If finding stocks to buy just meant identifying great companies, then investing would be a lot easier than it is. Sadly, price matters, and shares in strong businesses rarely sell at great prices.
Nonetheless, the stock market is volatile and highly unpredictable. That means it’s worth having a list of shares to buy in a sell-off, in order to be ready for when an opportunity presents itself.
Quality stocks
What makes a great stock for an investor to own? The answer comes down to two things.
First and foremost, the underlying business needs to be one that can generate a lot of cash. This is what drives the return, so it’s an essential part of a great investment.
Second, there needs to be something that acts as a barrier to competitors. A business with great economic properties is unlikely to keep generating returns if it’s easy for others to do the same.
With this in mind, here are two shares I think fit the bill. Both of them look too expensive right now, but either could be terrific if bought at the right price.
Diageo
Diageo (LSE:DGE) is an alcoholic drinks company. In my view, its business is one of the strongest on the FTSE 100.
Diageo generates around £5bn in operating income using £6bn in fixed assets. This means that it ticks the first box – it generates a good return considering how much it costs to run.
Alcoholic beverages can be a crowded marketplace, so there’s a risk of artisanal brands taking market share. But the business has some important advantages that limit this threat
First, Diageo has some first-rate brands. These give the company negotiating power with retailers that smaller participants don’t have.
Second, its scale gives it a big advantage. It means that marketing, distribution, and manufacturing costs are lower.
The stock currently trades at a price-to-earnings (P/E) ratio of 23, which I think is a lot for a business growing its revenues at 5%. In a market sell-off, though, I’d be looking to buy it.
If the share price dropped sharply, though, things might well be different. I think Costco would be a great stock to own, if only it were available at a substantially lower price.
Costco
Another stock on my list is discount retailer Costco (NASDAQ:COST). At a P/E ratio of 36, this is quite a way above the level I’d be interest in, but the underlying business looks excellent.
In general, retail companies don’t tend to make great investments. Low profit margins and fierce competition means that inflation can be a significant risk.
This is true of Costco. But the company’s membership fee revenue gives it a source of income that doesn’t depend on product margins.
This is what helps the retailer maintain lower prices than other retailers. And those low prices keep attracting customers who are willing to pay the membership fee.
Basically, Costco’s two strengths are mutually reinforcing. Customers pay to join because they know they’ll get low prices and the fee revenue allows the business to keep prices down.
The company’s business model is almost impossible for a competitor to replicate due to its size. That’s why I think it would be a great investment at the right price.
