Given widespread uncertainty in the stock market for the rest of 2020, it is more important than ever to identify high quality stocks for your portfolio. 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. I'm talking about some of the most respected names... 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.
In this article I'm going to tell you what makes these stocks so special - and I'm going to use Auto Trader (LON:AUTO) as an example. Auto Trader is a balanced, large cap in the Internet Services industry. If you've ever bought or sold a second-hand car, this company needs no introduction.
How can you tell whether a company has a moat?
Moats are desirable because they often guarantee a sustainable competitive advantage. But there are several ways that companies can get them. For example, they might have:
- 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 Auto Trader (LON:AUTO) 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 Auto Trader 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 Auto Trader, the figure is an impressive 52.1%.
- 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 Auto Trader, the figure is an eye-catching 52.8%.
- High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
- Auto Trader has a 5-year average ROE of 122.4%.
- High Operating Margins (compared to peers) - the measure of a company with pricing power
- Auto Trader has a 5-year average operating margin of 60.8%.
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 Auto Trader has some of the financial traits of an economic moat.
To find out more you might want to take a look at the LON:AUTO 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 Auto Trader, 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?