Warren Buffett makes it look so easy: find high-quality companies, wait for a fair price to buy, and then hold them... forever. The problem of course is that these stocks are hard to find - but there are signs that Ingevity NYQ:NGVT could be one of them.
Given uncertainty in the stock market caused by Coronavirus, it is more important than ever to find high quality stocks. That means buying safe, profitable companies with strong balance sheets. They're the kind of stocks that have the ability to resist competitive threats and generate breathtaking profits year after year. To do that, they need what Buffett describes as "an economic moat".
Defensive economic moats let companies compound returns at above-average rates over long periods. Here's a rundown on what makes these stocks so special - using Ingevity (NYQ:NGVT) as an example.
Signs of strength
There are several ways that businesses can make themselves very hard to compete with, including:
- 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 Ingevity 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 Ingevity, the figure is an impressive 18.1%.
- 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 Ingevity, the figure is an eye-catching 17.3%.
- High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
- Ingevity has a 5-year average ROE of 35.6%.
- High Operating Margins (compared to peers) - the measure of a company with pricing power
- Ingevity has a 5-year average operating margin of 15.8%.
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 Ingevity that you can find out about here.
Alternatively, if you'd like to find more shares that have some of the characteristics of promising economic moats, you should take a look at this Economic Moats screen.