When searching for investment opportunities, a question always beckons. How can we divine the future economics of the company we're looking at?
Warren Buffett, of course, had this pegged long ago. Where there are countless articles on how Warren Buffett solved this, I'm going to somewhat narrow it down to "Warren Buffett likes to buy monopoly-like situations." I also will talk about a few exceptions, but the best economics are clearly coming out of monopolies.
Warren Buffett Wasn't Always Like This
As it turns out, the beginning of Warren Buffett's career was actually characterized by his looking for deep value situations in accordance with Benjamin Graham's principles. Indeed, he is even quoted has having said "I'm 85% Benjamin Graham."
Warren Buffett was an activist as well. But between these two characteristics, you don't see anything about "monopolies." So what changed? What happened?
Charlie Munger happened. Charlie Munger fundamentally changed Warren Buffett's investment style and shifted it toward quality companies selling at cheap to fair prices, instead of deep value situations. We can safely say that Charlie Munger is the inspiration for Warren Buffett's quote which goes as follows:
It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price
As it were, these wonderful companies can be seen as a kind of monopolies.
For a more thorough account of this evolution, you can turn to Warren Buffett's own words in his Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) 2014 shareholder's letter. Read the section titled "Charlie Straightens Me Out" from page 26 to page 28.
Why Are They Monopolies?
Merriam-Webster defines monopoly as being the:
... complete control of the entire supply of goods or of a service in a certain area or market.
Monopolies are usually frowned upon by authorities because they can theoretically price goods and services with a view toward producing excess profits.
However, there are many situations where monopolies emerge. These can happen due to economics (of scale, "winner takes all" market structures, etc), legal limitations (patents, etc), physical limitations (limited supply of electromagnetic spectrum, etc) and other reasons.
Investing in a monopoly is thus a very attractive thing for an investor. Monopolies necessarily tend to make for wonderful businesses. Businesses which are highly protected from competition. Businesses which exhibit pricing power. Businesses whose prices are decoupled from their costs, and thus their margins can be as large as the market will bear. Businesses which gain from technological advancements instead of having to pass on those gains to their customers through cost arbitrage.
These are the business characteristics Warren Buffett likes (and you should, too).
Not All Monopolies Are The Same
However, there are myriad reasons for something to be some kind of monopoly. Not all are evident. The wonderful businesses Warren Buffett invests in tend to fall into these "not-so-evident monopolies."
For instance, broadly defined soft drinks are far from a monopoly: there are literally hundreds of different brands viying for the consumers' attention. Yet, when you sit in a bar and you ask for a Coke, you won't consider a Pepsi unless there's no Coke. You won't mind if there's RC Cola at half the price. You won't even want to know the price. Coca-Cola (NYSE:KO) thus has a monopoly in selling you those Cokes.
I would thus go further and expand what a monopoly can include powerful brands. Powerful brands can create monopolies because only Apple (NASDAQ:AAPL) can sell you an Apple product. If you want a Coke, you can only get it from Coca-Cola.
Warren Buffett also put a lot of money into railroads. What kind of monopoly is that? Anyone can build a railroad, and there's trucks and airplanes and whatnot.
Sure, but when it comes to linking two points effectively for large-scale freight, the railroad also will be a monopoly - since generally speaking, there won't be two railroads operating the same two-point link. And there's your monopoly - at the long-range freight-economics level, there will be just a single alternative, hence, a monopoly of sorts.
The same goes for electric utilities in what concerns transmission and delivery. There generally won't be a duplicated infrastructure for providing the electricity, and these businesses are regulated as a result. So returns are regulated but predictable. So, for any given area, transmitting and delivering electricity is a monopoly even if your returns are capped. Warren Buffett consequently also invested a lot into utilities.
The same goes for Moody's. Not exactly a monopoly, but an oligopoly (with S&P and Fitch). A legal monopoly of sorts, since the need for debt ratings is written into many contracts and laws requiring them.
The same goes for Procter & Gamble (NYSE:PG), which carries "smaller-scale" monopolies akin to Coca-Cola's in many different categories through strong brands.
Two Examples: One Which Warren Buffett Bought And One Which He Didn't Actually Buy But Regretted It Later
Beyond all those businesses which Warren Buffett put money into and which show these "monopoly-like" characteristics, I'd also like to highlight two more, one in which Warren Buffett invested and one in which he didn't and then regretted it.
