Although much has been written about them, there is only one thing that is true: they make good money.
In the minds of investors, the letter M should stand not only for “money” but also for “monopoly.”
Buffett has always discussed the idea of moat in the company. A moat is a lasting advantage for a company or a means of protection to keep profitability for a long time. He fully understands the power of earning superior returns through such businesses.
A good example of a monopoly is Microsoft (MSFT). The company has pricing power and no matter if Microsoft charges more for a product. People buying it are not likely to turn to another brand. But how can the profitability of Microsoft be measured? By comparing it to another large computer company. Let´s take IBM (IBM). The basic metric for comparing the two companies is operating income as a percentage of revenues or as a percentage of total assets.
Comparing operating income to total assets ratio across the two companies suggests that Microsoft is much more profitable than IBM.
Whenever a company creates a near-monopoly or an enduring competitive advantage, it offers a good investment opportunity. In many situations, it may not be possible to invest in those companies because they are not traded publicly. A monopoly still needs to be managed well to protect its profitability. Because of their high profitability, monopolies attract competition, and unless the monopolist can maintain its monopoly, profitability will decline over time. Monopolies do not last forever.
What is important is to investigate if the company can remain profitable for the foreseeable future. A large or even dominant company is not always a monopoly or near-monopoly. General Motors (GM) has been the world’s largest car manufacturer and currently has annual revenues of about $200 billion, yet it generates almost no earnings for its shareholders and went bankrupt in 2009.
These companies’ profitability is often regulated because they are considered to be natural monopolies; and their returns to shareholders, while adequate, are not high.
In the market, it is easy to find duopolies too. Duopoly means the market domination by two companies. They are usually more frequent than monopolies.
Often they are highly profitable, but their stock prices are also high. Hence, returns to investors may not be high. However, in economic slowdowns, their prices decline along with the rest of the market. Then, they offer good opportunities to buy because their profits almost surely revert back to normal when economies recover.
The best way to identify a monopoly is to look around. Generally, smaller companies in regional markets are somewhat monopolistic. Monopolies or near-monopolies that are as large, well-known, or dominant as Microsoft, Intel (INTC), and Cisco (CSCO) are not common. Many other opportunities may be found in less glamorous industries, such as exporters or regional suppliers for other firms.
Investors have to be careful. A company that appears to be a monopoly may not be at all. It is necessary to confirm first impressions by examining the company´s return on assets and on equity as well as its intrinsic value and margin of safety.
It is also useful to evaluate profitability in a number of years. But beyond profitability, there is price. The price paid is more important. The stock of a monopoly, such as Microsoft, Intel, or Cisco, generally trades at a high P/E ratio. Even at a high P/E ratio, shares of a monopoly are usually not expensive for a long-term investor.
Generally, it is good for the investor to wait for the price to decline. They usually decline for a variety of reasons.
Now, what happens if the investor has bought the stock and the price comes up? Is it better to sell the holding or not? The main tool is the estimate of the company’s intrinsic value. Usually, there comes a time when a company’s monopolistic edge erodes, which should show up in the estimated intrinsic value. If that is the situation, then its better to sell the shares.