Contrary to popular belief, all monopoly stocks are not risk-free investments.
In July 2021, we introduced you to the top 4 companies with strong monopolies. Since then, we’ve written about some more monopoly or near-monopoly stocks.
Along with stocks, these articles clarified the idea of bad (or say risky) monopoly stocks.
Contrary to popular belief, all monopoly stocks are not risk-free investments. On the contrary, some can single-handedly drive down your portfolio’s returns.
Look at the price charts of two well-known monopolies in India: Coal India and Nestle.
Coal India is the largest coal producer in the world. In fiscal year 2021, it accounted for 83% of total coal production in India.
On the other side is Nestlé. It has the Cerelac in its umbrella. It is the market leader (96.5% market share) in the baby food segment.
Despite having a monopoly, Coal India’s shares, which once traded for Rs 350 (in 2010), are now trading at Rs 186. Nestle’s shares grew by more than 600% from 2010.
So how do you differentiate between good monopoly stocks and bad monopoly stocks?
Here are some points that can help you with that…
#1 Avoid Expensive PSU Stocks
Primarily, the purpose of a PSU is to serve the country.
Despite having a competitive advantage, these companies do not thrive on profit.
A classic example is Air India.
In its mission to expand accessibility, the company operated many loss-making routes, some with occupancy rates below 30%. This put huge debts on the books.
Likewise, PSU banks build and operate unlucrative branches in remote areas for network expansion. This hinders overall profitability.
While providing easy access from a social perspective is great, it does little in the way of generating returns for an investor.
#2 Avoid stocks with limited/uncertain growth prospects
The company’s stock price depends more on future profitability than on current earnings. This is highly dependent on exploring the available growth prospects.
Controlling the market space within an industry does not imply strong growth. Look at the sales and profits of Bharat Heavy Electricals Limited (BHEL) over the past decade.
BHEL is the largest power generation equipment manufacturer in India. It is also the market leader in emission control equipment.
Although BHEL is on the list of monopolies, sales growth has been negative for years.
Being a PSU makes the situation worse. BHEL is not encouraged to raise prices, make more contacts or reduce costs.
Growth insecurity can also be found in private companies such as ITC. Even after diversifying into FMGC and hotel sectors, most of the profit comes from the cigarette segment.
This segment is very tax sensitive and therefore has unclear growth prospects.
Because of this ambiguity, ITC’s stock hasn’t changed all that much, despite having strong performances over the years.
#3 Avoid sectors with a lot of government intervention
While government policy helps create some monopolies, a high degree of intervention can change the entire valuation of the company.
In October 2021, the Ministry of Railways asked IRCTC to share 50% of the collected revenues as convenience allowances. The decision was reversed the next day.
But the stock price plummeted as investors recognized the extent of government influence over IRCTC.
Another example is Hindustan Aeronautics (HAL), the only monopoly company in the defense sector.
Regardless of whether it performs well in the stock market, the fate of the company heavily depends on the government.
Another example is Coal India. Shares of Coal India came under a lot of pressure when the government announced that the private sector would start doing commercial coal mining. This ended the government’s long monopoly in the coal sector.
The government also hampers the profitability of PSUs by restricting employee layoffs, hindering rationalization of the workforce.
#4 Avoid cyclical monopolies
Like other companies, monopolies can also be cyclical.
Take an example of Coal India.
It is the largest coal producer in the world, but the entire business depends on the amount of coal that is mined.
Coal is a natural resource with perishable reserves. The amount of coal imported also affects the need to mine.
Global anomalies such as the war between Russia and Ukraine also affect the profitability (albeit positive in this case) of such companies.
#5 Look for companies with strong canals
A strong economic moat protects competitors’ market share and increases long-term profitability.
An example: Asian Paints.
It has been a leader in the organized paint industry for four decades. The product mix and strong distribution channels meet the global presence in 17 countries.
In its early years, the company invested heavily in technology to gather and validate the demands of its consumers.
Today, the company can predict the amount and color of paint needed at any point of sale with an accuracy of 97%.
This combined with a distribution network that is twice the size of its closest competitor. It has created an impenetrable moat.
No wonder, the share price has nearly tripled in half a decade.
#6 Look for companies with clear growth paths
It’s very simple – Profit = Revenue – Cost.
To remain profitable, a company must increase revenues or reduce costs.
This can be done by expanding the product range or integrating the production process.
Take Pidilite Industries, for example. The product Fevicol is synonymous with adhesives in India.
The company continued to expand its product line with brands such as Fevikwik, Dr. Fixit, M-seal and much more.
Pidilite launched Hobby Ideas, India’s first arts and crafts chain offering cheaper alternatives to expensive imported products.
This demonstrates the company’s desire to capitalize on growth opportunities, making it an investable choice.
#7 Look for monopolies that crave profit
Most private companies are in business to make a profit. When the company generates good returns, you as an investor make money.
Nestle India presents a perfect model.
Nestlé’s brand Maggi (instant noodles) has no close competitors. Even then, the company indulges in market research to align with the ever-changing consumer tastes.
This clearly shows that the company is not ready to lose market share or accept lower margins that hurt its long-term profitability.
So are monopolies the same as other companies?
Yes and no.
In addition to general criteria such as industry analysis, company size, net asset value, financial stability, profit margins, etc., focus on moats when evaluating monopolies.
Canals can be formed in several ways: cost advantage, intangible assets such as patents, brands and licenses, switching costs, efficient scale, etc.
An important parameter is to understand the scalability of such canals.
Some canals depend on external factors, such as government policies, which change over time. This should be taken into account when investing in them.
The wider the canal, the stronger the company. If the canal is weak, eventually competition will come, erode returns and take away market share and profits.
Therefore, a smart way to invest is to choose companies with strong canals.
Have fun investing!
Disclaimer: This article is for informational purposes only. It is not a stock recommendation and should not be treated as such.
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