A buoyant stock market and an upbeat economic outlook could cause complacency among investors. Indeed, the FTSE 100’s 46pc recovery since the depths of the March 2020 crash and the UK’s 5pc forecast growth rate for the current year may lead some investors to assume that almost any stock can deliver high returns.

While that may be the case if present-day stock market and economic conditions continue indefinitely, history suggests that they will not. As a result, taking a highly selective approach when deciding which companies to purchase may become increasingly important as the stock market’s performance and the economy’s progress begin to revert to their long-term averages.

In Questor’s view, a sound starting point when assessing any company is determining the extent of its competitive advantage. Not only does a firm with a clear and sustainable competitive advantage offer less risk in challenging operating conditions, it can also generate higher returns when trading conditions are upbeat.

From a qualitative perspective, which essentially means using non-numerical information, a company’s competitive advantage can be deduced by considering factors such as cost advantages, economies of scale, switching costs and intangible assets.

For example, our recent ‘buy’ tip, Diageo, has a significant competitive advantage over its peers. Its broad stable of alcoholic beverages benefits from a large amount of customer loyalty. Not only are its brands well-known, in many cases consumers associate them with superior quality or familiarity that means they can command a higher price point versus rivals. 

It could also be argued that Diageo’s scale provides cost advantages that add to its competitive advantage. Smaller competitors may have lower profit margins if they match Diageo’s prices. Clearly, assessing the extent of a firm’s competitive advantage is highly subjective. As a result, using a quantitative approach, which essentially focuses on numerical information, alongside the aforementioned qualitative approach can be useful.

In Questor’s view, a company’s return on equity (ROE) offers an insight into the extent of its competitive advantage – especially when assessed over a multi-year time period. ROE essentially shows how efficient a company is at generating profit from its net assets. It is calculated by dividing net profit by average net assets over the same period to give a percentage figure.

For instance, returning to the earlier example of Diageo, its net profit in the 2021 financial year was £2.8bn. Net assets did not materially change during the period from a figure of £8.4bn recorded at the start of the year. This means the company’s ROE was around 33pc.

Calculating ROE over a handful of years can help to smooth out exceptional events and limit the impact of extreme trading conditions. Comparing average ROE over a long time period to sector peers can provide an indication of a firm’s competitive advantage. A company that is consistently able to produce higher profits from its net assets than its rivals may be a relatively appealing proposition.

One caveat when assessing ROE is that firms with higher leverage can appear more attractive. Larger debts reduce net assets. Therefore, it is important to take into account debt levels (which this column will discuss at a later date) when assessing the appeal of a specific business.

Ultimately, even a combination of qualitative and quantitative methods can only provide an estimate of any firm’s competitive advantage. However, in Questor’s view, its consideration should form a key part of an investor’s decision-making process when determining which companies offer the best chance of long-term profitability and growth.

Moreover, evolving economic and investment conditions may necessitate a more in-depth consideration of a firm’s market position compared to the recent past. Investors who are prepared to do the legwork in this regard may not only unearth the best companies, but could avoid those stocks that are enjoying favourable circumstances which will not last forever.

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