All happy companies are different: each one earns a monopoly by solving a unique problem. All failed companies are the same: they failed to escape competition – Peter Thiel in ‘Zero to One ‘, (2014)
Peter Thiel in his bestselling book, Zero to One (2014), compared Google with America’s airlines industry. He highlighted that the US airline companies serve millions of passengers and create hundreds of billions of dollars of value each year yet capture an insignificant amount of this value. Compare this with Google, which creates less value but captures far more for itself. Google brought in $50 billion of revenue in 2012 v/s $160 billion for the airline industry, however kept 21% of those revenues as profits – more than 100 times the airline industry’s profit margin that year (and the next year and the one after that). What separates Google from the airline companies is that Google is a near monopoly whereas the airline industry operates in a ‘perfect competition market’.
Where Google can plan for the long-term future and invest in innovation, America’s airline companies are focussed on protecting today’s margins. Thiel suggests that sustainable monopolies can think beyond protecting margins and have the flexibility to care about employees, invest in innovation and build sustainable moats. In contrast, competitive businesses in low margin sectors will pay their workers minimum wages and try to cut corners, sometimes even at the cost of the customer experience. A sustainable monopoly is good not only for its shareholders and its management but also for its employees, customers and business partners.
In a ‘dynamic’ world, evolution of both demand (i.e. customer behaviour) as well as the supply of a product or service can also disrupt some monopolies overnight, the way firms like Kodak and Xerox got disrupted. Therefore, a creative monopolist reinvests the monopoly profits to innovate new products, improve existing products and figure out better ways of meeting the customer’s demand. Hence, progress usually comes from monopolies, and not from ‘perfect competition’.
In ‘Zero to One’ Thiel has also given a framework for new entrepreneurs on how to build a monopoly. First step he suggests is to start small – target a niche market where competitive intensity is very low and the opportunity is being left unaddressed. Next, monopolize the market while building strong barriers to entry and then slowly scale up the business by moving to adjacent or related categories. He suggests a focus on four characteristics of building a monopoly – a) Proprietary technology, b) Network effects, c) Economies of scale, and d) Brand.
Whilst this framework was given by Thiel in the context of young technology start-ups, in India there exist several monopolies in other large traditional industries as well. The most common framework adopted by Indian monopolists for creating and sustaining a monopoly franchise is given in the flowchart shown above.
Here are a few examples of how dominant franchises in India have implemented this framework in India’s B2C segments:
It is easy to understand why monopolies are great for their shareholders – high free cash generation (i.e. ROCEs well above cost of capital) and consistent growth in earnings over the longer term tend to result in consistent wealth compounding for shareholders. The high cash generation of monopolies enables them to innovate, strengthen and evolve their competitive advantages. However, spotting the existence of such monopolies is not easy. As Peter Thiel says in his book ‘Zero to One’, “Anyone that has a monopoly will pretend that they’re in incredible competition…. If the monopolists pretend not to have monopolies & the non-monopolists pretend to have monopolies, the apparent difference is very small”. The presence of a business framework along the lines of what is shown in the exhibit above is one of the tools that investors can use to spot the existence of high barriers to entry created by a monopolist around his business.
Marcellus’ investment philosophy revolves around finding dominant companies where this culture of innovation and building new competitive advantages is ingrained in every layer of management because that is what will help them sustain their dominance over long time periods.
Disclosure: Asian Paints, Pidilite, HDFC Bank, Bajaj Finance and Dr. Lal Pathlabs are a part of most of Marcellus’ portfolios.
Deven Kulkarni is an analyst and Rakshit Ranjan is a fund manager at Marcellus Investment Managers