Co-written with James Cassidy.
As a militant capitalist, I don't approve of monopolies. As an investor, I always look for monopolistic situations, also called businesses with big moats.
Defining a monopoly is not always easy. The essence of business is to seek a competitive advantage. However, when that advantage leads to an impregnable position, the overall economy suffers from lack of competition. In a free economy, it is therefore the role of the regulators to make sure markets remain fair.
The problem with this laudable principle is the meaning of monopoly. What is fair and what is not? Perception tends to be very different depending on whether one is on the receiving end or not.
For example, local newspapers are often monopolies. Small markets the size of a town typically do not generate enough advertising income to allow for two newspapers to prosper. At the same time, The Walnut Springs Gazette (if it exists) is unlikely to attract regulators' attention.
Another example of a strong moat is a company with a dominant position in a sub-sector of an industry. If a company owns 90% of a region's billboards, for example, is that considered a monopoly and should it be broken up because of unfair competition? Probably not. The billboard industry competes with many other media. It is only a small part of the advertising industry, which is very competitive.
Some businesses are monopolistic in nature. Think of the Yellow Pages before the internet. The need for a single, centralized source of information made competition moot.
Classified ads in newspapers are another case in point. When consumers look for a second-hand car or when workers look for a job, they are likely to go to the specialized website. In a virtuous circle, the larger the choice of ads on a site, the more traffic it will generate. This has the potential to become a winner-takes-all business. But don't call it a monopoly.
The internet has created a number of such winner-takes-all businesses. Facebook (NASDAQ:FB) comes immediately to mind. This is what America does best: creating an industry out of a need we did not know we had. People under 40 (to take a random number below my age) can no longer live without Facebook. It is a one-company industry. Copycats will have an uphill battle because of the obvious monopolistic nature of Facebook.
Copycats may have a better chance starting in relatively untapped markets overseas. Baidu (NASDAQ:BIDU), for example, has built an empire by being the first mover in China. Their business model is quite simple: copy Google's every move but apply it to the Chinese market where Google is not a player. Incidentally, when Google did go after the Chinese market, they found out that Chinese politicians' priority is not fair competition.
The bottom line is that markets are not only not efficient, they are also not fair. Long-term investors do well to seek privileged companies that for one reason or another are not under the purview of regulators. When an investor finds such a jewel, he knows it takes a lot for management to screw up. MercadoLibre is such a company.
MercadoLibre, while little-known in the US, is the giant in Latin American e-commerce. Virtually no competition exists, and it is already too late for others to enter this market.
The Latin American e-commerce giant is built around MercadoLibre's online marketplace where individuals can bid for items as on eBay (NASDAQ:EBAY). Alternatively, they can use the website as an intermediary to buy from other vendors, as on Amazon (NASDAQ:AMZN). MercadoPago is the website's online payment platform, similar to PayPal, where customers can transfer funds using credit or debit cards, cash, or money orders. Thus, MELI combines the functions of eBay, Amazon and PayPal all in one!
MercadoPago may be critical to growing e-commerce in Latin America. This is because consumers there still have concerns about the security of using credit cards online, which probably accounts for the low penetration rate of e-commerce so far.
Considering their dominant position and the likelihood that the internet will become a more important part of the Latin American lifestyle, growth in MELI's business seems virtually guaranteed. According to eMarketer*, Argentina has the largest penetration rate of e-shoppers in the region with 45.7% of internet users actually shopping online. In Brazil, that number falls to 36% and in Mexico to 20.4%. Since internet usage is also lagging the US and other developed markets (60% in Argentina, 44% in Brazil and Mexico*), one can assume a lot of growth ahead. For example, still according to the same article, Argentina grew its digital buyer base by 27% last year. Among those three countries, Mexico is expected to grow the fastest in the coming years.
MELI has reached a market share and name recognition that makes it very difficult for anybody to challenge it. One can see a clear path to monopolistic growth in these fast growing markets. eBay owns 19.5% of MELI shares and is unlikely to challenge them separately. Despite a few Kindle sales and rumors of entry into Brazil, to date Amazon has no Latin American presence to speak of.
Amazon may have decided that the cultural barriers are just too high. After all, they know the Brazilian book and bookstore industry is going to put a major fight against online competition. One suspects that dealing with the French "diffe'rence" has made Amazon leery of cultural moats.
How to value MELI
If the business has such a clear path to Latin American dominance, how does one value the company? How to price a winner-takes-all business before it reaches maturity and becomes a cash machine?
Recent history tells us not to look at P/E ratios, only at the potential market ahead. Buying Microsoft, Google or Amazon in the early days at any multiple was the right thing to do. Even Facebook's IPO price now looks reasonable. The key is not to get seduced by a bad franchise - like so many dotcom startups in the 1990s. But, if the franchise is solid and the potential market enormous, investors should not be discouraged by high near-term earnings multiples. Look over the horizon instead.
Of course, that is more easily said than done. Many good investors have missed the boat on these new behemoths. Analyzing some of the best investors' mistakes is not just an exercise in schadenfreude, it can also be educational. Leon Levy, founding CIO of Oppenheimer, is only one of the Wall Street legends who understood the risks of the internet bubble. However, in his book The Mind of Wall Street he singles out Amazon as the most ludicrous example of the dotcom failed business models. He compares it to the old joke of a wholesaler who gains market share by selling suits costing $100 for $90. When asked "So how do you make money?" the wholesaler replies "Simple, I make it up on volume!"
Like Levy, I always failed to see the value in Amazon's triple digit multiples. I too have been proven wrong. But, whatever one's opinion on its valuation, the Amazon business model works. Levy was wrong when he wrote a decade ago that "Amazon was nothing more than a mail-order house." He wrote Amazon's epitaph a bit prematurely.
There are two lessons to take from this. One, the internet is often a winner-takes-all business. This is what Bezos understood better than anyone. Second, one has to use very different valuation methods when analyzing these companies. In the long run, competition will emerge. In the short run, size makes it very difficult for anyone to compete.
The question is how much does one pay for such a franchise? Amazon's stock performance since inception suggests almost any price makes sense. Just own it. Bubble-like multiples have stayed with Amazon.
The good news is that while some Amazon-like companies do trade at Amazon-like multiples (e.g. ASOS (ASOS.LN) in the UK), not all do. Rakuten (4755.JP) in Japan or Sports Direct (SPD.LN) in the UK, for example, trade at more-normal multiples.
Prepare for volatility.
These stocks are not, of course, without risk. High flyers will fall on any growth slowdown. Baidu's stock got punished on such news before resuming its long-term uptrend.
However, MercadoLibre adds another level of risk beyond that of short-term growth disappointments. MELI is exposed to an unusually high degree of country risk. Two of its major markets, Argentina and Venezuela, suffer from chronic revolution syndrome as well as devaluation disease. Several countries in which it operates, including Venezuela and Brazil, do not allow foreign companies to repatriate profits earned there. What multiple should an investor give to earnings that are locked up in Venezuela?
Today's PER of 55 and PEG of 1.6 does not look expensive relative to other successful internet stocks. Yet because MELI is more vulnerable to political risk, it is not a BUY at current levels. Instead, I recommend you "stay tuned" and scoop up MELI on news of a coup in Venezuela or another sovereign default in Argentina. That will be the moment you will look back on and smile.
* Argentina Leads Digital Buyer Penetration in Latin America, eMarketer article of Feb 23, 2013.