3 high conviction ASX stock picks for the next 5 years

McLean: The first thing we think about is that loss avoidance is the cornerstone of good investment performance. When we're looking at a stock, the first thing we do is think about the stocks we don't want to buy. Broadly speaking, these are low-quality companies. We assess them on a range of metrics such as leverage, value destroyers, and companies in earnings down cycle with highly volatile earnings. 

The next thing we do is find the type of companies we want to buy that tend to score well on what we call the five Ss. That's companies with:

• Sustainable competitive advantages, 
• Structural reinvestment opportunities, 
• Strong pricing power, 
• Supportive industry structure, and 
• Superior management. 

If you score well on that, we then assess the companies on the growth versus valuation. We're looking for companies with medium-term earning growth or in an earnings up-cycle, and a reasonable valuation relative to that growth profile. 

McLean: I think the first thing to understand when a stock is not working is - Has there been a cyclical or a structural change? 

If it's a structural change, that's likely to be a thesis breaker and would need to exit that stock. If it's more cyclical, you need to understand firstly where we are in the cycle and is it that we've bought in too early before the trough in the cycle and we can be patient, wait that out and perhaps buy more on weakness. Or is it that we've held the stock, it's hit the peak of the cycle, and it's now starting to turn down? And if we see a deep cycle coming, that's probably another time to exit the stock. 

Other indicators that we try and get a leading indicator on some of these changes are things like short interests. The guys that are shorting are smart and sophisticated investors. They're putting their money where their mouth is, so you need to think about what they know that I don't know. 

Secondly and similarly, it's insider selling. They've got asymmetric information, what does that tell you about the stock? And we're also looking for divergent earnings estimates. That's where the range of earning estimates is widening, and that can be a leading indicator in both directions of upgrades or downgrades in earnings as well. 

McLean: I think in the large-cap space we like CSL (ASX: CSL). It is one of those compounders that I talked about. If you look at their history, they're able to compound their earnings at about 20% over 30 years. That's been driven by their innovation and R&D spending. We don't think anything has fundamentally changed there. They should be able to grow their earnings around the mid-teens, we think over the long term. 

At the moment, that's driven by that core plasma business - CSL Behring - where we're seeing collection volumes increase. Their yields are also improving through some initiatives they're putting in place like the new Rika bed rollout and individualised nomograms, where they can adjust the amount of plasma that you take based on your height, weight, and red blood cell count. Donor fees are moderating in the industry as well as some of their competitors are under a bit of pressure. We can see margin improvement there. 

This comes at a time when the recent acquisition they made, CSL Vifor, is not performing that well. But we still see those businesses have the potential to grow their earnings by double digits over the longer term as well.

You've always got this emerging pipeline of innovative drugs at various stages of approvals as well that are coming through to support those earnings. So it's a stock we think can grow at 15% for the medium term and trades on about 25 times earnings. And when you compare that to some of its large-cap peers, it looks quite attractive.