ETFs, some index. So these types of companies would largely fall into my more conservative allocation category. Pay a dividend entrenched, not the fastest growers in the world. Although Intuitive Surgical is. Intuitive Surgical would not fall into my conservative bucket. It would fall into my growth-oriented, and we talked about the valuation that it's currently trading at. So just because the company has a monopoly, or a near-monopoly doesn't necessarily mean it falls into the more conservative category. But often that is what you'll see.

Chris Hill: As always, people on the program may have interest in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don't buy yourselves stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Chris Hill has positions in Activision Blizzard, Alphabet, Apple, Berkshire Hathaway, Microsoft, and Waste Connections. Mary Long has no position in any of the stocks mentioned. Ron Gross has positions in Apple, Berkshire Hathaway, and Microsoft. The Motley Fool has positions in and recommends Activision Blizzard, Alphabet, Apple, Berkshire Hathaway, Intuitive Surgical, Microsoft, and Union Pacific. The Motley Fool recommends Canadian National Railway, Duke Energy, and Waste Management. The Motley Fool has a disclosure policy.

Paid Post: Content produced by Motley Fool. The Globe and Mail was not involved, and material was not reviewed prior to publication.

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