Banks, biotechs and BNPL - the fundamentals of the ASX-20

Twenty-one years ago, at the beginning of the millennium, the ASX-20's top stocks were primarily financials and telcos.

In the 21 years since, we've seen the top 20 change dramatically. The world has hopped aboard the sustainability train, tech has reared its head and the market caps of the companies remaining have shot up. 

So what does the top 20 look like now? Investors are spoilt for choice with the ASX-20. Everything is on offer from banks to supermarkets, miners to infrastructure. It is safe to say, the top 20 has changed dramatically in the first 21 years of the decade. This made me think, what will the ASX-20 look like in ten years from now? Will tech still reign supreme or will we see a new entry as influential as CSL? How can we account for the future? 

In order to understand what the future of the ASX-20 will look like, I reached out to two of Australia's top mid-cap fund managers. In part 1 of this two-part Collection, the experts analyse what makes a top Australian company and predict what sectors we may see more of in the coming decades. In part two of the collection, the fundies will provide their predictions for the future of the ASX-20 - naming one company not currently within the top 20 and one that is that may not last long.

Responses come from: 

• Leon de Wet, Elston Asset Management 
• Catherine Allfrey, Wavestone Capital

The dividend road to success 

Leon de Wet, Elston Asset Management 

Within our investment universe, being the S&P ASX100, we really don’t differentiate with respect to the qualities we think a company should possess for us to risk our client’s capital by investing in it. Regardless of size, we’re looking for companies with:

• The balance sheet to withstand the ups & downs of the business cycle;
• A track record of growing earnings over the long term; and
• Proof that company management are effectively employing the capital we as shareholders are providing them (along with additional debt assumed), shown by profitability metrics like return on equity and return on assets.

At the risk of generalising, if there is a quality that is perhaps more relevant for companies in the S&P ASX20 it is dividend sustainability. We know that dividends are a very important component of the total return investors enjoy over longer periods, and this is probably more the case for some of Australia’s biggest companies like grocery retailers Coles and Woolworths. They’re great companies with strong free cash flow generation, but being mature businesses defending dominant market share, over the next decade we think it unlikely they can match the earnings growth potential of companies like James Hardie or Treasury Wines.

An important non-financial consideration for us is management’s approach to all its various stakeholders, not only the shareholders and obviously customers, but also employees, service providers and regulators amongst others, because balancing the often-competing requirements of these various stakeholders is critical to ensuring a sustainable long-term business model.

The next big sector 

With the caveat that we probably tend to overstate the potential impact of change in the short-term and underestimate it in the long term, the sector I think will have a larger presence is Healthcare, notwithstanding the fact that it is a complex and diverse sector.

The big picture attractions are well known and include being recession-resistant (to varying degrees), the fact that the healthcare sector improves the quality of life of people, the addressable markets (often underpenetrated) can be large given global reach, regulation may act as a barrier to entry and favourable demographic trends exist in developed markets as populations age.

Another potential tailwind in the wake of the coronavirus pandemic may be that the importance of healthcare as part of the country’s national security has been highlighted. While only time will tell, government policy may become more friendly toward companies with the ability to innovate and combat the health issues that threaten the quality of life of the broader society.

Now it is all good and fine having a favourable backdrop, but without the companies able to take advantage it’s a moot point. Fortunately, Australia in our view has some world class companies like CSL, a leading manufacturer of blood plasma critical to producing life-saving therapies and treating a growing list of diseases, or innovative obstructive sleep apnea device maker ResMed whose digitally-enabled strategy is driving out-of-hospital quality of life improvements for millions of patients or private hospital operator Ramsay Healthcare, a stock we do own and which is a beneficiary of ongoing demand for elective surgeries and growing waiting lists in the public hospitals both here and abroad in countries like the UK where it also operates.

The Holy Grail - Sustainable earnings growth 

Catherine Allfrey, WaveStone Capital 

Australia is a small market of 25 million people so to be a Top 20 company, a company is either part monopoly (TCL), have been a duopoly (supermarkets /WES/TLS) or an oligopoly (banks) or you’ve created a product that the world really wants! WaveStone’s stock-picking process uses a quality filter to look for companies that have a “Sustainable Competitive Advantage”. We look firstly at the internal attributes of success such as a company’s track record, why the company is #1 or #2 in their industry and how they have a successful strategy of engaging their employees, suppliers and customers to create sustainable earnings growth. Secondly, we use a form of Porter analysis to determine the industry conditions that a company operates in. These are always changing due to changes in consumer preferences, regulation and technology allowing new entrants into an industry. In the Top 20 the companies with the highest “Sustainable Competitive Advantage” are CSL, GMG, WES, MQG, TCL, APT and ALL.  

The next big sector 

Let’s consider a larger presence to mean a higher market capitalisation, bearing in mind that the Top 20 stocks currently have a combined value of $1.4 trillion. If we take a ten-year view on iron ore, it may revert to the long-run price of US$60 due to slower Chinese growth and alternative African iron ore supply. Under this circumstance, the likes of BHP, FMG and RIO may not hold their current combined market cap of $440bn. The technology sector should have a larger presence due to Xero already knocking on the door of the Top 20 with a market capitalisation of A$20bn. Furthermore, if we can convince the Australian based billionaires Farquhar and Cannon Brookes to dual list Atlassian with a market capitalisation of US$55bn they would gain immediate entry into the Top 20! Also, the ongoing IPO activity is mostly technology-based and if companies like Canva come to market we could see a much larger technology sector and potentially another technology stock in the Top 20.

Conclusion 

Whether it be attributable to dividends or sustainable earnings growth, the ASX-20 is a force to be reckoned with. It's clear that even the experts disagree with where the ASX-20 will stand in ten years, but one thing is certain - they've got some catching up to do! In part two of this Collection, the experts will be looking into the crystal ball to predict which new company will enter the top twenty in the next ten years. They will also cast their vote as to the company that currently sits within the list that won't in the next ten years. 

Make sure you FOLLOW my profile to be updated when I publish part two. 

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