We all like the idea of finding the best quality companies possible. These multi-bagger stocks resist competitive threats and generate breathtaking profits. 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.
In this article, I'm going to tell you what makes these stocks stand out - take Diageo (LON:DGED), for example. Diageo is a adventurous, large cap in the Distillers & Wineries industry.
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How can you tell whether a company has a moat?
Moats are desirable because they often guarantee a sustainable competitive advantage. But there are several ways that companies can get them. For example, they might have:
- 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 Diageo (LON:DGED) 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 Diageo stacks up against them:
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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 Diageo, the figure is an impressive 20.0%. -
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 Diageo, the figure is an eye-catching 15.6%. -
High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
- Diageo has a 5-year average ROE of 30.0%. -
High Operating Margins (compared to peers) - the measure of a company with pricing power
- Diageo has a 5-year average operating margin of 30.0%.
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 Diageo that you can find out about here.