In fact, Wall Street is more likely to undervalue a monopoly than over-value it. And it all boils down to one basic flaw of the analyst hivemind: comparable business valuation.
What’s a 20oz Coke Worth?
If I were to ask you what a 20oz Coca-Cola was worth, you could provide me with an answer in mere seconds. At the worst, you’d ask supplemental questions such as:
- Is it cold? Cold Coca-Cola is worth more than warm Coca-Cola; why else would warm 2-liters be cheaper than cold 20oz soft drinks?
- Where is this fine Coca-Cola specimen? I’m not certain, but I’d say that a Coke is worth way more in the Sahara desert than it is in the cold oil sands of Canada. Likewise, a Coke is worth more on the moon than it is in the American suburbs – shipping costs and such.
At the end of your analysis you’re going to give me your best price quote for a cold 20 ounce Coca-Cola bottle. I’m expecting you to give me a value of anywhere between $1 and $1.50. That’s the retail price in most places. I’ve seen mostly $1.25 prices or $1.30. (Nickels are the new penny!)
Your best valuation for a 20 ounce Coca-Cola will come from your experience in purchasing soft drinks. “Well…” you might say, “I paid only $1.25 for a 20 ounce Coke three weeks ago.”
Business Valuation and Coca-Cola
To financiers, cash flow is a commodity. When analysts – and the whole of Wall Street – assign a value to a future stream of cash flow, they seek to find a risk-adjusted price. There’s obviously good reason for risk adjustment – $100 in future cash flows from a quality company is less risky than a $100 repayment from your buddy Dave who needed some $1 bills to hit the strip club.
But where Wall Street fails is in assigning a value to cash flows based on a comparable company. If there’s only one 20 ounce can of Coca-Cola, you can’t value it based on previous sales. If there’s only one company – a monopoly in the industry – it’s quite difficult to give a valuation based on comparable companies. There aren’t any comparable businesses.
In much the same thread, you cannot easily value a piece of real estate at the end of an undeveloped suburban lot. The list goes on and on.
Wall Street Misses Billion-Dollar Monopolies
One firm I selected for the 2012 stock picking competitions is an effective monopoly – Darling International (NYSE:DAR).
The firm bought out a competing, private company to merge into an even larger entity. It’s also working on a multi-million dollar joint venture with Valero, one of the largest energy firms in the world, which will allow it to put a price floor under its product.
Now, there are several different competitive advantages that make this a near monopoly:
- Gross business – Rendering animal carcasses into usable commodities is not an attractive business. Very few people will wake up tomorrow and want to get in line to compete. It’s kind of like plumbing. You can make $75,000 a year as a plumber and have all the work in the world. Meanwhile, high school grads spend $100,000 plus four years for a degree in paper-pushing for a $40,000 a year job. Plumbing isn’t sexy; paper pushing is!
- Economies of Scale – Any time you build a bigger business you have less rigidity and less granularity. Darling can produce more with less, giving it a competitive pricing advantage in setting market prices, as well as demanding more from its customers. It can also scale up existing contracts due to gains in incremental bandwidth.
- Connections – In working with Valero in a joint venture, the firm has the connections it needs to establish itself as the go-to firm in this business. From the conference call, which was poorly attended by my dear Wall Street analysts, the firm intends to use it to arbitrage prices for its production. The ultimate goal is to squeeze additional pennies from its production. Efficiency begets higher margins, which bring competitive advantage in a mostly commoditized business.
- Headlocking the Competition – If the price of a core rendering product falls in value, the Valero play becomes central to the viability of the industry. It’s like an insurance policy against falling output prices. Also, their competitors don’t have the same infrastructure, which means Darling might eventually take a cut out of its competitors hard work. That’s a winner!
- Financial Economies of Scale – Darling is the only publicly-traded company in a sea of smaller, privately-held firms. When one of its competitors goes up for sale, guess who the investment bankers and business brokers are going to hunt down for a bid? The publicly-traded firm worth $2 billion with years of public financial statements, or the bank loan-funded private mom and pop down the street? If they want the best money possible in a sale, they’ll talk to the big fish!
A combination of scale, liquidity, and market position make it a key player in the business. Not to mention, big government is practically funding its joint venture with tax benefits.
Darling International has an earned monopoly. The company is worth nearly $2 billion at present valuation. Some $15 million worth of shares trade hands daily. It’s liquid enough for many fund companies.
So how many analysts are watching it?
Seven analysts are following the firm. How many follow Apple, a company that competes in arguably one of the most competitive industries? Some 48 analysts follow Apple, according to Yahoo Finance.
This incites a new tangent – Apple is huge. For Apple to be worth $437 billion there has to be a slew of people watching it, as many people have to be invested in it. That would be a good thesis if it weren’t for the second largest publicly-traded company – Exxon Mobil – having only 18 firms setting price targets.
Wall Street’s Silly Bias
Warren Buffett has a fantastic opinion on investing, and life in general. It goes a little something like this:
“There seems to be some perverse human characteristic that likes to make easy things difficult.”
Darling International makes money so long as dead animals and restaurant grease exist, and the lights are on at the processing plant. Apple makes money so long as people enjoy its products, which are right smack dab in the center of creative destruction. The tech industry literally eats itself each year to grow just a little bit more.
Now, I’m not one to say that technology won’t outperform rendering, or that Apple is over-priced. That isn’t the point. The point is how hard analysts work to predict the impossible, when the
possible certain bet is standing right in front of them.
Consider these two very different bets summarizing each company. As for Darling, you stand to make money so long as the US has dead animals and restaurant grease. As for Apple, you make money if a single company can keep its products in the number 1 position in an industry that reinvents itself once or twice every decade.
The basis for finance is to generate a risk-adjusted return in excess of the risk-free rate on US Treasuries. The only risk to US Treasuries is the risk the printing presses stop working. The only risk to Darling is the risk that there are no animal carcasses to be rendered or restaurant grease to be processed. Those risks seem to be in equity – they’re practically equal!
A 50-Year Choice
You have an investment decision. You have to buy a company and hold it for 50 years. Do you buy a company in one of the most volatile sectors on the planet – consumer technology – or one in a business that hasn’t changed since the beginning of mankind?
I know which I’d pick. And I wouldn’t care much about whether or not I had a comparable company to determine the value of one or the other. Sure, I can look to Apple’s competitors to determine more accurately what this specific business might be worth. But why is it better to follow firms only if they have competition? Admittedly, I favor comparable companies models, but not as much as I dig owning virtual monopolies.
You’re an investor. You want to own part of a business. Two offers come up. You pass on one because its a monopoly. You decide the business with 100 competitors is a better risk. In what reality does this happen?
Wall Street. The only place where risky cash flow is given more attention than certain cash flow.
Disclosure: Still long and strong DAR. Photo by: christopherdombres