Finding companies that can beat the market over long periods isn’t easy. But if you want to build the six-figure fund needed to double your State Pension, I believe that focusing on long-term winners is one of the best ways to invest.
One technique favoured by many successful investors is to look for companies with high profit margins and a clear competitive advantage. Known as quality stocks, these companies can often grow sustainably for many years.
In my view, FTSE 100 car marketing group Auto Trader Group (LSE: AUTO) is a good example of a quality business. More than 80% of the UK’s automotive retailers advertise on autotrader.co.uk, which receives about 55m visits per month.
Over the 12 months to 30 September, the group generated an operating profit of £232m on sales of £341.9m. That gives an operating profit margin of 67.8%, which is exceptionally high.
This is special
High profit margins are great, but they don’t tell the whole story of a firm’s profitability. To understand this, we also need to consider how much capital investment is needed to generate these profits.
Auto Trader doesn’t need expensive factories, warehouses or transport infrastructure. It just needs some offices and a fairly small number of staff. Capital investment in the business is low.
The combination of high profit margins and low capital intensity results in a very high return on capital employed (ROCE).
My sums show that Auto Trader generated a ROCE of 65% over the 12 months to 30 September. That means for each £1,000 of capital employed in the business, it generated an operating profit of £650. That’s extremely high.
Auto Trader’s high returns mean that it generates a lot of surplus cash. Some of this is returned to shareholders as dividends, but an increasing amount is being used to buy back and cancel the firm’s own shares.
The advantage of this approach is that it boosts future earnings growth and reduces the number of shares on which dividends must be paid. This supports more rapid dividend growth.
Auto Trader shares may not seem cheap, with a forecast P/E of 20 for 2019/20 and a dividend yield of 1.7%. However, earnings per share have risen by almost 50% since the group floated in 2015, and the dividend is growing at more than 10% per year.
I think further gains are likely and rate the shares as a long-term buy.
I’m avoiding this growth stock
In contrast to Auto Trader, online electrical retailer AO World (LSE: AO) faces brutal competition from larger rivals.
Trading figures released today suggest growth may be slowing. Group sales rose by 8.2% during the final quarter of 2018. That’s less than half the 16.6% sales growth reported for the same period in 2017.
That’s a potential concern, as I think one of AO’s most serious problems is that it’s not really big enough. The group’s sales are less than 10% of those made by market leader Dixons Carphone.
What happens next?
In fairness, AO’s UK business is profitable. However, these slim profits are being spent on a loss-making effort to expand into Europe. In my view, the company should scrap its European ambitions and focus all its efforts on the UK.
Doing this could give shareholders a chance to earn reasonable returns. However, another year of losses is forecast for 2018/19. I think this stock is seriously overvalued and best avoided.
Roland Head owns shares of Dixons Carphone. The Motley Fool UK has recommended Auto Trader. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.