ISA season means different things to different investors. For some there’ll be a rush to use up any unused tax-free savings allocation in the coming weeks. For others, the new financial year in April brings with it a new tax-free allowance to begin putting to work in the market.
Unlike last year, when market conditions were calm, this ISA season sees us in the throes of some modest market volatility. If anything, recent price falls have heightened a sense of uncertainty about what we’ll see in the market this year.
So for potential share buyers, the question is which strategy could offer greater certainty over the longer-term? One option is to consider the idea of finding companies with strong competitive moats. Companies with durable moat-like features have the potential to compound returns fairly reliably over many years. So how can you find them?
How to find a strong competitive moat
The well-known investor Warren Buffett is renowned for his affection for companies that can produce high returns because of their defendable competitive positions. His commentary on the power of economic moats has spurred huge interest in how and why they are formed.
There are several factors that can create a strong moat. Some of the more obvious ones are low cost and powerful brands, which can help businesses attract and retain large, loyal customer bases. Likewise, strong moats can be formed by companies that own large distribution or manufacturing operations that are very difficult for competitors to replicate.
But it isn’t just scale that creates moats. Switching costs are another major factor, because when it’s too much hassle for customers to leave a product or service, then that can be a strong competitive advantage. The same goes for so-called network effects, which are seen in firms whose products become more valuable as more and more people use them.
In his book, The Little Book that Builds Wealth, Pat Dorsey, a fund manager and former Morningstar analyst, explained the appeal of these features. “The company with the moat is worth more today because it will generate economic profits for a longer stretch of time. When you buy shares of the company with the moat, you’re buying a stream of cashflows that is protected from competition for many years.”
Screening for firms with a competitive advantage
While the features that make a moat are simple to describe, it’s not quite so easy to find stocks that genuinely have them. The good news is that a close look at a company’s accounts can tell you a lot about its competitive strength.
For a start, you’d expect durable businesses to have high levels of free cash flow as a percentage of their sales. You might also expect to see high operating margins and an ability to produce strong, stable returns from invested capital, which can be seen in measures like return on capital employed (ROCE), return on equity and return on assets (ROA).
With this in mind, we took these principles and applied it to a the Alternative Investment Market – where many investors will likely be looking this ISA season.
The rules we used included:
● Companies in the top 20 percent of the market based on their percentage of free cash flow to sales.
● A minimum average 10% return on capital employed and return on equity over five years.
● Companies producing above average operating margins in their respective sectors over five years.
We sorted the list based on Stockopedia’s QualityRank, which takes into account long-term quality factors, balance sheet strength and any potential accounting or insolvency risk red flags – from zero (poor) to 100 (excellent).
Name Mkt Cap £m ROCE % 5y Avg Op Mgn % 5y Avg ROE % 5y Avg FCF/ Sales % Quality Rank Polar Capital 442.5 34.4 30.2 28.1 24.2 99 Craneware 554.8 25.8 27.2 21.3 22.9 99 Quartix 171.2 37.1 31 34.9 25.6 99 Somero Enterprises 203.9 31.7 18.3 29.9 22.2 99 Abcam 2,388 19.7 30.6 17.9 19.4 98 Taptica International 283.9 381.2 13.5 483.5 20.1 98 M Winkworth 14.8 34.5 29.4 29 23.1 97 Bioventix 113.8 47.9 71.1 44.6 53.4 97 Advanced Medical Solutions 708.1 15 23.4 14.1 16.6 96 Plus500 1,253 113.5 55 105.8 48.3 94
Source: Stockopedia Past performance is not a guide to future performance
By definition, smaller companies don’t have the financial firepower and maturity that tends to be associated with large-caps that have significant competitive advantages. But that doesn’t mean that emerging firms can’t carve out niches. This list of stocks includes AIM shares that are well known for their hugely profitable competitive power. They include names like Abcam (ABC), Bioventix (BVXP), Craneware (CRW) and Advanced Medical Solutions (AMS).
For investors looking to the market this ISA season (and those who aren’t), the idea of competitive moats and their investment desirability can be useful. This kind of framework naturally focuses on higher quality more resilient firms. And when it comes to investing in smaller companies, high quality is an important consideration. Of course, competition is always changing – and moats can evaporate over time – but a strategy that looks for firms with a track record of generating strong, sustainable returns could be worth exploring.
Interactive Investor’s Stock Screening series is written by Ben Hobson of Stockopedia.com, the rules-based stockmarket investing website. You can click here to read Richard Beddard’s review of Stockopedia.com and learn more about the site.
Interactive Investor readers can enjoy a completely FREE 14-day trial of Stockopedia by clicking here.
It’s worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.
*No fee for publication is involved between Interactive Investor and Stockopedia for this column.
About the Author
Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including “How to Make Money in Value Stocks” and “The Smart Money Playbook”
ii publishes information and ideas which are of interest to investors. Any recommendation made in this article is based on the views of the writer, which do not take into account your circumstances. This is not a personal recommendation. If you are in any doubt as to the action you should take, please consult an authorised investment adviser. ii do not, under any circumstances, accept liability for losses suffered by readers as a result of their investment decisions.
The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest.
We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.
Please note that our article on this investment should not be considered to be a regular publication.
Details of all recommendations issued by ii during the previous 12-month period can be found here.
ii adheres to a strict code of conduct. Members of ii staff may hold shares in companies included in these portfolios, which could create a conflict of interests. Any member of staff intending to write about any financial instruments in which they have an interest are required to disclose such interest to ii and in the article itself. We will at all times consider whether such interest impairs the objectivity of the recommendation.
In addition, staff involved in the production of investment articles are subject to a personal account dealing restriction, which prevents them from placing a transaction in the specified instrument(s) for a period before and for five working days after such publication. This is to avoid personal interests conflicting with the interests of the recipients of those investment articles.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company’s or index name highlighted in the article.