Ten shares with competitive moats for ISA season

This year's ISA allowance deadline is looming, but investors looking for strong, stable returns face some difficult decisions. Market volatility in 2016 has shaken confidence in equities. Yet ultra-low interest rates mean that the alternative options for money are hardly inspiring.

In the search for returns, one solution could be to focus on the long-term compound gains that can be had from the stockmarket's most durable companies.

Dive into a wide economic moat

One of the leading authorities on buying and holding great quality companies for the long-term is billionaire investor Warren Buffett. His annual letters to shareholders of Berkshire Hathaway are often peppered with references to what he calls "moats".

For example, take his description of Berkshire's fully-owned auto insurance giant, Geico. In recent years he has regularly noted: "The company's low costs create a moat - an enduring one - that competitors are unable to cross."

The moat is a metaphor for the type characteristic that Buffett finds highly desirable in a business. It's now a widely-used investment term that describes firms with a durable competitive advantage. The idea is that great companies not only generate strong returns on capital, but they have ways of protecting those returns over the long-term.

In the case of Geico, the moat is the sheer scale of the business that allows it to dominate the market by operating at low cost. But moats aren't always about size, scale and cost. They can be market leading brands, or products that make it difficult for consumers to walk away, or there may be "networking effects" that instill sticky customer loyalty.

In his book, The Little Book that Builds Wealth, Pat Dorsey, a fund manager and former Morningstar analyst, put it like this:

Durable companies - that is, companies that have strong competitive advantages - are more valuable than companies that are at risk of going from hero to zero in a matter of months because they never had much of an advantage over their competition.

This is the biggest reason that economic moats should matter to you as an investor: Companies with moats are more valuable than companies without moats.

Screening for durable companies

When it comes to finding an economic moat, there are various clues to look for. In terms of company financials, durable businesses often have high operating margins and high levels of free cash flow. They're able 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 some of these ideas in mind, Stockopedia screened the FTSE 350 index for Interactive Investor. The rules included:

●     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

●     Companies in the top 20% of the market based on their percentage of free cash flow to sales

The table includes the current price-to-earnings (PE) ratio, the forecast dividend yield and the relative strength of each share against the market over the past three months. 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).

Unsurprisingly, these rules produce a list of some of the strongest and best known companies in the FTSE 350. Interestingly, some of them have seen their share prices underperform the market this year, with notable dips at Paypoint, Aveva and Next.

On most of the quality ratios, property sales website Rightmove wins out. Given that its business isn't capital intensive, Rightmove commands high margins and produces blistering returns. But on a forecast PE basis, Rightmove is also the most expensive share here at 29 times earnings.

Among the other big names are the newly merged betting group Paddy Power Betfair, health and hygiene brands giant Reckitt Benckiser, pizza chain Domino's and chipmaker ARM. All have a track record of exceptional profitability as a result of strong competitive advantages.

Jupiter Fund Management has the highest one-year forecast yield at 5.8%.

Hunting down quality

With ISA season upon us, investors looking for a long-term home for their capital may feel deterred by recent market swings. However, falling prices at some of the market's most profitable and durable companies could be an opportunity, although detailed research is always essential.

It's worth noting that an entire industry has been born on the idea of finding businesses with moat-like competitive advantages. While they can sometimes turn out to be an illusion, hunting down companies with a track record for generating strong, sustainable returns is a sound starting point - it worked for Buffett, after all.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson ofStockopedia.com, the rules-based stockmarket investing website. You canclick here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

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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.

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"

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.