While past performance isn’t necessarily a meaningful insight into how a company will perform into the future, it is possible to build a profile of companies that - everything else being equal - have the capacity to continue outperforming based on strong fundamentals, none the least being the quality of their underlying earnings.
What we’re ultimately looking for is stocks with the ability to continue delivering above average returns based on defendable points of difference that come from having a sustainable competitive advantage.
Companies enjoying strong competitive advantage typically either have a structural cost advantage, a capital advantage or attributes that foster pricing power, while the best companies, exhibit a combination of all three.
The more difficult or costly it is for competitors to recreate a stock’s business - aka as barriers to entry - the stronger its competitive advantage is likely to be.
Two key sources of competitive advantage include scale or size, government protection and/or regulatory barriers discouraging other players from entering the market.
A third source of competitive advantage is what’s called customer captivity and relates to the difficulty with which customers can move to another supplier.
These stocks benefit from the ‘network effect’ where the greater the number of people joining, the more valuable and bigger it becomes in scale, which only adds to pricing power.
Stocks that have a truly sustainable competitive advantage are rare, and what ultimately separates them from lesser quality stocks is their ability to continue growing.
In other words, for every $1 invested back into the business, they can continually achieve a $1.10 or more in return.
To unearth stocks trading with varying degrees of sustainable competitive advantage Market Index filters on the following key criteria.
Historical return on equity >10%: Demonstrates a track-record of growth, and rising shareholder value. Only one in every five stocks listed on the ASX has historically managed to deliver an historical ROE in excess of 10%.
Forecast return on equity >15%: Measures the forecast profitability of a company, and while quality companies deliver 10%-plus, typically less than 20% of listed companies ever achieve this.
Forecast earnings per share growth >10%: Measures the percentage change from the most recent historical EPS to forecast EPS, and while stocks should be able to deliver a minimum 5% EPS growth, only one in five stocks historically manage to do so.
Premium to intrinsic value< 40%: This measures the difference between an intrinsic value (IV) and the market price. It’s rare for good quality stocks to trade at a discount to IV.
Net-debt to equity <70%: The represents debt (less cash on balance sheet) as a percentage of total equity in the business. It’s desirable for stocks to keep net-debt to equity low.
Forecast change in value >5%: While it’s desirable that stocks increase their value over a forecast period by at least 5%, only one in five stocks managed to do so.
Cash flow ratio >0.80: Measures the quality of a company’s earnings by comparing earnings to cash flow. Companies with a higher proportion of cash earnings produce a higher cash flow ratio. While quality companies will have a cash flow ratio well above a desired 0.8, typically less than a third (30%) of listed stocks manage to do so.
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