My Duopoly And Oligopoly Shopping List

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Includes: AXP, BA, BAESY, BLK, CAT, CBOE, CME, CNI, CSX, CVS, DFS, DGX, EADSY, EFX, ESRX, EXPGY, FDX, GD, ICE, JNJ, LH, LMT, MA, MCO, MDT, NDAQ, NOC, NSC, RTN, S, SNN, SPGI, STT, SYK, T, TMUS, TRU, TTM, UNH, UNP, UPS, V, VZ, ZBH
by: Early Retiree Reality

Summary

Always have a shopping list ready when the markets give you an opportunity.

Among the universe of thousands of stocks to choose from, how do you go about picking them?

One way to reduce risk in picking the wrong stocks is discussed.

I consider myself a stock picker. In some circles, those are not nice words. After all, proponents on the other side of the aisle (including fans of indexing and/or balanced portfolios, efficient market theorists, etc.) can pull out studies that show most stock pickers lag the S&P 500 or some other index. We also hear that most actively managed mutual funds underperform the market. I'm sure there's some truth to that, but that isn't going to change my mind, being a stubborn fellow that I am. Plus, I'm not satisfied with average returns, as with most folks here on Seeking Alpha, I assume.

My biggest problem with index investing is that most indexes include the good and the not-so-good. Shouldn't one do better by simply investing only in the "good" components of an index? Of course, that's easier said than done, which leads to stock picking. There are thousands of stocks to choose from, so how do you go about picking them?

One of the best ways I can think of to reduce the risk of picking "bad" companies is to look for monopolies, duopolies, and oligopolies (MDOs). It's rare to find monopolies (except for government regulated utilities) so the focus of this article is on the latter two.

MDOs generally have wide economic moats due to the difficulty for new competition to arise, and generally have better profit margins than other peers in the same sector. They appeal to me in my buy-and-hold-and-collect-dividends stage of my investing career. This means I can hold them through good times and bad, without worrying too much if they will go out of business in the next recession. Another aspect I look for in my MDO investments is a low payout ratio and the company's penchant for rewarding shareholders via dividend growth.

Some consumer staples stocks are close to the "line" where I consider them an MDO or not. Coca-Cola and PepsiCo are fine examples. Although they are a duopoly in the soda business, that line of business is part of a larger more diverse beverage industry. About half of PepsiCo's revenue comes from its snack business. They are excellent businesses to invest in, whether they are MDO or not. That just goes to show economic moats can be achieved via branding or other ways.

Close to 40% of my portfolio is currently invested in what I consider are MDOs. The cash and cash equivalents I have reserved will be used to purchase stocks like these when opportunity knocks. The market will give me a chance to buy them sooner or later. I maintain a list of buy candidates at the ready.

Valuation is another matter. Each person has to decide what price they feel comfortable in paying for a security. As for me, it's on an industry-by-industry, case-by-case basis. Sometimes I will pay a small premium, other times not. It depends on the risk/reward ratio nebulously calculated in my brain (no, I do not use DCF analysis) and sometimes simple technical analysis. My best investment has been in a growth stock that's never been "cheap", but I will not overpay like that for 99% of stocks out there.

Without further ado, here is my list of duopolies and oligopolies that I maintain. (Statistics shown are based on intraday values on Friday, April 22, 2016 and from Yahoo Finance and Dividends.com.) These are not investment recommendations, but as starting points for further due diligence. For that reason, I won't go into too much detail about the risks and rewards for each stock, but instead a brief sypnosis on why I think they deserve investment dollars.

Package Delivery

Company

Profit Margin (NYSE:TTM)

Total Debt (mrq)

P/S

P/B

Yield

Payout Ratio

3-yr DGR

United Parcel Service (NYSE:UPS)

8.3%

$14.37B

1.25

37.84

2.96%

54.2%

8.6%

FedEx (NYSE:FDX)

2.3%

$8.5B

0.94

3.05

0.60%

9.3%

9.8%

Click to enlarge

NOTE: The U.S. Post Office is a real competitor for smaller parcels (10 lbs. or less). In some markets, Amazon utilities the USPS to deliver packages on Sundays, which is something neither of these companies do.

