There's an exclusive group of companies in the stock market that stand out because they've got what billionaire investorWarren Buffett callseconomic moats. Like medieval castles, their profits are fortified by impregnable business models... and there are signs that Fortescue Metals (ASX:FMG) might be one of them.
Given the present disruption andvolatilityin the stock market, it is more important than ever to identifyhigh-quality stocksfor 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 Fortescue Metals (ASX:FMG) as an example...
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Fortescue Metals (ASX:FMG)'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 howFortescue Metalscompares:
- 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. ForFortescue Metals, the figure is an impressive 34.9%. - High Return on Capital Employed- the measure of a company growing efficiently and profitably.
- A5-year average ROCEof more than 12 percent is a pointer to strong efficiency. For Fortescue Metals, the figure is an eye-catching 20.5%. - High Return on Equity(compared to peers) - the measure of a company making good profits from its assets.
- Fortescue Metals has a5-year average ROEof 23.1%. - High Operating Margins(compared to peers) - the measure of a company with pricing power
- Fortescue Metals has a5-year average operating marginof 38.6%.
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 withFortescue Metalsthat you can find out abouthere.
Alternatively, if you'd like to find more shares that have some of the characteristics of promising economic moats, you should take a look at
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