ASX mid-caps poised to outperform (and 1 stock Auscap says is due a re-rate)

Many regard Australian mid-cap companies – those within the ASX 100 but outside the ASX 20 in terms of market cap – as ideally placed in the coming months. Some reasons for this include this segment’s lower exposure to financials, its higher weighting toward cyclical sectors, and companies with P/Es that are below historical averages.

In the following Rapid Fire Q&A series, we ask Auscap Asset Management’s Will Mumford for his take on this part of the local market.

Superior earnings growth in ASX mid-caps

Mumford singles out “superior earnings growth” as the key differentiator between Australian mid-caps and other companies.

“Our fundamental view is that across market cycles, the total return you should expect for a given company is predominantly driven by the sum of the compound earnings growth and the dividend yield,” he says.

Mumford believes focusing on this “strips away all the short-term factors, such as unpredictable changes in valuation multiples, the effects of macroeconomic events, geopolitical shocks, global pandemics or inflation.”

He refers to historical figures for the ASX MidCap 50 Index, which delivered compound earnings growth of 7.5% in the last decade – compared with 3.9% from the ASX 20 Index and no growth at all from the ASX Small Ordinaries.

The current annualised return of the ASX MidCap 50 Index is 11.3%, versus 7.4% for the ASX 20 and 6% from the ASX Small Ordinaries.

While noting there are individual companies from both the large-cap and small-cap universe that will deliver earnings growth, “as a general rule, the largest number of quality companies we see, with many years of compound earnings growth ahead of them, are in the mid cap space, consistent with what has played out historically.”

He also points out that the P/E multiple for the ASX MidCap 50 Index is now very similar to that of the ASX 20 Index, despite its superior earnings track record.

The biggest risks

Mumford acknowledges different parts of the market can outperform and underperform for various reasons. For example, he notes that the ASX MidCap 50 Index lags the ASX 20 Index by 3.9% over the last three months, “largely due to a strong rally in large-cap financials, which we would not have predicted sitting here three months ago.”

“Who knows what happens in the next three months? Ultimately, we think it is important to focus on what drives long-term performance.

"We are confident that there are many mid-caps that will deliver superior earnings growth, which we see as a key driver of superior long-term performance,” says Mumford.

He also refers to the continued growth in passive investing, where returns of those focused on global large gaps are benefiting from indices’ overweight exposure to the likes of Nvidia, Microsoft and Apple.

“Passive strategies in the US have had a great run. Less than 25% of stocks are outperforming the S&P500 Index, the lowest percentage of stocks outperforming the overall market in at least 40 years,” Mumford says.

“Contrast that with a passive ASX investment. You are very overweight the big banks, the big iron ore miners, a few energy companies and the supermarkets. While these businesses might offer an attractive dividend yield, we do not see significant earnings growth out of most of these companies over the next decade.”

In the Australian market context, he notes the historical highs of CBA’s earnings multiple – which is the biggest index weight.

“But what about the outlook from here? We would back a sensible collection of businesses, primarily in the mid cap space, that deliver superior earnings growth over an Australian passive investing strategy over time,” Mumford says.

“The domestic market looks well placed for active management to deliver strong outperformance over the coming decades.”

Sectors with the greatest upside

The main sectors Auscap highlights are:

• consumer discretionary,
• financials,
• healthcare,
• materials,
• real estate, and
• communication services.

“Within these sectors, we think there are many high-quality businesses that have opportunities to compound earnings at attractive rates for many years into the future. That is probably also true for some companies in the information technology sector, but the valuations in this space feel very full,” Mumford says.

Must-have attributes for companies in the Auscap portfolio

“We want businesses that are established, dominant in their field, that have significant opportunities for earnings growth and reasonable valuations,” Mumford says. He also cites companies should have conservative balance sheets that demonstrate consistent profitability.

“Finally, our process also places large emphasis on management alignment. Most companies we own are either founder-led or have an executive or board member with a significant personal interest in the business.”

A mid-cap stock due for a re-rate

ResMed (ASX: RMD)

Auscap’s thesis for this founder-led business, which sells CPAP (continual positive airway pressure) devices to sufferers of obstructive sleep apnoea (OSA), is built around ResMed’s dominance within its sector. Mumford emphasises its EPS has grown by 15% per annum for a decade, alongside a ROE of more than 20%.

He notes the large selloff of the share price in the last year – and again in recent weeks - in the wake of the perceived potential impact of GLP-1 drugs.

“Having spoken to many industry participants, we think the concerns are overblown,” Mumford says.

Reasons for this include potential side-effects of GLP-1s, treatment costs, and patient adherence.

“Feedback suggests that ResMed remains the strongly preferred CPAP standard of care, with physicians tending to view GLP-1s as an adjunctive OSA therapy to CPAP and demand trends for the CPAP sector remain extremely strong,” says Mumford.

“It also appears that the sudden focus on weight and health that has arisen from the GLP-1 fervour has substantially increased awareness of OSA, a particularly under-diagnosed condition, which is increasing the number of patients looking for a solution.”

He also refers to ResMed estimates that the potential global OSA market is approximately 1 billion people, with just 23.5 million people connected to ResMed devices as of FY23.

“ResMed is currently trading on a forward price to earnings multiple that is a significant discount to where it has traded historically, and even more so relative to the broader market, which we think is a great opportunity to buy in at an attractive price for long term investors,” Mumford says.

Managed Fund

Auscap Ex-20 Australian Equities Fund

Australian Shares

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