When it comes to investing, I'm convinced it pays to buy and hold the best quality companies possible. I'm talking about some of the market's most respected names... but also quite a few that you might not have heard of.
What makes these elite stocks so appealing is their ability to resist competitive threats and generate breathtaking profits. They compound investment returns at consistently above-average rates over the long term.
These stocks are different because the've got what billionaire investor Warren Buffett, calls economic moats. Like medieval castles, their profits are fortified by impregnable business models.
In this article I'm going to tell you what makes these stocks so special - and I'm going to use Somero Enterprises Inc as an example. Somero Enterprises Inc is an adventurous, small cap in the Heavy Machinery & Vehicles industry - it makes concrete levelling machines.
How can you tell whether a company has a moat?
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 Somero Enterprises Inc (LON:SOM) 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 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 Somero Enterprises Inc 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 Somero Enterprises Inc, the figure is an impressive 24.5%. - 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 Somero Enterprises Inc, the figure is an eye-catching 46.4%. - High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
- Somero Enterprises Inc has a 5-year average ROE of 40.0%. - High Operating Margins (compared to peers) - the measure of a company with pricing power
- Somero Enterprises Inc has a 5-year average operating margin of 26.7%.
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 Somero Enterprises Inc 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.