Buy Hold Sell

The stocks headed for the ASX 20 (and 2 on the way out)

Mon 08 Apr 24, 11:25am (AEST)
20240328 BHS-Thematic Primary
Source: Livewire Markets | Auscap's Will Mumford, Market Index's James Marley and Blackwattle's Tim Riordan

Key Points

  • Mid-cap stocks have consistently outperformed large and small caps over 5, 10, 15, and 20 years, with similar volatility but higher earnings growth, attributed to established competitive advantages and global expansion opportunities
  • Companies like Mineral Resources and Xero, are touted as potential contenders to enter the ASX 20, while incumbents like South32 and Santos face challenges like capital allocation and industry headwinds

Over the last five, 10, 15 and 20 years, mid-cap stocks have managed to outperform both their large and small-cap counterparts. They've done this with the same volatility as small caps and, over the last decade, they've grown earnings at around 7.5% per annum - more than double that of the small and large-cap indices.

So, why is this? According to Blackwattle's Tim Riordan and Auscap's Will Mumford, it all comes down to quality. These businesses are more likely to have established themselves with some sort of competitive advantage and have more of a growth runway ahead of them to expand globally.

Meanwhile, two-thirds of the ASX 20 - Australia's largest listed businesses - are either major banks, reliant on China's iron ore demand, or exposed to the declining long-term outlook for oil and gas. So in this episode, Livewire's James Marlay was joined by Riordan and Mumford for a look at two companies that could push these incumbents out of the ASX 20. Plus, they also provide a deep dive into the mid-cap segment of the market, the positive factors that investors should look out for, and some of the red flags to have on your radars.

Note: This episode was recorded on Wednesday 27 March 2024. You can watch the video, listen to the podcast or read an edited transcript below.

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Edited Transcript

James Marlay: Hey folks, welcome to Buy Hold Sell, brought to you by Livewire Markets. My name's James Marlay, and today, we're going to be talking about what is believed to be one of the sweet spots on the ASX. It's not the top 20. It's not the micro-caps. We're going to be talking about mid-cap stocks today. It's where a lot of the growth companies exist. Joining me to talk about midcaps, I've got Will Mumford from Auscap and Tim Riordan from Blackwattle. Gents, welcome to the show.

Tim, I'm going to start with you. No growth, tired old businesses in the top 20. We keep being told we need to move out of there. The small cap index has only done about a bit over 4% over the long term. Why are mid-caps the point of interest in the Australian market?

Why mid-caps?

Tim Riordan: I actually didn't realise this until we dug into some of the numbers. And you've seen mids over five, 10, and 15 years well and truly outperform both large and small-caps. A bit of a surprise. So, what's the catch? Well, it's not volatility either. So, mids have done that with the same volatility as small-caps. So, from a risk-adjusted perspective, you're getting just this huge bang for your buck in mids.

That's history. What about the future? So, the way I think about it is, and you touched on it with the analogy of the top 20 - you've seen those companies are more stalwarts. Smalls are probably harder to find consistent winners, but a lot of those businesses are where we look to start and grow, businesses that have found a way to establish themselves. And then, it's really that mid-space, particularly the ones we're looking for, have got some quality attributes to them. So, they've found a way to establish themselves with some sort of advantage, and it gives them just this foothold. And we're often seeing businesses founded here in Aus are starting to grow globally. And so, that opportunity set is really rich and wide and the runway can be really quite long. So, yeah, that's what we think is special about it.

James Marlay: Okay. Will, over to you. First of all, for viewers, can you give us some definition of what is the midcap space? What size companies? The top 20 to outside the 20 to the 100? Define the universe for us and maybe you can build on what Tim's told us. What are some of the attributes that you like about the midcap space?

Will Mumford: Well, I agree with everything that Tim said. And there's a few ways you can define midcaps, but most people would say maybe outside the ASX 20 down to say the 100. But for example, if you were to look at the midcap index, which is 51 to 100, and like Tim said, over five, 10, 15 or 20 years, that's come first, large-caps have come second and small-caps have come third in terms of performance. And actually, the only exception to that is the last couple of years where large-caps have outperformed due to a really strong 2022, which perhaps creates another opportunity for midcaps.

I think there are two reasons here. The first is quality. So, if you were to look at the All Ords and divide it up by the 10-year average statutory historical ROE, the ASX 100 is where you've got the highest ROE on average. And that includes both the large and midcaps.

