Why monopolies outperform

In the press, monopolies often face criticism. Peter Thiel, in his book Zero to One, observes that true monopolies go to great lengths to appear non-dominant, while competitive businesses strive to market themselves as 'segment monopolies.' This paradox highlights a fascinating reality: monopolies are both feared and coveted.

At 5AM Capital, we take a different perspective. We actively seek out investment opportunities in monopoly-like businesses and "cosy cartels," even as many of these companies deny their monopolistic nature. This recalls my decade-long experience at Macquarie in New York, where we invested in monopoly infrastructure like pipelines, cell towers, airports, toll roads, and rail lines. Yet, we were forbidden from using the term “monopoly” in internal documentation. One compliance officer’s primary role seemed to be running a CTRL + F search for such forbidden terms.

Even in the tech world, companies like Google embody this delicate balance. At a recent U.S. antitrust hearing, Google’s CEO Sundar Pichai highlighted how their advertising footprint is small relative to global advertising, yet Google commands over 85% of global search—an astonishing statistic. This was the topic of our June 2022 Quarterly Letter (pre-the launch of ChatGPT)[1].

However, for savvy investors, monopolies can be a goldmine (an ironic phrase as we won’t invest in mines). Companies that hold significant market share tend to outperform their competitors, delivering outsized share price performance.

In this article, we delve into why monopolies are at the core of our strategy at 5AM Capital and explore how they can be leveraged to achieve outperformance for your portfolio.

Why monopolies outperform

Monopolies, by definition, have little to no competition. This enables them to set prices, control supply, and generate higher profit margins. Unlike firms in competitive markets, monopolies enjoy pricing power, which allows them to invest heavily in research, development, and growth initiatives. This also creates a buffer against market fluctuations and economic downturns, ensuring stable revenue streams.

But importantly for our style of investing, it helps to build conviction in the long-term durability of their business and earnings profile.

In technology and online platforms, network effects often reinforce market dominance. Network effects occur when a product or service becomes more valuable as more people use it. Social media platforms, for example, grow exponentially as users join, creating a cycle of growth and dominance. Companies that reach critical mass can leverage these effects to maintain their monopolistic position, making it exceedingly difficult for competitors to catch up.

This allows them to set prices, control supply, and enjoy higher profit margins.

We like monopolies that benefit shareholders, customers and society

Peter Thiel, a co-founder of PayPal and Palantir and a vocal advocate for monopolies argues that monopolies are essential for innovation. In Zero to One, he distinguishes between monopolies that create new value and those that simply extract rents. At 5AM Capital, we share this philosophy. Our focus is on investing in companies that generate a "win-win-win" for shareholders, customers, and society. ‘Win-Win-Win” was the focus of our 30^th of September 2024 letter to investors, our short-hand for companies on building a moat and ensuring the long-term durability of our portfolio companies to compound returns over time.

For example, we value companies with strong pricing power but believe they should “earn the right” to increase prices by delivering superior value to customers over time. Amazon’s AWS division exemplifies this approach. Through scale and innovation, AWS has improved its services dramatically while sharing these benefits with customers—creating value for all stakeholders.

Real-World Examples: Intuit and Hemnet

Two standout examples are 

• Intuit which has compounded its share price at 21.5% since IPO in 1993 
• Hemnet which has compounded its share price at 32.5% since IPO in 2021 

1. Intuit - a 30 year compounder!

Most Aussie readers will be more familiar with Xero, but we prefer the US giant Intuit (NASDAQ:INTU), which is more dominant, operates in a far larger market and is also valued at a lower EV/EBIT multiple (24x Fwd)!

• With its QuickBooks software, Intuit has a dominant 80%+ market share of the U.S. online accounting market for small-to-midsized enterprises (SME) (i.e. 8.3 million of the circa 10 million US businesses that use accounting software[2]).
• While QuickBooks continues to dominate the market having amassed 8.3 million customers[3], only one third of all US SMEs (circa 33 million[4]) use cloud accounting software, leaving significant room for growth in customers.
• These SME businesses will migrate to cloud based accounting software in time – and we anticipate the vast majority of the 23 million of these SME businesses migrating from manual processing, paper and spreadsheets to cloud accounting software will eventually use Quickbooks.

o Note: Intuit see their customer TAM in the US small business and mid-market as 47 million. Thus they see online accounting penetration at only 15%. We however estimate the penetration of potential customers to be closer to 30%. Either way you cut the numbers – it is low.

As QuickBooks has established itself as the leading platform for SME accounting in the US, it has cultivated an invaluable "free salesforce" in the form of accounting practices. These professionals, who manage the books for SMEs, play a pivotal role in recommending QuickBooks to their clients. Here's why they are such effective advocates:

• Deep Familiarity with the Platform: Accountants are highly knowledgeable about QuickBooks and comfortable using it. Over time, they’ve mastered the platform, making it their go-to solution for managing client accounts efficiently.
• Streamlined Operations for Accountants: Many accounting firms rely on QuickBooks not just for individual clients but as a centralized hub to manage multiple client accounts through master logins. This streamlined setup simplifies their own workflows, creating a strong incentive for them to encourage all their clients to adopt QuickBooks.
• Trust and Credibility with Clients: Accountants hold a trusted advisory role for their SME clients. When they recommend QuickBooks, their endorsement carries significant weight, as business owners naturally trust their accountants to suggest the best tools for financial management.
• No Cost to Intuit: This “salesforce” is both highly effective and incredibly efficient. Intuit benefits from the accountants' advocacy without having to pay salaries or commissions. These professionals promote QuickBooks because it enhances their own operations and provides clear benefits to their clients—not because they are financially incentivized by Intuit.
• Mutual Value Creation: By encouraging their clients to use QuickBooks, accountants not only benefit from streamlined operations but also enhance the client experience. QuickBooks' user-friendly interface and integrations make it easier for business owners to collaborate with their accountants, reinforcing the platform's reputation and dominance.

