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The best calibre of companies resist competitive threats year-in, year-out, while their competitors fail. This cycle of consistent outperformance and reinvestment can lead to incredible compounding returns – especially in times of worldwide economic uncertainty.
What makes these companies different is that they've got what billionaire investor Warren Buffett, calls economic moats.
Defensive moats let companies generate outsize profits over long periods. They can be an investment goldmine. And while these stocks can be hard to find, there are signs that Digital Arts (TYO:2326) might be one of them.
Before we get started on why this looks like a high quality business, here are some of the main ways that a company can build a strong moat around itself:
Great Scale - Comprised of large infrastructure and distribution networks
Intangible Assets - Such as brands, patents or regulatory approvals
Network Effects - When customers become part of a product
Cost Advantages - Gained through superior processes and unique locations and assets
Switching Costs - It might be too costly or complicated for customers to leave
Digital Arts (TYO:2326)'s economic 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 Digital Arts 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 Digital Arts, the figure is an impressive 57.4%.
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 Digital Arts, the figure is an eye-catching 30.6%.
High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
- Digital Arts has a 5-year average ROE of 23.6%.
High Operating Margins (compared to peers) - the measure of a company with pricing power
- Digital Arts has a 5-year average operating margin of 42.3%.
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 Digital Arts that you can find out about here.