Does Smith amp; Nephew (LON:SN.) have an economic moat?

Economic uncertainty and market volatility have shown once again why it's vital to have high quality stocks in 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 Smith & Nephew (LON:SN.), which is active in the Healthcare Equipment & Supplies industry, as an example.

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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 Smith & Nephew stacks up against them:

1. 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 Smith & Nephew, the figure is an impressive 14.8%.

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 Smith & Nephew, the figure is an eye-catching 13.5%.

3. High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
   - Smith & Nephew has a 5-year average ROE of 14.9%.

4. High Operating Margins (compared to peers) - the measure of a company with pricing power
   - Smith & Nephew has a 5-year average operating margin of 18.2%.

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 Smith & Nephew has some of the financial traits of an economic moat.

To find out more you might want to take a look at the LON:SN. StockReport from the award-winning research platform, Stockopedia. StockReports contain a goldmine of information in a single page and can help to inform your investment decisions.

To find more stocks like Smith & Nephew, you'll need to equip yourself with professional-grade data and screening tools. This kind of information has traditionally been closely guarded by professional fund managers. But our team of financial analysts have carefully constructed this screen - Stockopedia’s Moats of the FTSE 350 - which gives you everything you need. So why not come and take a look?