In short, accountants act as an organic, highly motivated, and trusted extension of Intuit's sales team. Their deep knowledge of the platform, reliance on its functionality, and influence over their clients create an unbeatable distribution network—one that has helped QuickBooks secure its position as the undisputed leader in SME accounting software.

Lastly, in addition, Intuit is growing its customer base to include medium to larger-sized companies (beyond its original core focus of 1-10 employee groups) through its QuickBooks Advanced / Intuit Enterprise Suite offering.

QuickBooks Enterprise plays a crucial role in Intuit's strategy to retain and grow with its most successful customers. By offering robust features tailored for larger, more complex businesses, helps bridge the gap between traditional small-business accounting solutions and enterprise-level systems. This ensures that as a company scales, it can continue using QuickBooks without outgrowing its capabilities.

We see this as somewhat akin to the Shopify Plus launch which has helped it win large-scale businesses such as Nike – moving well beyond the small mom-and-pop e-commerce client. These capabilities were even further enhanced in September of last year, with the launch of additional AI features.

2. Hemnet

Sweden’s leading property classifieds portal exemplifies the power of network effects. With 90% of properties sold in Sweden listed on Hemnet, it generates 9x the traffic and commands an audience 11x larger than its nearest competitor. It is much more dominant than even REA in Australia (a business that we also like and have a small indirect position)!

The core of our thesis is that it is very difficult to disrupt a monopoly position supported by very strong network effects (sellers want to advertise where there are the most eyeballs and home buyers want to search where there are the most listings!).

Additionally, we believe that Hemnet has a strong pricing power that has been far under-exploited in an attractively structured and resilient end-market. For example, in the past financial year Hemnet took roughly 0.25% of the total transaction value (rev per transacted house / average house price in Sweden), which is significantly lower compared to its developed market peers (Germany’s Scout24 charges 0.39%, and Australia’s REA charges 0.37%). Hemnet’s opportunity to bridge this gap through a combination of its monopoly position, improved value, price increases and product development is central to our investment thesis.

The Risk of Regulation

Monopolies are undeniably attractive from an investment perspective due to their ability to dominate markets, set prices, and generate substantial profits. However, with such power comes significant responsibility and inevitable scrutiny—a reality best captured by the well-known adage (popularized by Spider-Man): With great power comes great responsibility.

Governments across the globe are increasingly vigilant about the potential downsides of monopolistic practices, particularly when these practices harm consumers or stifle competition. At 5AM Capital, we recognize these risks but remain clear-eyed about the distinction between being a monopoly and abusing market power. Regulation tends to target abusive behavior rather than the existence of a dominant market position itself. This awareness enables us to capitalize on the advantages of monopolistic businesses while preparing for potential regulatory changes.

Take Verisign, for example—a business in our portfolio often described as the "toll road of the internet." Verisign operates under stringent regulation by ICANN, with predictable pricing increases and contract renewals linked to their operational performance. Despite this oversight, Verisign exemplifies the stability and compounding returns that regulated monopolies can provide over the long term. Such businesses thrive by striking a balance between market dominance and the value they deliver to their stakeholders.

At its core, the legality of a monopoly hinges on how it wields its power. As long as customers continue to benefit from the company’s products or services, and receive more value over time, it’s difficult to argue that the monopoly is exploitative. In fact, it is not illegal to be a monopoly—only to abuse that position.

Mitigating Regulatory Risk

When evaluating monopolistic stocks, we actively seek businesses less likely to attract regulatory scrutiny. These typically fall into one of two categories:

1. Essential Services and Natural Monopolies
   While these businesses are often regulated, their indispensable nature helps mitigate the risk of severe regulatory penalties. For instance, utilities, cell-towers providers, airports often have pricing mechanisms tied to inflation or pre-agreed formulas, offering predictability and stability. These companies are typically subject to regulation, but the nature of their business makes them indispensable, which can mitigate the risk of severe regulatory actions.
2. High Barriers to Entry and Innovation-Driven Niches
   Technology companies leading in niche markets with proprietary technologies or unique business models are another key focus. These businesses typically build ecosystems that are difficult for competitors to replicate, ensuring long-term dominance. Continuous innovation and the value they provide to customers often shield them from harsh regulatory scrutiny. Additionally, these companies tend to operate outside the direct spotlight and tend to operate as an essential service reducing the risk of becoming a political or public target.

For example, we favour businesses with substantial network effects, pricing power, and strategic advantages that allow them to maintain market dominance while benefiting customers and shareholders alike.

Conclusion

Monopolies may face criticism and regulatory challenges, but their ability to dominate markets, innovate, and deliver exceptional value makes them compelling investment opportunities. At 5AM Capital, we believe that, when managed responsibly, monopolistic businesses can be a driving force for progress, financial performance, and societal benefit.

By focusing on companies with robust pricing power, network effects, and the ability to innovate continuously, we position our portfolios to harness the unique advantages of monopolies. Firms like Hemnet and Intuit demonstrate how market dominance, when combined with innovation, can create long-term success.

Through thoughtful selection and strategic investment, we aim to deliver sustainable, outsized returns while contributing to a win-win-win for shareholders, customers, and society.

At 5AM Capital, we see monopolies not as threats to be feared but as opportunities to be embraced. Properly managed, they represent a potent combination of innovation, stability, and financial outperformance.

So, the next time you hear the word "monopoly," think of it as an opportunity for outperformance in your investment portfolio.