Investors looking for worthwhile companies to add to their portfolios should consider a few factors that make up a ‘high-quality’ stock. The company’s product or service and the relative moat around them are among these factors. Moat is a word today’s newer retail investors throw around, so here’s a better definition.
A relatively recession-proof product or service with predictable demand—that is ideally growing—is needed. These products or services can be found in companies like Colgate-Palmolive (NYSE: CL) or H&R Block Inc. (NYSE: HRB), as they are needed regardless of what the underlying economy is doing. As these are one extreme of stability and predictability, their stock price becomes boring.
Not swinging into the ‘unpredictable’ or ‘unstable’ side of the spectrum, investors can find the middle in stocks like Copart Inc. (NASDAQ: CPRT), Ulta Beauty Inc. (NASDAQ: ULTA), and even Altria Group Inc. (NYSE: MO) and the products or services they offer. More than that, a few other business requirements need to be met, including:
Three Must-Haves for Every Value Investor
Once an investor can identify a product or service that is predictable and stable in demand through the economic cycle but not too stable or predictable to wash away the investment's wealth-compounding effects, further financial ratios can be analyzed.
Focusing on profitability and bringing home the bacon (returns) for investors, these are some of the few that Warren Buffett fans boast about in their books and Twitter (now X) accounts:
- Gross Margins: Businesses with gross margins above 20% typically achieve this by having an attractive positioning in their respective market or niche, which translates into pricing power and audience penetration.
- Return on Invested Capital (ROIC): This tells investors what each dollar invested into the business is expected to return to them; of course, the higher, the better, as ROIC can determine a wealth-building investment from the start.
- Reasonable debt: Counting with these two first requirements would amount to nothing if the business carries a heavier-than-ideal debt burden, so a relatively low percentage of debt (as a total of the balance sheet).
Now that investors have a post-it note-sized guide, it is easier to stay on track when looking over the stocks on this list.
Ulta’s Dip Comes First and Foremost
After coming down to only 66% of its 52-week high price, shares of Ulta Beauty could become attractive for those investors looking to buy a one-quality business at a discount today.
Make-up and other skincare products are typically part of this ‘moat’ category, as their user base will probably keep making a budget for them regardless of whether the economy is booming or busting.
Investors can quantify this relationship in the company’s financials, which show a gross margin rate of up to 43%. Keeping more dollars each time a sale is made enables management to reinvest this capital at high rates of return, where Ulta’s steady 25% average ROIC comes in to steal the spotlight.
Last but not least, Ulta’s balance sheet shows that only 45% of total capital comprises debt. Because leases on the property are considered debts, Ulta’s physical locations (and their leases) represent most of this debt balance, with nothing to worry about.
And analysts really aren’t worried, as the stock holds a consensus price target of $535.5 a share, daring it to rally by as much as 40.2% from where it trades today.
Copart Stock is Good Enough for Smart Money
Which isn’t that smart if retail investors follow this simple formula. Up to $14.9 billion in institutional buying was reported for Copart over the past 12 months; if it’s good enough for them, it’s good enough for anyone, and here’s why.
A 47.3% gross margin is characteristic of many technology companies. However, this is more of an automotive stock with a technology layer added on top, like Carvana Co. (NYSE: CVNA), but better.
Better how? Carvana has barely any profits, so its ROIC for the past 12 months (the only positive one) was only 1.8%. Compared to Copart’s average of 15.5% over the past 5 years, this is one quality stock to follow.
The best part is that the company has barely any debt, as its balance sheet shows only 1.5% of total capital being debt. No wonder the stock recently traded up to 94% of its 52-week high.
Altria’s Returns Show Saints Don’t Live on Wall Street
Shares of Altria are trading at a new 52-week high, though today’s price remains only a fraction of the stock’s all-time high of $77.8 in 2017, giving investors a bit more bullish breathing room.
Investors can check these features off the list when examining the company's financials, starting with gross margins. As of the past 12 months, Altria's margins stood at 69.5%, proving the brand's pricing power and market penetration through tobacco and other non-cyclical products.
Keeping more capital rotating within the business allows management to recently deliver an ROIC rate of 36.2%, with a five-year average of 32%, making Altria stock a potential wealth compound candidate.
Following this thread, analysts at Jefferies Financial saw fit to set a price target of $56 a share for Altria. The stock would need to rally by 20.9% from its current level to prove these predictions correct.
