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Given that widespread uncertainty in the economy and the stock market is likely to endure for many months, it pays to know that you're investing in high-quality stocks, rather than speculative ones. This means safe, profitable companies with strong balance sheets.
Most investors would agree that the best quality companies in the stock market often make the best investments as well. They're the ones that seem to be able to make consistently stunning profits over the long term.
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.
These stocks are different because they've got what billionaire investor Warren Buffett, calls economic moats. Like medieval castles, their profits are fortified by impregnable business models.
Here's a rundown on what makes these stocks so special - using Encore Wire (NSQ:WIRE) as an example...
Clues to quality
Before we get started on why Encore Wire 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 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
Has Encore Wire (NSQ:WIRE) 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 Encore Wire 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 Encore Wire, the figure is an impressive 14.4%.
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 Encore Wire, the figure is an eye-catching 19.2%.
High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
- Encore Wire has a 5-year average ROE of 17.4%.
High Operating Margins (compared to peers) - the measure of a company with pricing power
- Encore Wire has a 5-year average operating margin of 11.0%.
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 Encore Wire that you can find out about here.