Most investors would agree that the best quality companies in the stock market often make the best investments as well. I'm talking about some of the most respected names... 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.
In this article I'm going to tell you what makes these stocks so special - and I'm going to use Sage (LON:SGE) as an example. Sage is a balanced, large cap in the Software industry.
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 Sage 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 Sage 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 Sage, the figure is an impressive 22.2%. - 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 Sage, the figure is an eye-catching 17.6%. - High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
- Sage has a 5-year average ROE of 21.7%. - High Operating Margins (compared to peers) - the measure of a company with pricing power
- Sage has a 5-year average operating margin of 20.5%.
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.