The Case for Investing in Natural Monopolies
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Most companies usually need to have special qualities in order to develop a sustainable competitive advantage: a lower cost structure, a differentiated brand or a valuable patent for example. But on other occasions, it just doesn't make sense to have more than one supplier on a certain industry from a business point of view. And investors in this kind of business can enjoy big returns for long periods of time without having to worry too much about competition.
One clear example is railroads. Once a company is covering a certain route; there is little or no incentive to build a competing railroad on the same geography. Trains still compete against other means of transport like trucks, but they have a natural cost advantage that makes them more efficient, and it would be really hard for trucks to gain a lot of market share in the transport of coal, for example.
Norfolk Southern (NYSE: NSC) has enjoyed its competitive advantage in coal and other products for a long time, and the company delivers juicy returns on its capital with a Return on Equity (ROE) ratio barely below 20%. Norfolk rewards investors with a 2.7% dividend yield, and the company has accumulated 11 consecutive years of dividend increases.
Investors have been concerned about the effects of low natural gas prices on companies like Norfolk. Utilities are using more gas instead of coal due to its relative cheapness, and trucks could reduce some of the cost gap if they keep switching to natural gas for fuel. But those concerns are already reflected on the stock price; Norfolk trades at a P/E ratio of 12, which is sensibly below the company's five year average P/E of around 15.
Another interesting bet on the naturally monopolistic railroad business could be Canadian National Railway (NYSE: CNI). The biggest railroad in Canada covers that country from coast to coast and extends through Chicago to the Gulf of Mexico. This company is not so exposed to coal as Norfolk; Canadian has a more diversified business with a bigger participation of forest products and chemicals.
Perhaps for this reason, Canadian has held up better than Norfolk, and is more expensive with a P/E ratio of 15 and a dividend yield of 1.8%. On the other hand, Canadian has very strong profit margins and an enviable trajectory of cash flow generation. Canadian is one of the most profitable companies in its industry with a ROE ratio near 23%.
Utilities are also prone to natural monopolies, and Waste Management (NYSE: WM) is generating strong returns from its dominant position in the integrated waste services industry. With nearly 300 landfills and an unparalleled scale in collection routes, Waste Management is the undisputed leader in its industry. Due to environmental regulations, it’s really hard to get permission for new landfills, which keeps competition at bay.
The trash collection business is a boring and stable activity, but this company is also involved in the very exciting business of converting trash into energy; the technology is already being implemented and it clearly has some very attractive potential. The company converted nearly 7% of its trash into energy last year; and management estimates that if it were able to transform into energy 100% of the 92 million tons it hauled away in 2011, revenues could see an explosive increase from $12.3 billion to more than $40 billion.
Trading at a P/E ratio of 16 and yielding a 4.4% in dividends shares of Waste Management are reasonably priced, and they provide an interesting combination of the solid and stable business of waste collection and the much more innovative conversion of trash into energy.
It certainly doesn't make sense to build a new airport near an existing one, which means than Grupo Aeroportuario del Pacifico (NYSE: PAC) has a very strong natural monopoly. The company has the rights to operate 12 airports in the Mexican Pacific region until 2048, and it makes money by charging airport user fees to airlines and passengers, as well as services like car parking, food and retail sales.
The business is exposed to regulatory risks, and high fixed costs can mean fluctuating profit margins with a considerable sensibility to the economic cycle. At the same time, exchange rate fluctuations are another source of uncertainty for investors in Grupo Aeroportuario.
The airport business is capital intensive, so ROE is relatively low below 7% and the P/E ratio of Grupo Aeroportuario doesn't look too attractive at more than 19. On the other hand, the company has been able to generate positive results through various economic conditions, and its juicy dividend yield of 6.1% is a very attractive incentive for investors in times of ultra-low interest rates.
Natural monopolies are one of the easiest ways to invest in companies with rock solid competitive advantages, and this kind of businesses are very strong candidates to hold for the long term. As these simple examples show, successful investing strategy doesn't need to be complicated.
acardenal owns shares of Waste Management. The Motley Fool owns shares of Waste Management. Motley Fool newsletter services recommend Canadian National Railway, Grupo Aeroportuario del Pacific S.A.B (ADR), and Waste Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.