Parcel delivery is an essential service we need, whether it involves commerce or sending packages to friends and family. E-commerce is still growing nicely, and this is a good way to participate in that growth. One negative aspect of this industry is the high capex (labor and equipment costs have a linear relationship to revenue). Maybe that's why profit margins are relatively low.

Another thing to watch out for is to see what Amazon is doing to cut delivery costs, such as using drones to deliver small packages, effectively cutting out the delivery companies. It is too early to predict what the net effect will be however.

Credit Ratings Agencies

Company

Profit Margin

Total Debt (mrq)

P/S

P/B

Yield

Payout Ratio

3-yr DGR

Moody's (NYSE:MCO)

27.0%

$3.4B

5.52

-34.25

1.50%

31.1%

28.6%

McGraw Hill Financial (NYSE:MHFI) - Standard & Poors unit

21.8%

$3.61B

5.14

140.99

1.40%

28.5%

9.0%

Click to enlarge

NOTE: The third big player is Fitch, but it is privately owned (actually 80% owned by Hearst Corp.)

The credit ratings agencies are in many ways gatekeepers to the bond market. Issuers of debt in most cases need a rating in order for investors to consider them. It is appealing because it's a repeat business, needed in good times and bad, and requires little capex. Despite the blow to the reputation of these firms arising from the housing crisis, they are still humming along.

I'm long MCO.

Consumer Credit Services

Company

Profit Margin

Total Debt (mrq)

P/S

P/B

Yield

Payout Ratio

3-yr DGR

Equifax (NYSE:EFX)

26.8%

$1.20B

5.15

5.93

1.14%

26.2%

17.2%

TransUnion (NYSE:TRU)

0.39%

$2.21B

3.33

4.07

none

N/A

N/A

Experian plc (OTCQX:EXPGY)

14.9%

$3.50B

N/A

7.70

2.21%

57.16%

N/A

Click to enlarge

Consumer credit scores are used by all types of lenders, and even in some cases insurance companies, to assess risk. Much like the credit ratings agencies, this type of business has low capex, repeat customers, and needed in good times and bad. Its clientele gladly subscribe to their services to mitigate bad loan risk.

Payment Transaction Processing

Company

Profit Margin

Total Debt (mrq)

P/S

P/B

Yield

Payout Ratio

3-yr DGR

Visa (NYSE:V)

47.6%

$15.88B

13.41

6.41

0.71%

20.1%

26.4%

MasterCard (NYSE:MA)

39.4%

$3.30B

10.95

17.99

0.78%

21.5%

82.7%

Click to enlarge

These two companies control over 80% of all credit card transaction volume and over 90% of debit card transactions globally (according to a 2015 Nilson Report for data as of 2013). Even though they take a fraction of each transaction in fees, they really add up across trillions of dollars in consumer and commercial purchases each year. I love "tollbooth operators" like these.

American Express (NYSE:AXP) and Discover Financial Services (NYSE:DFS) are somewhat competitors but are not pure plays, since both are issuers (banks) and thus assume credit risk whereas Visa and MasterCard do not. American Express' purchase volume actually exceeds slightly MasterCard's due to their targeting of high-end customers. However they will lose exclusivity at Costco soon and it remains to be seen what effect it will have on their transaction volume.

Is there a nascent threat to V and MA with the new contactless payments like Apple Pay, Paypal, etc.? Well, Apple Pay still uses your credit cards behind the scenes (along with their networks), so that's not a viable near term threat. Same with Paypal if you tie it to a credit card. It's something to keep an eye on, but I'm not worried near term.

I'm long both V and MA.

Exchange Trade Funds Providers

Company

Profit Margin

Total Debt (mrq)

P/S

P/B

Yield

Payout Ratio

3-yr DGR

BlackRock (NYSE:BLK)

29.3%

$36.27B

5.46

2.12

2.51%

46.7%

13.3%

State Street Corp (NYSE:STT)

19.1%

$25.19B

2.30

1.34

2.20%

28.5%

2.9%

Click to enlarge

NOTE: Vanguard is the second largest ETF provider but is privately held. BlackRock is the dominant firm by the AUM measure in the U.S., almost 70% more than that of Vanguard as of 2015. State Street is third, with less than half of BlackRock's AUM.

