Does A2 Milk (ASX:A2M) have an economic moat?

Most investors would agree that it pays to buy and hold the best quality companies possible. I'm talking about some of the market's most respected names... that ones we'd all like to hold for the long-term. 

What makes these elite stocks so appealing is their ability to resist competitive threats and generate breathtaking profits. They compound investment returns at consistently above-average rates for long periods.

These stocks are different because the've got what billionaire investor Warren Buffett, calls economic moats. Like medieval castles, their profits are fortified by impregnable business models.

In this article I'm going to tell you what makes these stocks so special - and I'm going to use A2 Milk (ASX:A2M) as an example. A2 Milk is an adventurous, large cap in the Food Processing industry.  

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 approvals
• 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

Has A2 Milk (ASX:A2M) got a moat?

When it comes to searching for companies with moats, some of the biggest clues actually lie in their financial statements. By looking 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 A2 Milk stacks up against them:

1. 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 A2 Milk, the figure is an impressive 20.2%.   
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 A2 Milk, the figure is an eye-catching 30.7%.
3. High Return on Equity (compared to peers) - the measure of a company making good profits from its assets.
   - A2 Milk has a 5-year average ROE of 25.1%.
4. High Operating Margins (compared to peers) - the measure of a company with pricing power
   - A2 Milk has a 5-year average operating margin of 14.7%.  

If you want to find more Australian companies with these kinds of attractive moat-like traits, you can try out this pre-set screen.

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 A2 Milk that you can find out about here.