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The persistent risk of economic uncertainty and market volatility mean that it can be worth seeking out high quality stocks for your portfolio. Safe, profitable companies with strong balance sheets can offer solid returns over the long term, even in a crisis.
The best quality companies are often some of the market's most respected names... but there are others that you might not have heard of. What makes them stand out is their ability to resist competitive threats and generate breathtaking profits. They compound investment returns at consistently above-average rates over time.
These stocks have got what billionaire investor Warren Buffett, calls economic moats. Like medieval castles, their profits are fortified by impregnable business models.
Here's a quick explainer on what makes these stocks so special - using Nongfu Spring Co (HKG:9633) as an example.
Signs of strength
First of all, here are some of the ways that companies actually establish these very profitable competitive moats:
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
When it comes to finding companies with moats, some of the biggest clues actually lie in their financial statements. Here's what they are and why they are important - and how Nongfu Spring Co 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 Nongfu Spring Co, the figure is an impressive 30.0%.
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 Nongfu Spring Co, the figure is an eye-catching 44.5%.
High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
- Nongfu Spring Co has a 5-year average ROE of 42.2%.
High Operating Margins (compared to peers) - the measure of a company with pricing power
- Nongfu Spring Co has a 5-year average operating margin of 27.7%.
What does this mean for potential investors?
Some of the best quality stocks in the market have defensible models that can deliver high levels of shareholder returns over the long term. But there are no guarantees and it's important to do your own research. Indeed, we've identified some areas of concern with Nongfu Spring Co that you can find out about here.