So, the small-caps, you can obviously have these huge winners, but at the same time you've also got businesses that are unproven, pre-profit, and aren't leaders in their field and are perhaps at a competitive disadvantage. So, on aggregate, that index underperforms, even though it trades at a PE premium. But the real reason for mid-cap shine is earnings growth.

So, over the last decade, midcaps have grown earnings at about 7.5%. That's more than double both large and small caps. And like Tim said, if you look at the ASX 20, two-thirds of that index is either a major bank, exposed to Chinese iron ore demand, or exposed to the flat to declining long-term profile for oil and gas.

Positive and negative signals in mid-cap stocks

James Marlay: Well, it sounds pretty rosy so far. Can't all be good news about the midcaps. What are some of the red flags and things people need to look out for? And what are some of the techniques that you use to identify those midcaps you want to own?

Will Mumford: Well, like I said, the mid-caps over-index in businesses that are consistently profitable, have good financial metrics, and have earnings growth. So, I think if you can fill a portfolio with stocks with those characteristics, and then be mindful of insider alignment, balance sheets as well as valuation, I think you're off to a huge head start. In terms of issues to avoid, well, I think it's important to have a high bar. So, I'd be avoiding stocks with the opposite characteristics, and also, stocks where, one, I'm not confident in the long-term growth outlook for that sector. Secondly, where the company has a history of operational challenges and not meeting its own forecasts. And thirdly, companies where they might be large, but they're still at a competitive disadvantage, perhaps to an even larger peer.

James Marlay: Tim, I'm going to go to you. Same set of questions. What are the things that you need to see that get you excited and put a midcap stock onto your radar? And maybe back it up with some of the things that will strike them off the list?

Tim Riordan: So, quality's our key driver. From that perspective, we're really trying to hone in on what we think are the highest-quality companies in the universe. And so, using a scorecard approach would basically just focus on the top quartile. We focus on a lot of the characteristics Will mentioned. We're looking for high margins and strong returns from a financial characteristics perspective. And then, when you drill down into the fundamental research, the things that pop up, that percolate for us in terms of trying to build a concentrated portfolio, these sorts of businesses with alignment in terms of the way the management runs the business. And often, that comes through with innovation in terms of culture, people who really believe in the business, and you'll often see really low levels of turnover.

James Marlay: What's an example of a company that has those attributes?

Tim Riordan: I always go back to CAR Group (ASX: CAR), so that's always been solid for us. And again, the same as Will, the opposite is true for the red flags. What are you not looking for? If we're seeing inconsistency in terms of the attributes that we're looking for, that makes it harder for us to stack that up.

I think one of the key learnings we've learned over time in looking for high-quality businesses is really seeing businesses that are in the third and fourth quartile from a quality perspective. We might, as an analyst, come up with a story around how they're going to improve over time - this big turnaround thesis.

The number of times we've got that right versus the number of times we've got that wrong is way on the wrong side of the ledger. It's really reinforced just focusing on the very high-quality businesses and it's just a lower probability.

James Marlay: So, don't bank on the turnaround?

Tim Riordan: It's hard work.

Management: Founder-led versus agency CEOs

James Marlay: You've talked a little bit about alignment. How important is it to you to have one of these founder-led businesses? Like Jamie Pherous, Corporate Travel is a classic example. Xero was founder-led for a really long period of time. I would imagine they're classic midcaps. Is it a deal breaker? Is it a must-have?

Tim Riordan: It's probably a nice-to-have. So, I would say we are happy to have a little bit from column A, and a little bit from column B in terms of founders, not founders. It really goes back to alignment. So, can we see from the board, through management, in the strategy, the alignment with the way the strategy is presented and what's likely to be achieved? And are we feeling aligned as a shareholder? I think the key things that can tie that together are often a shareholding or some line of sight to some major reward through an LTI and the like. But does it have to be a founder? No, I don't think so. But maybe that's just an easier starting point.

James Marlay: Will?

Will Mumford: I agree with Tim. Founders and alignment are huge for us. So, the majority of both of our portfolios on a weighted basis are either led by a founder or have an executive or board member with at least $10 million worth of stock in the company, which compares to maybe a quarter for the broader index.

