10 of the most profitable companies in the FTSE 350

Stock selection is being put to the test in tricky market conditions, so Stockopedia's Ben Hobson identifies 10 of the best large, durable businesses with strong and consistent profitability.

The FTSE 350 index of the UK's largest quoted shares is currently down by around 7% since the start of October. Market pressure over the past two months has seen share prices tumble across the board - and that’s rattled investors.

These kinds of periodic price swings are inevitable in equity investing. They're an uncomfortable reminder that after a long bull run, prices can go down too. It's at these moments that investment strategies and stock selection are really put to the test. As Warren Buffett once said:

"Only when the tide goes out do you discover who's been swimming naked."

In this column we regularly explore the kinds of data and strategies that point to the stockmarket's strongest shares. Robust and improving profitability driven by business models that are resistant to competitive threats are highly sought after by investors. These "moat-like" characteristics echo the kind of strategy employed by Buffett himself. While it's true that these stocks can also be hit by market volatility, the difference is that they're potentially better at resisting pressure and bouncing back quicker.

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The "moat" is a metaphor often used as a measure of durable competitive advantage. The idea is that a select few companies not only churn out persistently strong returns, but they have extra advantages that make it difficult for rivals to copy them. As a result, their investors can benefit from superior returns that are compounded over the long term.

Moats can be created in several ways. They can reflect the sheer scale of a business, or those with large distribution infrastructure that would be difficult and expensive to replicate. Others have products and services with 'networking effects', which encourage customers to feel part of an exclusive club. Or they may have brands that customers closely identify with. 

Screening for durable companies

By definition, there's a lot of qualitative assessment in figuring out whether a firm has a moat or not. It's not quite so easy to see one just through the lens of a set of accounts. But there are aspects of company moats that can materialise in the numbers. 

For a start, you'd expect durable businesses to have high levels of free cash flow as a percentage of their sales. You might also expect to see high operating margins and an ability to produce strong, stable returns from invested capital, which can be seen in measures like return on capital employed (ROCE), and return on equity (ROE).

With this in mind, this week we've screened the FTSE 350 using some of the key hallmarks of strong and consistent profitability. The rules include:

• Companies in the top 20% of the market based on their percentage of free cash flow to sales.
• A minimum average 10% return on capital employed and return on equity over five years.
• Companies producing above average operating margins in their respective sectors over five years.

Source: Stockopedia          Past performance is not a guide to future performance

The companies that regularly pass these rules really don't change very much over time. That's really what you'd hope or expect in a search for stocks with consistently strong profitability. 

This snapshot includes well-known names like Rightmove, Moneysupermarket, Persimmon and Burberry. 

Since Warren Buffett first made mention of company moats, the power of sustainable profitability and competitive advantage has captured the imagination of investors. 

In the UK, even with simple rules, this approach tends to highlight some of most admired companies in the market. These stocks are rarely cheap to buy, but when markets are in turmoil and prices come under pressure, they may offer a more resilient option for investors.

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