I'd like to highlight them exactly to show that something in them also contained the "monopoly-like" ingredient. Here they go:
Back in 2012 Warren Buffett bought into Verisign and then increased his position throughout 2013 and 2014. How is Verisign a monopoly?
As it turns out, Verisign is indeed some kind of legal monopoly. Verisign is the registry for the .net and .com URL extensions, which together account for ~55% of all top level domains in the world. When some registrar (there are thousands of registrars) registers an URL ending in one of these extensions, it has to pay an yearly fee to Verisign. This yearly fee is $7.85 for .com and $7.46 for .net (starting on February 1, 2016).
When it comes to these fees, they are:
- Unavoidable, if you want your URL to end in .com or .net.
- Nobody can challenge Verisign for their collection (nobody can compete with Verisign, no matter how high the margins are).
So Verisign's business is basically invulnerable when it comes to those fees and (very high) associated margins. And for quite a while, Verisign also had pricing power, too - regularly increasing the cost for a .com domain until the government stepped in. As it were, Verisign kept the pricing power for .net domains and continued to increase that fee regularly (though .com is more relevant since it represents nearly 50% of all domains in the world).
This monopoly is legal since the ability to provide registry services is awarded by a government regulatory body (a non-profit, actually, organized by the State of California): ICANN (Internet Corporation For Assigned Names and Numbers).
However, it should be said that Verisign's business model is not free of risk. The contract with ICANN runs out and might be exposed to significant competitive threats upon renewal (due to the incredibly attractive economics - VRSN's EBITDA margin is ~65%):
- The .net extension contract comes up for renewal during 2017.
- The .com extension contract comes up for renewal during 2018.
These renewals can conceivably be "automatic" as long as certain requirements are met, reducing the risk to Verisign.
However, it's not unconceivable that a competitive threat could emerge, and if such threat appeared it would most probably be on the same grounds which led to NeuStar (NYSE:NSR) losing its NAPM contract. That is, the threat would always emerge through a massively lower cost proposal.
Interestingly, this also shows us that Warren Buffett doesn't necessarily insist on his "holding forever period" when considering these monopoly-like situations.
As interesting as the situations Warren Buffett buys into are perhaps the situations where Warren Buffett doesn't buy into and then regrets it.
One such situation was when Warren Buffett missed on the pharmaceutical boom. Warren Buffett did not invest in pharmaceuticals and publicly regretted it. He did so when answering a shareholder - saying that he'd "blown it" and that he'd invest in these businesses if he had the chance to do so at a reasonable valuation.
Why would Warren Buffett know these were intrinsically good businesses and that he'd missed them? Well, pharma is yet another example of a legal monopoly. When a pharmaceutical company launches a new drug, this drug can only be provided by it, no matter what the price.
Other companies cannot sell a drug based on the same active principle for as long as that drug's patent protection lasts. That's 20 years in the U.S. During those 20 years, drug companies don't face competition and even have significant pricing power as the scandal around Gilead's (NASDAQ:GILD) pricing reminds us so often.
Moreover, better drugs for the same indication can take years to reach the market, and pricing is usually borne by third-party payers (the state, insurance companies, etc). Plus the buying decision is decoupled both from the payer and the consumer - the buying decision is made by the doctor. These are dream circumstances for a business to be in.
That said, it's hard to predict who will be able to successfully market a drug (gain approval). And for existing pharma companies, the schedule to lose patent protection gains a lot of relevance - along with the pipeline of new products.
First off, and as I said, Warren Buffett didn't start out tied to this philosophy of it being better to buy a wonderful business at a fair price than a fair business at a wonderful price.
Remember, the present Berkshire Hathaway was a textiles mill - certainly the antithesis of a monopoly. Warren Buffett bought it because it seemed like a bargain. The hunt for bargains has certainly lingered in him, taking him to such places as investing in shoes and textiles.
There is one exception, though, where something more systematic - even if not consistent with the search for monopolies - was at work. I mean Geico.
First off, Warren Buffett's investment in Geico started when he was pursuing bargains rather than wonderful businesses. However, it was clear that by the time Warren Buffett completed buying Geico (through buying it all) he was already after wonderful businesses. Yet, Geico still could not be called a monopoly, since anyone could issue the same kind of insurance policies it did. So in what systematic way is it an exception to the monopoly rule?
In my view, that systematic way is that Geico is the lowest-cost producer within a commoditized business. Hence, it's a business able to produce economic returns and grow even while exposed to significant competition.
That's the main exception. If you're not going to buy stock in an economically-protected situation (a monopoly for some reason), then chose the (sustainably) lowest-cost producer between whatever else you're looking at (as long as it's a bargain).