It's really because we want management focused on the long-term earnings outlook and the competitive position for the business. We don't want them focused on the next half's EPS upgrade or downgrade or pursuing M&A, so they can have a bigger empire. And I think the best way to do that is to have someone there, a decision maker, who has a large part of their net worth focused on the long term.

The other point I'd make is that because of the free-float requirements of the index, often founder-led companies get disadvantaged in terms of index inclusion. Some good examples are Reece (ASX: REH) and WiseTech (ASX: WTC), which are out of indexes because of their high insider ownership, which we would argue is an advantage.

James Marlay: Could be an opportunity.

Will Mumford: Could be.

2 stocks headed for the ASX 20

James Marlay: All right, let's talk specifics. Will, I'm going to start with you. We've got a midcap that you think over the medium term, say three years plus, can nudge its way into the top 20?

Mineral Resources (ASX: MIN)

Will Mumford: I mean there are a couple of obvious answers just outside of the 20, but I thought I'd bring a bit of a wild card and my stock's Mineral Resources. So, the main reason here is that there are a few different ways in which earnings can be meaningfully higher for the business in the coming years. So, management has already announced that they're going to triple their mining services business in the next five years. They're going to 5x their lithium and iron ore businesses, and that's just what they've announced. Despite this, the stock's gone nowhere for two and a half years because of the collapse in the lithium price.

Right now, we're coming into a period that's quite catalyst-rich. There's a potential positive decision on exporting gas in WA. There's also the potential for a balance sheet transforming transaction, and the lithium price is finally showing some signs of life.

So, I think there are a few catalysts, some asymmetric upside, and reasons to believe the business can be meaningfully bigger.

James Marlay: Tim, same question for you.

Xero (ASX: XRO)

Tim Riordan: You mentioned Xero before, that's mine. Xero at the moment is 25th on the list. So, it's there or thereabouts, but index-wise, it's probably got to outperform by about 50% to be promoted, possibly more. So, how does it do that? You mentioned historically led by a founder. And Rod's just recently gone off the board. So, what's changed is that over the last couple of years, the new CEO has established a broader management team around a change in philosophy.

Effectively the guiding light is the rule of 40. Effectively, the growth rate in revenues and the free cash flow ratio add up to 40%. So, they're looking for both revenue growth plus earnings growth and growth in free cash, which hadn't been the case before.

The management team have just recently reviewed and confirmed opportunity is rich in the US and I think that's a pretty interesting place for us to be. But having said that, the growth in the business together with a push for profitability leaves it with that sort of plus-50% outperformance, that's a non-zero probability.

2 stocks on the way out

James Marlay: Which stock is it going to replace? What's the top 20 stock that Xero could bump out?

South32 (ASX: S32)

Tim Riordan: So, we don't spend a heap of time up there, but the one we were thinking is probably South32. Feels like it's been a tough road. They've had some poor luck, weather and the like, never great when you get too much rain when you're a miner. But capital allocation is probably the issue we have. And the most recent example is selling Illawarra Coal. It's a decent-returning asset. Coal's on the nose, I get that. So, there are some peculiarities around that transaction. But if you're going to funnel that money into what we think is a negative IRR zinc mine just to be part of the new metals halo, I'm not sure that makes sense.

James Marlay: Okay. Will, what's the top-20 stock that Min Res is going to knock out of the index?

Santos (ASX: STO)

Will Mumford: Yeah, equally, this isn't something we spend a huge amount of time on, but if you had to push me, I'd go with Santos. Firstly, it's towards the bottom end of the 20. If you look at their own numbers, the long-term outlook for oil and gas demand is flat to negative. Also, a significant amount of their cash flow is either going out as dividends or going back into CapEx to achieve fairly modest production growth. So, I can see a scenario where its market cap might move sideways and some of the businesses with more structural growth could overtake it. There's also been some corporate interest there, and so that's the other way it could end up out of the 20.

James Marlay: Well, ladies and gentlemen, that wraps up our mid-cap-focused special. Hopefully, you learnt a few new things about that part of the market and have a few ideas to conduct your own research. If you did enjoy that episode, hit subscribe. Remember, we're adding fresh content just like this every week.

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Buy Hold Sell

Buy Hold Sell is a regular video series where Australia's leading professional investors share their views on Australian and Global Shares. This content is produced by Livewire Markets and has been syndicated to the Market Index website.

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