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Given that economic uncertainty is likely to be a feature of stock market investing for some time to come, it is more important than ever to know how to identify high quality stocks for your portfolio. This means safe, profitable companies with strong balance sheets.
When it comes to investing, it pays to buy and hold the best quality companies possible. 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.
What makes them different is that they've got what billionaire investor Warren Buffett, calls economic moats.
Here's a quick guide to what makes these stocks stand out - using Trex Co (NYQ:TREX) as an example...
Has Trex Co (NYQ:TREX) 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 Trex 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 Trex Co, the figure is an impressive 27.2%.
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 Trex Co, the figure is an eye-catching 41.3%.
High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
- Trex Co has a 5-year average ROE of 40.4%.
High Operating Margins (compared to peers) - the measure of a company with pricing power
- Trex Co has a 5-year average operating margin of 25.2%.
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 Trex Co that you can find out about here.