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Investing in Monopolies

Relics of the past or a winning strategy?

Market Sentiment

Aug 28, 2022

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We don't have a monopoly. Anyone who wants to dig a well without a Hughes bit can always use a pick and shovel - Howard Hughes

At the beginning of the 20th century, the ever-increasing demand for oil was pushing companies and industries to find new oil fields and drill faster oil wells. Like everyone who drilled for oil, Howard Hughes Sr. also had trouble creating holes deep in the underground rock formations. The problem was that the existing drill bit at that time wore down too quickly and the process of replacing it was expensive and time-consuming.

Hughes Rock Bit (DeGolyer Library, Southern Methodist University)

Hughes began experimenting with different modifications to the existing tool bit and struck gold with an improved version in 1908. He patented it and started a company that unsurprisingly became extraordinarily successful - everyone who drilled an oil well wanted the best tool bit to optimize their cost and improve the chances of striking oil (running an oil rig was expensive at ~$250 per hour in the 1900s). In 1933, two engineers of the Hughes Tool Company invented the Tricone bit that drilled faster and straighter than any other drill bit in existence and immediately patented it. For the next 17 years the patent ran, and Hughes's market share approached 100% - Almost all the successful oil discoveries during this era were done using Hughes's tool and helped Howard Junior become the richest man in the world!

A monopoly in business is a company that dominates its sector or industry and controls the majority of the market share. The consumers are left with no real alternatives and the business ends up having incredible pricing power. While the U.S Govt has actively passed various laws (Sherman Antitrust, Clayton Act, etc.) that try to prevent the existence of such monopolies, the past few decades have seen an ever-increasing rise in market share for the top few firms.

Hiding in plain sight

If you think that monopolies are relics of the past, this report released by Open Markets Institute is a must-read. Here are some stunning excerpts:

Since 1993, consolidation has reduced the number of large defense firms from 107 to five.
Amazon sells 74 percent of all e-books sold online, and it sells 64 percent of all print books sold online.
CVS and Walgreens control 89% of the drug store business.
Google controls 64 percent of all desktop searches and 94 percent of all global and mobile tablet searches.
Two companies, Mars and Hershey, control 75% of the candy market in America.

Big Tech companies are the most well-known offenders with a few companies controlling almost everything we do online.

While it’s Big Tech that captures all the headlines, almost all the industries are now dominated by a few companies. Look around your store the next time you go grocery shopping - you might think that as a consumer you have a plethora of choices. But in reality,

There are arguments for and against a few companies controlling the majority of market share that are beyond the scope of this article. The question which I’m interested in as an investor is whether these companies tend to outperform the market and provide stable returns while doing so.

After all, Warren Buffett’s favorite types of business are the ones that have huge economic moats which are near-monopolies in the industries they operate in. Once, asked at an annual meeting what his ideal business was, Buffett argued that it was one that had “high pricing power, a monopoly.” The message is clear according to Buffett: If you’re investing in a business with competition, you’re doing it wrong.

Monopoly Returns

Anyone who has played the Monopoly board game knows the unbridled joy of collecting rent for the properties you own and driving your competitors to bankruptcy. I wanted to see if the same process is reflected in real life where companies having a monopoly in certain sectors could drive out competitors, rise prices, and give an outsized return on investment.

If you try to do a backtest on the biggest monopolies of today, you would quickly run into hindsight bias. The companies that are monopolies now might or might not have been monopolies a decade back. For example, there was no way of knowing Google would dominate the in-app ecosystem in Phones, and that Amazon would be the king of cloud services back in 2010.

To overcome this, I went back in time (using this nifty little feature from Google) and searched for publications covering monopoly investments. I found two relevant articles that we can use for the analysis.

The next 7 American Monopolies - Business Insider (2010)
The Forbes.com Monopoly Index - Forbes (2001)

A total of 17 stocks were covered by the two publications. Our benchmark as always is the tried and trusted S&P 500 as most of the companies covered in the research are large-cap stocks.

The results are incredible. Monopoly companies on average returned double that of the S&P 500 benchmark during the same period. 65% of the companies in the list beat the benchmark and only in 2 cases would you have lost money on your investments (yes, even adjusting for inflation).

The results were so surprising that I checked academic research papers to see if what I was observing was in line with the norm (as we are slightly away from the sample size required for significance). While there are no direct papers evaluating the performance of monopolies, established research shows that companies having large market share tend to outperform smaller competitors and the market.

Journal of Business & Economics Research evaluated the performance of 85 companies (50 Large-Cap & 35 Mid-Cap Firms) with wide economic moats.

Relative to the market, the aggregate appreciation of large-caps surpassed more than 85 percent of all stocks and the mid-caps more than 78 percent. While there were individual laggards on both lists, they were relatively few in number. The author’s subset demonstrated the most pronounced gains. All three lists would have handily surpassed the S&P benchmark during the benchmark period.
Source: Is sustainable competitive advantage an advantage for stock investors?

Applied Economics investigated the stock returns of companies with sustainable competitive advantage (the moat).

Our results indicate that Wide Moat stocks have created significant value for their investors. An equal and value-weighted portfolio of these companies rebalanced annually has outperformed both the S&P 500 and Russell 3000 indices over the period of our study (June 2002–May 2014).

Conclusion

I wish this would be as simple as investing in companies in industries having a high concentration. But, as always, all the simple & direct strategies tend to be captured already in the market. Recent studies indicate that

Stocks in concentrated industries trade at higher multiples as the market is smart enough to recognize their monopoly power. Therefore, an investment strategy that simply buys companies in concentrated industries does not outperform.

This does not mean all is lost - We just have to go one step deeper. The same studies show that you can outperform the market by:

a. Investing in industries with rising concentration as the market seems slow to recognize their increased prizing power

b. Adding a layer of valuation metric - When monopoly companies run into difficulty, investors tend to underestimate their ability to rebound and undervalue their shares.

So the next time you’re considering a stock for long-term investment, add this layer to your analysis: Does the company have prospects of growing into a monopoly or dominant player in a market with just a few players, or is it a lucrative market where competitors can eat away the profits? The first is what you should bet on.

That’s it for this week’s deep dive - Let me know what your take is in the comment section below,