For Monopolies, Look to Smaller Businesses

There is nothing I hate more, speaking as an investor, than competition. I don't want my companies to compete with anybody; I want them to be able to raise prices, spend minimally on research and marketing, and pass on any cost increases to the consumer. So I'm always on the lookout for a good monopolist.

The trouble is that finding a durable monopoly is hard. Our free market system makes it so. When someone finds a good game in town, it attracts competitors that drive down prices. And if, for whatever reason, viable competitors don't materialize, then the Justice Department usually does.

This is good for the consumer but bad for the investor.

If you actually find a legitimate unregulated monopoly in this country -- one that the DOJ is not hassling and whose position is long-lasting -- generally four conditions must hold:

  1. It produces a niche product that does not draw a lot of attention.

  2. It's in a slow-growth, low-profile industry.

  3. Its product has an incredibly strong brand.

  4. It's usually (surprise!) a small-cap stock.

Monopolies are usually small caps
Yep, you heard me right: Sustainable monopolies are generally small businesses! (Though most small businesses are not monopolies.)

Need some examples? Think of WD-40 (NYS: WDFC) , Fair Issac (NYS: FICO) , and Steinway Musical Instruments (NYS: LVB) .

All small caps in slow-growth niche markets and all monopolists -- and all CAPScalls of mine.

WD-40 makes, well, WD-40. Can anyone name a competitor?

Fair Issac comes up with the credit score algorithm for Experian and other credit bureaus. It has no serious competitor.

Steinway makes the world-famous Steinway piano. 97% of the world's solo piano concerts are performed on a $137,400 Steinway concert grand. The company's primary competitor, according to its 10K, is its own used product! The famous diamond cartel DeBeers had this same unorthodox "competitor," which is why it came up with the "A Diamond Is Forever" campaign to help prevent people from reselling their diamonds on the used market.

I'll be writing on Steinway in depth later this week.

Now, dear reader, can you think of some sustainable monopolies that aren't small caps?

I'm sure some of you are dying to say Microsoft. True, but it had its run-in with the DOJ. And Apple (NAS: AAPL) and Google demolished Mr. Softy in music and search. That, and Macintosh is a real competitor in operating systems now.

Speaking of which, some of you might say Apple is a monopoly. But I don't think its business is stable enough to be considered a monopoly, which was one of my original concerns. And it also has its issues with the DOJ and e-books now.

And then there is Google. OK, I'll give you Google in search. Next question.

The downside to monopolies
Nevertheless, there is trouble in paradise. Monopolies aren't perfect.

Being a monopoly tends to breed complacency and bad management (old AT&T comes to mind). WD-40, Fair Issac, and Steinway don't have extraordinary returns on invested capital. Their ROICs are generally less than duopolies like Altria.

This is in large part due to the tendency for monopolies to reinvest cash into worse businesses (what Peter Lynch called "deworsification"). Witness WD-40's acquisition of Lava and Solvol, FICO's other products that no one has heard of, and Steinway's commodity (and heavily unionized) band business, which is, thank goodness, in the process of being sold.

Still, despite these problems, I expect these companies to outperform the small-cap index as a whole. (I wrote recently on why the small-cap "value" index is a bad deal right now.)

Great small caps
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At the time thisarticle was published Fool contributor Chris Baines is a value investor. Follow him on Twitter, where he goes by@askchrisbaines. Chris' stock picks and pans have outperformed 96% of players on CAPS. He owns no shares of the companies mentioned. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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