10 great UK shares that Warren Buffett would pick

Warren Buffett continues to prove that buying and holding high-quality companies is a reliably profitable long-term strategy. Stock screen expert Ben Hobson demonstrates how you can do the same.

Berkshire Hathaway’s annual general meeting has turned into a spectacular and closely watched investment jamboree over the years. This year’s meeting, held earlier this month in Omaha, Nebraska, was no different.

When you mix genuinely exceptional long-term returns and a leader with cult-like status, you’re always going to attract attention. Warren Buffett and his business partner Charlie Munger now preside over several hours of televised Q&A at the yearly Berkshire Hathaway (NYSE:BRK.B) bash - with all eyes, and ears, focused on every word they say.

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This year, Berkshire’s meeting was held in the shadow of a major shift in the market environment. After years of benign conditions, inflation, rising rates and recessionary forces shifted the narrative - but it didn't dull the mood.

While many of Berkshire’s legion of wholly owned businesses - plus many of those it owns stakes in - are expecting to see earnings grow at slower rates this year, it will barely affect Berkshire.

After decades of compounding growth, the group is so flush with investment firepower that economic wobbles are hardly noticeable. This year it reported retained earnings of just over half a trillion dollars. Buffett and Munger oversee investments worth around a trillion dollars.

There was a telling moment when Buffett revealed that Berkshire’s vast pile of Treasury bills had been earning around $40 million dollars a year in the recent (low-rate) years. But with yields on Treasuries soaring recently, that annual income hit a staggering $5 billion in 2022.

Among the other highlights from the meeting, Buffett reiterated his affection for Apple Inc (NASDAQ:AAPL), which is a major holding of his. He described the tech giant as a wonderful business because of the devotion of its customers to their iPhones.

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But when it comes to strategy - and the appeal of companies such as Apple - what is it that a Buffett-like approach really looks for?

At least part of the answer is a focus on companies that can generate high returns because of their defendable competitive positions.

These so-called moats exist in firms that have some kind of special sauce that sets them apart from competitors. It could be well-loved brands that customers stick with, or it could be large and complex distribution or manufacturing operations that are almost impossible for others to recreate.

Some companies become so intertwined in their customers’ lives that it becomes unthinkable for them to leave for a competitor. Sometimes there isn’t a competitor.

Others have special intellectual property, regulatory approvals or other unusual advantages that give them monopoly-like control in their markets.

How to measure a moat

In many cases, the drivers of competitive strengths are difficult to quantify. But what is undeniable is that the clues to high-quality businesses often lie in their financials.

They have a habit of being consistently profitable. Their margins, cash generation and returns on invested capital are also often well above average over time.

Some argue that these exceptional companies attract competition and that unusually high profitability will almost always be eaten away over time. The job of the investor is to find them early and be willing to buy when the market periodically marks them down in price.

In this example screen, I have looked for strong consistent performance (greater than 15%) across a series of quality profit measures, including free cash flow margin, return on capital employed, operating margin and return on assets. Here is what those measures look for:

• A consistently strong free cash flow margin can be a pointer to firms that are good at turning revenues into free cash flow
• A consistently strong return on capital employed (ROCE) can indicate that the company is efficient at deploying capital to produce a profit
• A consistently strong operating margin (compared to others in the same sector) can be a signal that the company has pricing power and generates strong profits from sales after costs
• A consistently strong return on assets can show that a firm is efficient at squeezing a profit from the assets at its disposal

With these measures in mind, here are some of the companies in the FTSE All-Share that appear to show the signs of strong quality in their finances:

Data: SharePad.

One of the interesting features of screening for firms with moat-like competitive advantages is that the results remain stable over multiple years. Often, the forecast price/earnings valuations for these kinds of shares tend to be high - because they are in demand. But that isn’t always the case, and the forward P/Es in this list cover a surprisingly broad range - from 7.8x to 25.1x.

Rightmove (LSE:RMV), the online property sales and lettings portal, has consistently been a very profitable business despite emerging competitors. It’s a high return business with a well-recognised brand. Somewhat similar stocks include Auto Trader (LSE:AUTO), which specialises in online auto sales, and Moneysupermarket.com (LSE:MONY), a leader on online price comparison tools.

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In a slightly different way, Games Workshop (LSE:GAW) is another classic moat-like profit machine, given its strong creation and distribution network, unique games and committed customers. A strong network and customer familiarity are also hallmarks at PayPoint (LSE:PAY), the consumer payment services business.

Among the others, house construction is not really what you might consider a moat-like industry. But Persimmon (LSE:PSN) is the largest in the sector, which gives it cost advantages and brand familiarity. It shows that moat-like traits can be found in surprising places.

A Buffett-like focus on quality

With the annual Berkshire bash over for another year, the message as always from the Sage of Omaha is to focus on quality and not make major mistakes. With speculative growth shares falling out of favour over the past 18 months, quality has come back into focus.

With sticky inflation and recessionary forces creating headwinds for companies, a focus on higher profitability - especially if you can buy it at reasonable prices - makes intuitive sense.

While moats will always captivate those investors looking for impregnable business models, the bigger picture is that finding companies that are great at churning out profits and protecting themselves from trouble is a sound, long-term approach.

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.