Given that widespread uncertainty in the stock market is likely to endure for the rest of 2020 and beyond, it pays to know that you're investing in high-quality stocks, rather than speculative ones. This means safe, profitable companies with strong balance sheets.
Most investors would agree that the best quality companies in the stock market often make the best investments as well. They're the ones that seem to be able to make consistently stunning profits over the long term.
What makes these 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 they've got what billionaire investor Warren Buffett, calls economic moats. Like medieval castles, their profits are fortified by impregnable business models.
Here's a rundown on what makes these stocks so special - using AJ Bell (LON:AJBA) as an example...
Clues to quality
Before we get started on why Aj Bell looks like a high quality stock, here are some of the main ways that a company can build a strong moat around itself:
- 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 Aj Bell (LON:AJB) 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 Aj Bell 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 Aj Bell, the figure is an impressive 20.9%. - 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 Aj Bell, the figure is an eye-catching 35.8%. - High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
- Aj Bell has a 5-year average ROE of 31.3%. - High Operating Margins (compared to peers) - the measure of a company with pricing power
- Aj Bell has a 5-year average operating margin of 29.8%.
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 Aj Bell 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.