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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 eQ Oyj (HEL:EQV1V) might be one of them.
Given the present disruption to world economies, it is more important than ever to know how 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 eQ Oyj as an example...
eQ Oyj (HEL:EQV1V)'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 eQ Oyj 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 eQ Oyj, the figure is an impressive 48.9%.
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 eQ Oyj, the figure is an eye-catching 32.5%.
High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
- eQ Oyj has a 5-year average ROE of 35.1%.
High Operating Margins (compared to peers) - the measure of a company with pricing power
- eQ Oyj has a 5-year average operating margin of 52.6%.
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 eQ Oyj that you can find out about here.