Four signs of a competitive fluke at Automatic Data Processing (NSQ:ADP)
Since widespread uncertainty in the economy and stock market is likely to last for many months, it pays to know that you are investing in high quality stocks, rather than speculative stocks. This means safe and profitable businesses with strong balance sheets.
Most investors would agree that the best quality companies in the stock market often also make the best investments. They are the ones who seem to be able to consistently make mind-boggling profits over the long term.
What makes these stocks so attractive is their ability to withstand competitive threats and generate jaw-dropping profits. They accumulate investment returns at rates that are consistently above average over the long term.
These stocks are different because they have what billionaire investor Warren Buffett calls economic moat. Like medieval castles, their profits are bolstered by impregnable business models.
Here’s a look at what makes these actions so special – using Automatic data processing (NSQ: ADP) for example…
Before starting why Automatic data processing looks like high-quality stock, here are some of the main ways a company can build a strong moat around itself:
- Intangible assets – Like brands customers love, valuable patents or regulatory approvals
- Change costs – It may be too expensive, complicated or unnecessary for customers to look elsewhere
- Network effects – When customers are part of a product, it creates extremely powerful businesses
- Cost advantages – Superior processes and unique locations and assets make it tough for others to compete
- Large scale – Large infrastructure and distribution networks are powerful barriers to entry in many sectors
Does Automatic Data Processing (NSQ:ADP) have a gap?
When it comes to researching companies with moats, some of the biggest clues are actually found in their financial statements. By examining a small number of important ratios, you can get an idea of a company’s competitive strength and profit capacity.
Here’s what they are and why they’re important – and how automatic data processing compares to them:
- High free cash flow rates – the measure of a successful business.
– A high ratio of free cash flow to turnover can be a very positive sign. For automatic data processing, the figure is an impressive 14.3%.
- High return on capital employed – the measure of an efficient and profitable growing business.
– An average ROCE over 5 years of more than 12% is an indicator of strong efficiency. For automatic data processing, the figure is 32.6%.
- High return on equity (compared to its peers) – the measure of a company making good profits on its assets.
– Automatic Data Processing has an average ROE over 5 years of 44.9%.
- High operating margins (compared to its peers) – the measure of a company with pricing power
– IT has an average operating margin over 5 years of 20.9%.
What does this mean for potential investors?
Some of the highest quality stocks on the market have defensible models that can deliver high levels of shareholder return over the long term. But there are no guarantees and it is important to do your own research. Indeed, we have identified some areas of concern regarding automatic data processing which you can read about here.
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