Even though total investment capital committed to mutual funds dwarfs ETFs by an order or more than tenfold in the U.S. (according to Investopedia), there's no question ETFs have experienced tremendous growth since its creation in 1993. One statistic shows a 2500% growth since the year 2000, and includes a 28% global growth in 2013. It is estimated the ETF industry can grow 15 to 30 percent per year in the next five to ten years. Factors that led to the popularity of ETFs over actively managed mutual funds are low cost, liquidity, and diversity of investment instruments.

I'm long BLK.

Diagnostic Testing Services

Company

Profit Margin

Total Debt (mrq)

P/S

P/B

Yield

Payout Ratio

3-yr DGR

LabCorp (NYSE:LH)

5.1%

$6.42B

1.42

2.44

none

N/A

N/A

Quest Diagnostics (NYSE:DGX)

9.5%

$3.66B

1.43

2.29

2.13%

31.6%

29.3%

Click to enlarge

These two effectively is a duopoly in independent lab testing services. Hospitals and some doctors' offices also perform testing (the majority as a matter of fact), but they are not as cost efficient, due to the scale of these two players. As health insurers look for ways to cut costs, these two are beneficiaries.

There was also a threat of disruption by a startup called Theranos, whose claim to fame were much cheaper, quicker, and less painful blood tests. However they are now in serious trouble because of questions about the accuracy of their tests, and whether their technology works at all.

I am thinking of initiating a position in DGX soon.

Commercial Airliner Manufacturers

Click to enlarge

Company

Profit Margin

Total Debt (mrq)

P/S

P/B

Yield

Payout Ratio

3-yr DGR

Boeing (NYSE:BA)

5.4%

$9.96B

0.90

13.78

3.33%

51.6%

27.4%

Airbus Group (OTCPK:EADSY)

4.2%

$10.31B

0.71

7.64

2.28%

36.01%

N/A

Click to enlarge

It doesn't get stronger than this duopoly. These two effectively control the worldwide commercial airliners market. China and Russia will try to break the duopoly, but that's a tough nut to crack. After all, would you get into a jetliner not made by Boeing or Airbus?

I'm surprised at the low profit margin here. Maybe that's due to the high cost of development, intense competition, and shaky customer finances?

These manufacturers experience long development cycles, so their profits ebb and flow based on where they currently are. Boeing, for example, spends billions to develop a new jetliner before they can reap profits. Therefore it pays to be patient getting into these guys.

Financial Products Trading Exchanges

Company

Profit Margin

Total Debt (mrq)

P/S

P/B

Yield

Payout Ratio

3-yr DGR

CME Group (NASDAQ:CME)

37.5%

$2.24B

9.97

1.55

2.54%

54.4%

3.7%

Intercontinental Exchange (NYSE:ICE)

38.2%

$7.31B

6.27

1.94

1.41%

21.2%

N/A

Nasdaq (NASDAQ:NDAQ)

32.3%

$2.36B

3.19

1.88

2.00%

34.0%

32.1%

CBOE Holdings (NASDAQ:CBOE)

32.3%

none

8.48

20.82

1.40%

36.1%

17.7%

Click to enlarge

The companies listed have their hand in virtually all stock and derivatives trading (options, commodity futures, Forex, etc.) taking place. They, like Visa and MasterCard, are the ultimate tollbooth operators. In addition to the bread-and-butter transaction fees, these companies also make money via listing fees, market data fees, technology service fees, etc.

This industry is appealing to me because it's a repeat business, very profitable, and requires relatively little capex. The risk is that trading volumes can be depressed during bear markets. However I'm not as concerned since options are becoming more popular as hedging tools for retail investors, so that may make up for lost volume. Derivatives trade in good times and bad.

I'm long ICE, NDAQ, and CBOE.

Home Improvement Retailers

Company

Profit Margin

Total Debt (mrq)

P/S

P/B

Yield

Payout Ratio

3-yr DGR

Home Depot (NYSE:HD)

7.9%

$21.32B

1.90

26.71

2.05%

44.7%

15.1%

Lowe's (NYSE:LOW)

4.3%

$12.65B

1.15

9.04

1.12%

28.2%

19.3%

Click to enlarge

Where do you go when you need supplies for home improvement projects, fixing stuff around the house, buy a new water heater, or gardening supplies? Chances are, you're heading to either Home Depot or Lowe's. Sure there are regional hardware store chains, but this duopoly dominate this retail category.