To this day, Warren Buffett's shareholder letter includes a reference to Geico which references this Geico quality (emphasis is mine):
When I was first introduced to Geico in January 1951, I was blown away by the huge cost advantage the company enjoyed compared to the expenses borne by the giants of the industry. It was clear to me that Geico would succeed because it deserved to succeed. No one likes to buy auto insurance. Almost everyone, though, likes to drive. The insurance consequently needed is a major expenditure for most families. Savings matter to them - and only a low-cost operation can deliver these
What About Now?
Sure, we know all about those monopolies. But where can we get some of that stuff today? As it were, I can actually provide an example.
An Example Today
Remember those YieldCos I've been talking about? Anyone can build a solar project so surely those aren't a monopoly, right?
Well, think again. What happens after you've built the solar project and signed a PPA (Power Purchase Agreement) for its output over the next 20 years? Incredibly, you have a monopoly on that output. No one can come in, underprice you on that power, and take your business away. That's one of the most important characteristics monopolies have.
Unfortunately, you cannot raise the prices on that output either: they're fixed by the PPA. But still, it's nice to know the returns on that business for the next couple of decades are known in advance.
Now the question beckons: If I'm so smart to say that the business behind YieldCos like TerraForm Power (NASDAQ:TERP), TerraForm Global (NASDAQ:GLBL) and Abengoa Yield (NASDAQ:ABY) is something that fits the Warren Buffett modus operandi, why hasn't Warren Buffett invested in these things? The interesting thing is, as a matter of fact, he has. Warren Buffett is the third-largest holder of solar power plants in the U.S.
He got there by buying several solar projects, such as this one for $2-$2.5 billion in California. And you guessed it, the projects Warren Buffett buys come complete with 20-25 year PPAs, which is what makes them attractive.
So that's an example of a Buffett-like business you have trading for a discount today. YieldCos. A business model Warren Buffett has in effect been investing into.
There's also something which isn't an example of those monopolies but it's a clear example of the exceptions.
Remember that if you're buying a commodities producer, like Geico, you need to buy the lowest-cost producer. Well, there is a clear example today of a business that sells commodities and where, for geological reasons, there are clear low-cost producers.
I am talking about iron ore. When it comes to mining iron ore, it's a large advantage to just dig it up from the ground in surface mines where the thing you dig from the ground is already "up to spec" in terms of being a product you can ship. That's what happens with iron-ore bearing hematite dug up from the ground in Australia. Here's a description from Geoscience Australia:
High-grade hematite ore is referred to as direct shipping ore (DSO) because it is mined and the ores go through a relatively simple crushing and screening process before being exported for use in steel making. Australia's hematite DSO from the Hamersley region averages from 56% to 62% iron. Like hematite ores, magnetite ores require initial crushing and screening, but undergo a second stage of processing which relies on the magnetic properties of the ore and involves magnetic separators to extract the magnetite and produce a concentrate.
So there you have it. There are a small number of producers which are financially sound and have access to these ores. They're basically Rio Tinto (NYSE:RIO), BHP Billiton (NYSE:BHP) and Vale (NYSE:VALE) in Brazil. At much higher iron ore prices, other producers could conceivably try to enter the market (like Fortescue did). However, at the present levels only RIO, BHP and VALE are likely to remain economically sound.
So there's the exception - if you're going to buy something which doesn't have the comforts of a monopoly, then you need to buy those which are the sure lowest-cost producers of whatever commoditized market you decided to delve into.
Warren Buffett hasn't put money into these miners, though. And I'm not sure he ever will. While Warren Buffett will put money into any monopoly he can find, he's certainly not that interested to put money into every exception to that rule. Neither am I (I haven't bought into the iron ore miners, either). That said, they merit monitoring on account of that lower-cost characteristic which they share.
The main conclusion to be drawn from this article is that this "monopoly-like" characteristic is one of the most desirable traits any investment opportunity can have. It trumps valuation. It trumps short-term concerns. Be on the look out for it more than for something being a bargain or not.
If a business has this characteristic, and if it enjoys decent margins, we will know that those margins are likely to remain attractive in the future. It might even be possible for it to increase prices (and margins) without fear of competition eating its cake. Under these circumstances, it might make a lot more sense to pay, say, 15-20 times earnings for such a business than to pay 10 times for the relative bargain we see elsewhere which has no such characteristic.
Disclosure: I am/we are long GLBL. 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.