Investing in oligopoly

In a classic “Dance of the money bees”, the author, John Train writes on Investing in oligopoly.

“For most investors the only way to make large profits in a portfolio is to buy prime growth stocks in periods of market weak­-ness and hold them for long periods of time. It is difficult to catch turnarounds in cyclical issues, and even if successful, one pays high capital gains taxes on each transaction. Over the long term, most conventional cyclical industries are slowly squeezed by the unions, government regulation, higher costs, and the Japanese. Only the exceptional growth companies can leave these constraints far behind.

A prime growth stock should have most, or if possible all, of the following characteristics:

– A dominant position internationally in a growth industry, and a good reason why the position should continue: preferably what might be called an unfair advantage. Examples are Xerox's patents; IBM's huge sales force and research budget; Avon's head start; or Gannett Newspapers' regional monopolies. The dominant company usually understands the industry best and profits most from opportunities.

– A long record of rising earnings, with sustained high profit margins. These high margins are a sure tipoff that you are in the presence of an oligopoly (a market with a limited number of sellers).

– Superb management, in sufficient depth, with a stake in own­ership. Business management ability is fundamental; technical ability can be bought. Innovative capacity and marketing skill are essential.

– An impressive research program, and leading record of innovation.

– The ability to pass on labor and other cost increases to the consumer. This follows from a dominant position in an industry.

– A strong financial position. (Growth stocks usually have little debt. A heavy debt load usually suggests low profitability.) Ready marketability of the stock, preferably on the New York Stock Exchange. It helps to have an attractive, understandable "concept"; for example, a stock whose name is that of an outstanding product, like Coca-Cola or Sony.

– Relative immunity to "consumerism" and government regula­tion. The government's natural instinct is to hold down prices in order to buy votes, which can bankrupt the object of such regulation.

If one buys such a stock at an acceptable multiple of earnings (presumably fifteen to twenty times, and ideally not much higher than the company's own growth rate) and the growth in fact con­tinues, then the multiple should be maintained or increased. The stock price should therefore rise over the long term at least as fast as the earnings: with luck 12 to 15 percent a year or more. One should not be prepared to pay extremely high multiples for even the finest stocks, because in all human situations there are changes and surprises.

There are probably less than a hundred companies in the coun­try that satisfy these criteria, and probably only a few dozen that can actually be identified and about which one can get regular access to first-class information. The rewards of finding and keep­ing a Merck are so enormous, however, that one should concen­trate on this search. Even the largest investment firms cannot afford to follow all the standard industrials and still do an authen­tic job on the growth issues.

I would avoid the large, cyclical industrials even if they are supposed to be ripe for an upward swing. As mentioned above, usually it does not occur; and if it does, then sooner or later you must sell, pay taxes, and try to buy back the growth stock you really wanted quite possibly having lost ground against it in the process. The same is true of stocks with allegedly high asset values. The joy went out of them when capital gains taxes went way up-if indeed the assets really turn out to be both there and realizable.

The number of prime growth stocks is so limited that they are the pearls of great price of portfolio investment. One can be sure they will always be in demand and get top prices. (In bear-market bottoms they may become reasonably priced for a while.) One should not ordinarily sell a stock with a high built-in capital gain merely because the multiple is high (unless it becomes simply outrageous, where pruning may be justified). One should sell it if the whole market has started to slide and the company's earn­ings are flattening. That is the moment of maximum market vul­nerability.

Once one has developed a portfolio "core" of prime growth stocks that have appreciated substantially, then one can try for larger (and riskier) gains in "emerging" growth stocks. Several may have to be tried and discarded (probably at a loss) for each one that proves to be a big winner.

Volatility (with low yield) is the price of the major gains possible in growth-stock investing.”