While some investors have a knack for buying struggling businesses that look set to go bust but ultimately manage to turn around their fortunes, this is arguably a particularly difficult strategy to succeed at. While far from easy, a safer strategy can be to focus on identifying high quality businesses and then waiting for an attractive time to purchase them – this final step is often where investors get into trouble.
There are a number of both qualitative and quantitative measures that can be used for identifying high quality (and indeed low quality) businesses. Some of the quantitative ratios which can be helpful include: above average return on equity (ROE) and profit margins, and below average debt metrics.
Here are five companies that stand out for their ability to generate exceptionally high rates of return on equity, and which also enjoy high profit margins, and strong balance sheets, in some cases net cash positions.
1) Altium Limited (ASX: ALU) had a ROE of 77.5% according to Morningstar Research for financial year 2013.
2) Carsales.com Limited (ASX: CRZ) had a ROE of 55% according to Morningstar Research for financial year 2013.
3) JB Hi-Fi Limited (ASX: JBH) had a ROE of 48% according to Morningstar Research for financial year 2013.
4) Magellan Financial Group Limited (ASX: MFG) had a ROE of 43.5% according to Morningstar Research for financial year 2013.
5) CSL Limited (ASX: CSL) had a ROE of 40.5% according to Morningstar Research for financial year 2013.
As mentioned above, identifying high quality businesses is only part of the exercise for investors looking for potential companies to buy. The other vital and important ingredient in the mix is to accurately assess the intrinsic value of a business and then have the patience to only purchase the stock when the odds are in your favour.
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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.