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If you were to look at a list of shares with the very strongest price performance over the past year you'd see a clear trend. Twenty of the top 30 shares with the highest price strength are natural resources companies, and most of them are mining shares.
That pattern reflects a major change in the attitude of investors. After several years in the doldrums, natural resources companies are bouncing back right across the market. From blue chips to small-caps, a rising tide of sentiment has floated the whole sector.
For momentum traders, this kind of cyclical upswing can be profitable while it lasts. But for investors looking for a long-term home for their funds this ISA season, there could be a better approach. Instead of chasing the latest trends, it could be more productive to focus on the long-term compound gains that can be had from the stockmarket's most durable companies.
Buying shares in great quality stocks is hardly a new idea. Warren Buffett, the billionaire US investor, routinely refers to the appeal of companies that have 'economic moats'. It's a term that describes firms with a durable competitive advantage. Not only do these sorts of companies generate strong returns on capital, but they have ways of protecting those returns over the long term.
Unsurprisingly, given the huge compound gains that Buffett has made from top quality companies, it's an approach adopted by many others. Popular fund managers like Nick Train and Terry Smith are obvious examples.
Moats can take a variety of forms. In some cases they can be formed through the sheer scale of a business that allows it to dominate the market by operating at low cost. Others manage it by controlling market-leading brands, or products that make it difficult or pointless for consumers to look anywhere else.
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."
Analysts spend a lot of time agonising over moats. Often they are imperfect or uncertain, but there are 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 also 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 this ISA season, we went looking for moat-like characteristics in companies across the FTSE 350. 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 forecast 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).
|Name||Forecast PE Ratio||Forecast Yield %||FCF/ Sales %||ROCE %||3 Months Relative Strength||Quality Rank|
|Jupiter Fund Management||12.9||6.5||35.7||27.7||-7.26||97|
Unsurprisingly, these rules produce a list of some of the strongest and best-known companies in the FTSE 350. Leading the list is consumer payments business Paypoint, followed by business software group, AVEVA. On most of the quality measures, property sales website Rightmove is a consistently the strongest, although it's also one of the most expensive based on its forecast PE ratio of 24.8.
Housebuilders Taylor Wimpey and Persimmon also pass these rules, with other big names including Fresnillo, Moneysupermarket, Jupiter Fund Management and Reckitt Benckiser.
This ISA season it would be easy to get distracted by some of the trends in the market that are driving equity prices. The recovery of the mining sector is undoubtedly good news, but its cyclical nature is proof that sensitive, less durable companies can hurt investment returns.
Sometimes the signs of a moat can turn out to be an illusion, so careful research is essential. But hunting down companies with a track record for generating strong, sustainable returns is a sound starting point - and the hallmark of some of the market's most successful investors.
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.
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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.
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"
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