Given widespread disruption and uncertainty in the stock market, it is more important than ever to find high quality stocks for your portfolio. That means safe, profitable companies with strong balance sheets.
We all like the idea of investing in the best quality companies. These multi-bagger stocks resist competitive threats and generate breathtaking profits, especially when the competition collapses. They compound investment returns at consistently above-average rates over the long term because they've got what billionaire investor Warren Buffett calls economic moats.
Here's a quick guide to what makes these stocks stand out - using Sage (LON:SGE) as an example...
How can you tell whether a company has a moat?
Before we get started on why this 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 approval
- 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
So, has Sage (LON:SGE) got a moat?
When it comes to finding 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 20.2%. - 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%.
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 Sage 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.