Wall Street Hates Monopolies

by JT McGee

Contrary to popular belief, Wall Street doesn’t really love monopolies.

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:

  1. 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?
  2. 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:

  1. 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!
  2. 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.
  3. 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.
  4. 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!
  5. 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.

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

{ 9 comments… read them below or add one }

Darwin's Money February 7, 2012 at 23:30

I love the idea of investing in monopolies. That’s one of the reasons real estate can do well in the right environment (location, location, location)… you have a monopoly on a hot spot. When it comes to stocks, if markets are truly efficient, you’d think investors would catch on to the monopolistic pricing power, earnings that are derived as result, etc… but if this is a smaller company without that message out there, more power to ya!

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JT McGee February 8, 2012 at 01:47

One of these days you real estate investors might convince me!

I don’t think markets are remotely efficient – there’s simply no way. The equities markets might be efficient if we’re comparing actively managed funds with $10B+ in assets with 100 different stocks but I don’t think the efficient market hypothesis begins to apply for hedge funds and private ventures that aren’t bound by the same diversification rules and marketing gimmicks. I mean, if I were a mutual fund manager, I’d stick 90% of the fund in SPY and play with the remaining 10%. You match the market and never diverge that greatly as far as under- or over-performance. Given that marketing is the name of the game, it sounds like as solid strategy for any portfolio manager.

I’m convinced that anyone armed with the least bit of financial/accounting knowledge could do a minimum of 25% per year on assets of less than $100 million. Analysts are too busy chasing the difficult picks to bother finding the easy pickings in the collection of small cap bargains.

If I ever make it to Wall Street, I plan on being the boring old grandpa stuck in his ways. Boring, slow, and methodical is a profitable strategy!

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AverageJoe February 9, 2012 at 08:19

Interesting case for Darling. A quick look at the company profile and key statistics bear out your points…this appears to be a profit-generating machine right now.

I also agree with your point above w/ Darwin about how easy it is to make money if you’re the average guy who actually uses some of the tools available. Some days I kick myself that my portfolio isn’t doing better only because I pay attention to it sporatically….still more than the average guy, but not nearly as much as I should. I have a methodology for everything else (working out, blogging, work, etc.). I need to develop a system of portfolio monitoring for my own stuff.

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JT McGee February 9, 2012 at 13:56

I struggle with keeping a routine on my investments, as well. Finally, I started keeping a watch list, and I have spreadsheets of every company I want to own, and what price I’m willing to pay for them.

Usually, I only get 6-7 really good opportunities a year, and try to chase those. I tend to think that if I can’t make an investment work – or I can’t find one I had previously identified – it’s just fate and I shouldn’t buy it. Stupid? Yeah, probably. But if I’m not bending over backwards to buy a company I probably didn’t want it anyway.

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Sandy February 9, 2012 at 16:53

It seems a bit backward choosing the company in the volatile sectors over a company that has little competition. Darling International sounds great to me

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JT McGee February 11, 2012 at 08:26

It does, doesn’t it? People are attracted to hard problems. I guess I can’t blame them. But I like to put my money on easy solutions to common problems with a future that is as sure as the sun rising the next morning. I like bets where I make money so long as I live another day. 😀

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Dividend Monk February 10, 2012 at 10:14

That’s a good article. Monopolies (or any other powerful company with a durable competitive advantage), generally deserves a bit of a valuation premium above its competitors even if it doesn’t often get it. It can be difficult to quantify qualitative aspects of a company.

I’m not familiar with DAR but it sounds like a good one. My favorite example of this is Compass Minerals. Largest underground salt mine in the world, located right on the Great Lakes for easy boat/rail shipping of their commodity product (so price is everything, and much of the price is transportation). It’s rather difficult to compete with that, and impossible to replicate. There are weather-related risks, though.

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JT McGee February 11, 2012 at 08:25

Darling has its own industry specific risks, primarily from the cost of natural gas. Thank God for fracking. Drill, baby, drill! 😉

The thing I do like about virtual monopolies is valuing them. You know that when the biggest problem you have is whether or not to discount future cash flows with corporate bonds or the long bond US treasury yield you’re doing something right. I’ll have to take a look at Compass Minerals. Never heard of it, but it sounds like the boring, and generally unattractive businesses that I love so much.

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101 Centavos February 12, 2012 at 19:53

I guess we have to be content with even a mere seven analysts following an icky business.

Good article. I use the same reasoning with food companies… ya gotta eat! At the end of the day, people will eat their burgers and fries, and animals carcasses, like you say, will still need rendering.

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