A funny thing I noticed is that a lot of Home Depot and Lowe's stores are located in close proximity to each other. It just goes to show a duopoly can compete effectively without killing each other's margins.

They do face competition in certain segments however, such as major appliances and flooring. Personally I have purchased all my major appliances over the years from either Lowe's or Home Depot, except once from Best Buy.

Wireless Carriers

Company

Profit Margin

Total Debt (mrq)

P/S

P/B

Yield

Payout Ratio

3-yr DGR

Verizon (NYSE:VZ)

13.6%

$110.24B

1.60

12.46

4.50%

56.6%

3.2%

AT&T (NYSE:T)

9.1%

$129.62B

1.59

1.91

5.04%

67.4%

2.2%

Sprint (NYSE:S)

-5.1%

$33.75B

0.45

0.73

none

N/A

N/A

T-Mobile (NASDAQ:TMUS)

2.3%

$29.07B

1.03

1.99

none

N/A

N/A

Click to enlarge

NOTE: Verizon and AT&T each has about one third of the market share. The four listed has 99% market share.

VZ and T are perfect all weather, low beta stocks for income seeking investors. After all, their services are needed in good times and bad. However they have a huge debt load due to the capex required in this industry.

It is a very mature industry, so one can't expect much growth here. Instead, one can expect a DGR that's a little above the rate of inflation.

I'm long T.

Orthopedics

Click to enlarge

Company

Profit Margin

Total Debt (mrq)

P/S

P/B

Yield

Payout Ratio

3-yr DGR

Johnson & Johnson (NYSE:JNJ) - DePuy Synthes

22.0%

$19.86B

4.45

4.37

2.66%

45.6%

7.1%

Stryker (NYSE:SYK)

14.5%

$4.03B

4.08

4.77

1.40%

26.7%

17.5%

Zimmer Biomet (NYSE:ZBH)

0.8%

$11.56B

3.81

2.38

0.84%

113.62%

N/A

Smith & Nephew (NYSE:SNN)

8.9%

$1.48B

3.23

3.77

1.80%

43.4%

-15.9%

Medtronic (NYSE:MDT)

9.0%

$35.92B

6.48

2.12

1.93%

34.8%

2.7%

Click to enlarge

NOTE: Johnson & Johnson, of course, is a healthcare conglomerate, but it does have the leading market share for orthopedic devices. Some companies do not break out sales by divisions, so it's difficult to gauge effective market share for orthopedic devices. It's probably better to invest in this group using a basket approach anyway.

Personally I find orthopedic device makers a safer bet than biotechs in the healthcare sector. They do not face patent cliffs like biotechs, nor do they face the same level of pricing outrage. It is a fiercely competitive field however, as they try to invent a better mousetrap than the next guy. Surgeons generally stick with the same manufacturer though, since switching costs are high.

The aging population in the U.S. provides a tailwind for this industry, as well as global economic growth. Risks include a costly and lengthy FDA approval process and reimbursement risk (like most companies in healthcare).

I'm long JNJ.

Weak Oligopolies

Just to round things out, the following companies are part of weak oligopolies, since they by themselves don't exactly hold significant majority market share in their respective industries. However there may be investment opportunities if you buy them at their cyclical lows.

Construction & Mining Machinery

Click to enlarge

Company

Profit Margin

Total Debt (mrq)

P/S

P/B

Yield

Payout Ratio

3-yr DGR

Caterpillar (NYSE:CAT)

4.5%

/438.10B

0.96

3.05

3.98%

84.8%

5.8%

Click to enlarge

NOTE: Caterpillar holds a 28.3% market share (according to Statista) while Komatsu (a Japanese privately held company) holds 16.9%. The rest of the market is divided almost evenly between much smaller players such as Hitachi, Volvo, Terex, Liebherr, John Deere & Co., XCMG, Sany, and Doosan Infracore.

