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Is Diageo (LON:DGE) the ultimate FTSE 100 stock for your ISA?

18th Mar '19 by Jack Brumby

The ISA deadline is rapidly approaching - if you’ve not yet fully taken advantage of your allowance for this tax year, you need to act fast. With that in mind, today I've been looking for the highest quality stocks in the FTSE 100 for my Stocks and Shares ISA.

What makes these elite stocks so appealing is their ability to compound investment returns at consistently above-average rates over the long term, thanks to what billionaire investor Warren Buffett calls economic moats.

One such company, according to my screens, is spirits and beers giant Diageo (LON:DGE). Here's why.  


Has Diageo (LON:DGE) got a moat?

Some of the biggest indicators of an economic moat actually lie in a company's 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:

  1. High rates of Free Cash Flow - the measure of a thriving company.
    - For Diageo, the figure is an impressive 22.3%.   
  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 Diageo, the figure is an eye-catching 15.3%.
  3. 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 29.8%.
  4. High Operating Margins (compared to peers) - the measure of a company with pricing power
    - Diageo has a 5-year average operating margin of 29.1%.  

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

For Diageo, we could be looking at a combination of scale, cost advantages, and intangible assets.

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.

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 this Economic Moats screen.

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