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Given the months of widespread disruption and uncertainty in the economy, it is more important than ever to know how to find high quality stocks for your portfolio. That means safe, profitable companies with strong balance sheets.
We all like the idea of investing in the best quality companies. These multi-bagger stocks resist competitive threats and generate breathtaking profits, especially when the competition collapses. They compound investment returns at consistently above-average rates over the long term because they've got what billionaire investor Warren Buffett calls economic moats.
Here's a quick guide to what makes these stocks stand out - using Nvidia (NSQ:NVDA) as an example...
How can you tell whether a company has a moat?
Before we get started on why this 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 approval
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
So, has Nvidia (NSQ:NVDA) got a moat?
When it comes to finding 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 Nvidia 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 Nvidia, the figure is an impressive 30.2%.
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 Nvidia, the figure is an eye-catching 25.1%.
High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
- Nvidia has a 5-year average ROE of 37.9%.
High Operating Margins (compared to peers) - the measure of a company with pricing power
- Nvidia has a 5-year average operating margin of 31.2%.
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 Nvidia that you can find out about here.