Stock investing is tricky business, as we all know. We battle the day-to-day fluctuations in stocks driven by upgrades, downgrades, Icahns & Einhorns, stimulated like 11 year-old kids who just signed up for Instagram or 40 year-olds new to Facebook to "post" transactions because we should. What if there was a tiny part of the market that just plodded along, seemingly under the radar, to deliver market-beating, I mean clobbering, returns over a reasonable period of time? To be clear, in a return-constrained environment, such as what we have had the last 10 years, equities, especially the U.S. variety, haven't been a great asset allocation choice. The last ten years or so have been the lost decade, right? Not for this investment oligopoly. The industrial gas trio, Praxair (NYSE:PX), Airgas (NYSE:ARG) and Air Products & Chemicals (NYSE:APD), all have handily beat the S&P 500 the last ten years and are poised to keep the streak alive--you should consider these stocks for your portfolios.
What makes this group of stocks an investment oligopoly is the sheer fact their businesses face little, meaningful, competition in the U.S. and abroad. Because of this, revenue growth becomes more predictable; the management teams are well-versed in periodically taking price increases as needed to maintain gross profit margins. This is why these companies sport above-average P/E multiples. Over the long run, their gross and operating margins have improved steadily as their growing businesses leverage their slower-growing cost structures.
Praxair is the big guy, with the capability to install the largest, on-site, industrial gas production facilities absolutely required for the construction of refineries, production lines, etc. No other company has their expertise, know-how and efficiency--they are the global leader and you have to like those take-or-pay contracts.
Airgas reminds me of Coca Cola's (NYSE:KO) can/bottle distribution network (think trucks!). Founder, Chairman Peter McCausland started the company in 1982 and through nearly 400 acquisitions and internal growth, has created the largest national distribution network in the U.S. packaged gas industry. This is a one-of-a-kind network that would take decades to establish and their products are absolute necessities to the food (sterilization), medical (sterilization, anesthesia) and construction industries. Over 25 years ago, I saw this first-hand at my part-time hospital shipping & receiving job while studying undergrad. Every Wednesday the Airgas truck came with helium, oxygen and nitrogen and delivered 20-30 tanks and took away the empties. The only thing that has changed since then is there are fewer choices for buyers, which is good for pricing power, leading to a lengthening period of gross margin stability and operating leverage. All three of these companies possess these qualities.
The equity market loves this and rewards companies with such predictable characteristics with high P/E multiples. These are the high PEG (P/E to Growth) stories that scare many investors perpetually as they wait for a better entry point than the typical 10-15% declines afforded by these three companies off of their 52-week highs and never get involved. These companies are so investment-worthy, that downward revisions to guidance have negligible impacts to their stock prices. For example, ARG revised guidance downward on January 24th (see ARG's 1/24/13 earnings release) and the stock trades today at less than 2% off of its 52 week high. These stocks have sported premium P/E & other valuation multiples relative to the S&P 500 year after year--really good franchises do this.
To be clear, I like all three stocks. If I had to rank them, I would choose ARG, PX and then APD. ARG's distribution network asset is so valuable, many companies would benefit greatly from owning it. To boot, their gross margins are substantially higher than both APD and PX, so in a consolidation scenario where ARG gets acquired, a transaction would most likely be massively accretive to the acquiring company, even with a nice premium. Also, PX and ARG have dividend payout ratios in the 30s. If they boosted this closer to 50%, both stocks would probably normalize at a higher trading level in the short run; however, I anticipate they will continue to focus on growth initiatives and managing their businesses as such to keep valuations at current levels.
In summary, these stocks offer investors ownership in key characteristics that are well-liked by equity markets:
- Limited competition/significant barriers to entry-cost prohibitive (+ for margins, scarcity value boosts valuations)
- Pricing power (+ for, sales, EPS, dividend growth; margins and valuations)
- Recurring/predictable revenues (+ for valuations)
- Consistent earnings growth (+ for valuations)
- Market dominance & leadership (+ for valuations & lowers downside volatility)
- Great operating cash flow generators; all these businesses are extremely capital intensive, however, their competitive positions are so strong, the market seems to be ignoring this detraction.
- There are only 3 ways to play this industry in U.S. equity markets which creates what I call an investment oligopoly for this excellent industry. Scarcity is usually good for stock prices.