A buoyant stock market and optimistic economic outlook could lead to complacency among investors. Indeed, the FTSE 100’s 46% rally from the depths of the March 2020 crash and the UK’s projected 5% growth rate for the current year may lead some investors to assume that almost any stock can deliver high returns.
While this may be the case if current market and economic conditions continue indefinitely, history suggests this will not be the case. Therefore, taking a very selective approach when deciding which companies to buy may become increasingly important as stock market performance and economic growth begin to return to their long-term averages.
According to Questor, a good starting point for evaluating a company is to determine the extent of its competitive advantage. Not only does a business with a clear and sustainable competitive advantage offer less risk in difficult operating conditions, but it can also generate higher returns when business conditions are favorable.
From a qualitative point of view, which essentially involves the use of non-digital information, a firm’s competitive advantage can be inferred by considering factors such as cost advantages, economies of scale, change costs and intangible assets.
For example, our recent buying advice, Diageo, has a significant competitive advantage over its peers. Its large stable of alcoholic beverages enjoys strong customer loyalty. Not only are its brands well known, but in many cases consumers associate them with superior quality or familiarity, which means they can command a higher price than their rivals.
It could also be argued that Diageo’s size offers cost advantages that add to its competitive advantage. Smaller competitors may have lower profit margins if they match Diageo’s prices. Obviously, assessing the extent of a company’s competitive advantage is highly subjective. Therefore, using a quantitative approach, which mainly focuses on numerical information, alongside the aforementioned qualitative approach can be helpful.
According to Questor, a company’s return on equity (ROE) offers insight into the extent of its competitive advantage, especially when assessed over a period of years. ROE basically shows how efficient a company is in generating profits from its net assets. It is calculated by dividing the net profit by the average net assets over the same period to give a percentage.
For example, going back to the previous example of Diageo, its net profit for the financial year 2021 was £2.8 billion. Net assets were not materially changed during the period from a figure of £8.4 billion recorded at the start of the year. This means that the company’s ROE was around 33%.
Calculating the ROE over a few years can help smooth out exceptional events and limit the impact of extreme trading conditions. Comparing the average ROE over a long period with industry peers can provide an indication of a company’s competitive advantage. A business that is consistently able to generate higher profits from its net assets than its competitors can be a relatively attractive proposition.
A caveat when evaluating ROE is that companies with higher leverage may appear more attractive. Larger debts reduce net assets. Therefore, it is important to consider debt levels (which this column will discuss at a later date) when assessing the attractiveness of a specific business.
Ultimately, even a combination of qualitative and quantitative methods can only provide an estimate of a company’s competitive advantage. However, according to Questor, its consideration should be a key part of an investor’s decision-making process when determining which companies offer the best chance of profitability and long-term growth.
Additionally, changing economic and investment conditions may require a closer look at a company’s market position relative to the recent past. Investors who are willing to do the legwork in this regard can not only unearth the best companies, but also avoid stocks that benefit from favorable circumstances that won’t last forever.
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