Caterpillar is in a very cyclical industry, so steady profits are hard to come by. Also, there are worldwide competitors, and no single company holds a dominant market share. However, Caterpillar has been through previous downturns before and has an excellent history of paying back shareholders. It might be a good buy at the bottom of the cycle for total return. It is currently going through what is probably the longest downturn in the company's history.

I'm long CAT.

Defense Contractors

Company

Profit Margin

Total Debt (mrq)

P/S

P/B

Yield

Payout Ratio

3-yr DGR

Lockheed Martin (NYSE:LMT)

7.8%

$15.26B

1.51

22.20

2.91%

56.4%

14%

General Dynamics (NYSE:GD)

9.4%

$3.40B

1.36

4.00

2.21%

32.5%

2.3%

Northrop Grumman (NYSE:NOC)

8.5%

$6.53B

1.54

6.57

1.59%

31.5%

13.0%

Raytheon (NYSE:RTN)

8.9%

$5.33B

1.62

3.74

2.31%

41.8%

10.7%

BAE Systems (OTCPK:BAESY)

5.5%

$5.69B

0.94

5.29

5.01%

70.26%

N/A

Boeing

5.4%

$9.96B

0.90

13.78

3.33%

51.6%

27.4%

Click to enlarge

NOTE: Lockheed is by far the largest player, however, there's a bunch of second tier players with a huge market share combined. The top 10 defense contractors account for 41% of the U.S. defense budget.

World peace is probably never achievable, so there's always a market for arms makers. There's also the heavy lobbying going on in Congress and strategic plants (i.e., jobs) spread across many states to keep the money flowing to these companies. The technical challenges as well as political connections keep potential competition out.

A basket approach of stocks is probably wise here to reduce the risk of a program getting cut, etc.

Railroads

Click to enlarge

Company

Profit Margin

Total Debt (mrq)

P/S

P/B

Yield

Payout Ratio

3-yr DGR

Union Pacific (NYSE:UNP)

21.9%

$14.20B

3.46

3.67

2.46%

41.7%

31.0%

Norfolk Southern (NYSE:NSC)

14.8%

$10.37B

2.55

2.21

2.61%

43.8%

6.8%

CSX Corp (NASDAQ:CSX)

16.7%

$10.70B

2.29

2.27

2.63%

40.2%

9.0%

Canadian National Railway (NYSE:CNI)

28.1%

$8.03B

5.26

4.48

1.77%

42.6%

9.5%

Click to enlarge

NOTE: BNSF is a major player, but not listed because it's part of the Berkshire Hathaway conglomerate.

These railroads are generally duopolies in the geographic markets that they serve. Rail volumes have recently declined due to the drop in volume of coal. The biggest risk is that this is a cyclical industry.

There's most likely not going to be new railroads being built, so these companies will stay in business for a long time. Their healthy profit margins tell me they have pricing power and are doing a good job at competing with one another.

Pharmacy Benefit Management

Click to enlarge

Company

Profit Margin

Total Debt (mrq)

P/S

P/B

Yield

Payout Ratio

3-yr DGR

Express Scripts (NASDAQ:ESRX)

2.4%

$15.59B

0.46

2.88

None

N/A

N/A

CVS Health (NYSE:CVS)

3.4%

$27.46B

0.73

2.99

1.68%

29.2%

29.1%

UnitedHealth Group (NYSE:UNH) - OptumRx

3.7%

$32.10B

0.80

3.75

1.50%

25.4%

32.8%

Click to enlarge

This "Big Three" holds a 66% market share (according to a PBMI 2014 report), and none are pure-plays. This oligopoly is on shakier ground in my opinion, since they don't hold a dominant market share. On the positive side, people do get sick in good times and bad, so business is always brisk.

A risk is that some health insurance companies can become competitors instead of clients if their scale is big enough (e.g., due to industry consolidation), such as Blue Cross Blue Shield (Prime Therapeutics unit) and Humana.

Other risks include government regulation and unforeseen effects of healthcare reform. For now though, they do provide a needed service to control drug pricing. However some would argue they are not doing a very good job.

Conclusion

This is one way I use to pick stocks, not the only way. I'd be interested in hearing about candidates I omitted, so please add them to the comments if you have them!

Disclosure: I am/we are long MCO, V, MA, BLK, ICE, NDAQ, CBOE, T, JNJ, CAT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.