Top analysts and investors such as Warren Buffett and Michael Mauboussin say capital allocation - the deployment of company time, money, ideas, and people - is the key to building moat-like quality and profitability characteristics. This is important as moat characteristics are perhaps the most fundamental driver of future share price performance.
In other words, if you find a company that consistently allocates its capital profitably, chances are you are onto a long-term winner – and Netflix Inc might be one such company.
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Screening for upwardly mobile, high quality companies
If, as an investor, you’re only looking at sales and earnings growth there is a vital question not being asked: how is this growth being funded?
That’s where ratios like return on equity (ROE) come in. ROE measures how efficiently a company uses Shareholders’ Equity to generate profits. It is calculated by dividing net income by book value of equity.
It’s no coincidence that Buffett is a fan of the measure - companies with high ROEs tend to exhibit the high-quality, moat-like business traits that he is so fond of gaining exposure to.
To find high ROE stocks whose fantastic business models are being rewarded by the market, you can create a stock screen that selects only stocks with both positive one-year relative strength and upgraded current year broker forecasts. The former ensures these shares have been outperforming the market and the latter suggests outperformance can continue.
One of the stocks that currently qualifies for this simple screen is Netflix Inc. The group has:
- A trailing twelve month return on equity of 29.8%
- An average current year EPS forecast upgrade of 9.97% from brokers, and
- A one-year relative strength of 15.6%
Stocks exhibiting these traits are typically a solid mix of quality and momentum. We can see this with Netflix Inc, which has a Quality Rank of 83 and a Momentum Rank of 99.
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 Netflix that you can find out about here.