When it comes to investing, it pays over the long-term to buy and hold the best quality companies possible. That's because these elite stocks have moat-like features that means they can resist competitive threats year-in, year-out. This cycle of consistent outperformance and reinvestment can lead to incredible compounding returns.
In this article, I'm going to tell you what makes these stocks so special - let's take 3i (LON:III) as an example. 3i is a balanced, large cap in the Investment Management & Fund Operators industry.
How to spot moat indicators
Moats are desirable because they often guarantee a sustainable competitive advantage. But there are several ways that companies can get them. For example, they might have:
- Intangible Assets - Such as brands that customers love, valuable patents or regulatory approvals
- Switching Costs - It might be too costly, complicated or unnecessary for customers to look elsewhere
- Network Effects - When customers become part of a product it creates tremendously powerful businesses
- Cost Advantages - Superior processes and unique locations and assets make it hard for others to compete
- Great Scale - Large infrastructure and distribution networks are powerful barriers to entry in many industries
Has 3i (LON:III) got a moat?
When it comes to searching for companies with moats, some of the biggest clues actually lie in their financial statements. By looking at a small number of important ratios you can get an idea about the competitive strength and profit power in a business.
Here's what they are and why they are important - and how 3i stacks up against them:
- High rates of Free Cash Flow - the measure of a thriving company.
- A high ratio of free cash flow to sales can be a very positive sign. For 3i, the figure is an impressive 69.6%. - High Return on Capital Employed - the measure of a company growing efficiently and profitably.
- A 5-year average ROCE of more than 12 percent is a pointer to strong efficiency. For 3i, the figure is an eye-catching 17.0%. - High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
- 3i has a 5-year average ROE of 21.6%. - High Operating Margins (compared to peers) - the measure of a company with pricing power
- 3i has a 5-year average operating margin of 95.9%.
Next steps
Some of the best quality stocks in the market have defensible models that can deliver high levels of shareholder returns over the long term. By analysing some key medium-term profitability and efficiency metrics, it's possible to start tracking them down. On this basis, it certainly appears that 3i has some of the financial traits of an economic moat.
Disclaimer: These articles are provided for information purposes only. The content is not intended to be a personal recommendation. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser. The author has no position in the stocks mentioned, unless otherwise stated.