There's an exclusive group of companies in the stock market that stand out because they've got what billionaire investor Warren Buffett calls economic moats. Like medieval castles, their profits are fortified by impregnable business models... and there are signs that Alfa Financial Software Holdings (LON:ALFA) might be one of them.
Given the present disruption and volatility in the stock market, it is more important than ever to identify high-quality stocks for your portfolio - and finding companies with moats is one way to do it.
Moats come in different forms, but they mostly consist of:
Intangible Assets - Such as brands that customers love, valuable patents or regulatory approvals
High 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
Here's a quick guide to finding the clues to economic moats - using Alfa Financial Software Holdings (LON:ALFA) as an example...
Alfa Financial Software Holdings (LON:ALFA)'s impressive metrics
Some of the biggest indicators of a moat involve persistent strong margins and high levels of cash generation – cash being especially important given the recent shocks to the worldwide economy. Here are a few ways of gauging these characteristics - and how Alfa Financial Software Holdings compares:
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 Alfa Financial Software Holdings, the figure is an impressive 24.1%.
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 Alfa Financial Software Holdings, the figure is an eye-catching 32.4%.
High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
- Alfa Financial Software Holdings has a 5-year average ROE of 26.1%.
High Operating Margins (compared to peers) - the measure of a company with pricing power
- Alfa Financial Software Holdings has a 5-year average operating margin of 31.2%.
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 Alfa Financial Software Holdings has some of the financial traits of an economic moat.
To find out more you might want to take a look at the LON:ALFA 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 Alfa Financial Software Holdings, 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?