Growth stocks are all the rage - here's how to pick the best of the bunch (and 2 ASX examples)

Whether you’re an experienced investor or just starting out, identifying stocks with the potential for significant long-term growth is both an art and a science.

Growth stocks have historically been some of the biggest wealth creators in the market, but finding the right ones requires careful analysis, patience, and let's face it, a bit of intuition. 

Whilst most growth stocks will have strong metrics, like revenue and earnings growth and improving earnings per share, a host of less tangible factors help separate the great from the good. 

How strong is the company's competitive advantage, for example? How good is the management team? And how innovative or disruptive is the company - and does it even need to be?

In this episode of Buy Hold Sell, David Wilson from First Sentier Investors and Joe McCarthy from Elston Asset Management join Livewire's Hans Lee to share their process for identifying growth stocks, the key metrics they focus on, and the red flags that would see them steer away from opportunities.

Not content with just theorising however, they each share their top ASX growth stock for 2025.  

Note: This episode was recorded on Wednesday 30 January 2024. You can watch the video, listen to the podcast or read an edited transcript below.

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Edited Transcript

Hans Lee: Hello, and welcome to Livewire's Buy Hold Sell. I'm Hans Lee, and today we're going to be unpacking how professionals identify great growth investments. Are there any reasonably priced companies left, given equity markets continue to hover around all-time highs? Let's find out with David Wilson of First Sentier and Joe McCarthy of Elston. Welcome to you both. Thank you for joining me.

All right, we've got a lot to cover. So, David, I'm going to start with you. What is your process for identifying great growth stocks?

Identifying great growth stocks

David Wilson: At First Sentier, our approach is very much looking at things like return on capital and return on equity. We also spend a fair bit of time understanding the business model, looking at the competitive and regulatory environments as well. So getting both a qualitative and quantitative feel for the company's prospects. And Australia has actually been pretty good at generating growth companies over the years.

Hans Lee: Joe, same question for you. What's your process?

Joe McCarthy: At Elston, we're a style-neutral manager. So we look at both value and growth stocks. In terms of our process, it really starts off with getting to know the business. So we want to find out about the industry, the competitors, business model, the management and strategy. And from there that all feeds into the valuation. So what the growth profile looks like, the investment that is required into the business to get it where it needs to go, their ability to extract profits, and the risk. And from there, hopefully, you end up with a growth company where the prospects are undervalued, and off you go.

Hans Lee: Joe, I'll stay with you. In that process, how much does the macro matter when it comes to identifying those stocks?

Does the macro matter?

Joe McCarthy: It’s an interesting question. It does matter, but it's a question of whether it's a portfolio construction issue or whether it's a really important driver of the business or an enabler. And if it's the latter, that is when it needs to be really carefully considered.

Hans Lee: How about you, David? Do interest rates, GDP, inflation, those kinds of things impact how you hunt for opportunities?

David Wilson: The way we like to approach this is by being macro aware. I think it's really the bottom-up drivers that determine the company's growth profile, but you have to be aware of the regulatory risks, economic risks, even interest rate risks, effects risk, commodity price risks as well. So there's a lot of other things you factor in, but during 2024, really what you saw is actually the key driver wasn't what was happening in China or even what was happening in America, it was actually really what companies themselves really determined the earnings performance.

How important is management?

Hans Lee: David, staying with you. Let's talk about something that likely has a lot more impact than the macro, and that's management. How important is management? And when you get to talk to management at the various companies that you hold and you're eyeing, how important is it to talk to them when it comes to your decision-making?

David Wilson: Now, management matters a lot. Really, you want them focused on returns and you want them understanding the risks. And also what's quite important, and it's perhaps underappreciated, is the interplay between the chairman, the CEO and the CFO. So have they got the necessary skills, but also do they have the checks and balances when they're actually looking at particular opportunities?

Hans Lee: Okay. Joe, I'll ask you a similar question, but maybe with a slight twist. Is it the track record or the personality or a combination of the two that is most important for you?

Joe McCarthy: The track record's important, but the personality's priceless. So at the end of the day when you're leading a company, you're leading your employees, you're dealing with your customers, regulators, all your stakeholders, but they're people not machines. And it's really important to be able to balance often conflicting trade-offs between those stakeholder groups and engage with them appropriately to really bring everyone along for the journey.

Key metrics

Hans Lee: Joe, let's talk metrics. What are maybe two key metrics that a growth stock must possess for you to make it into your portfolio?

Joe McCarthy: It’s probably a bit of a different one, but looking at free cashflow to EBIT, because it tells you a lot about what's going on in the business and also what they're up to in terms of the investment side, or maybe what they're not telling you. And the second one is sales and marketing to revenue. So when you start to see that drop off, it gives you a good indication that maybe the sales growth is also about to drop off.

Hans Lee: Okay. David, how about you? Are there other key metrics you like to see in your respective growth names?

David Wilson: I mean, we like to look at EPS growth. I know it's a simple measure, but it's an important one. But also the trend as well as the level of return on capital or return on equity. So you want to see that improving over time. Otherwise, if you're actually seeing that decline, it's actually telling you that the growth is really slowing up. And the other final one is actually again a simple one, is just revenue growth. Are you able to sell more product to your customers?

What about red flags?

Hans Lee: David, I'll stay with you. We never have an investing discussion without talking about risks. What are a couple of red flags you look out for?

David Wilson: First bit of trivia for the day: the collective noun for red flags is actually a bunting of red flags. It's not a herd or a flock; it's a bunting of red flags. And there are a lot of companies in Australia that do have a bunting of red flags. The sort of things that we look at, accounting, just in terms of below the line accounting, issues like that. We also look at balance sheet. Obviously that's another important risk. Succession planning is another important one. And probably the final one is just the disclosure and the metrics used when companies make an acquisition. That's a real insight into the thinking of a particular company.

Hans Lee: All right. Accounting and succession planning among them. How about you, Joe? What are some of those red flags that would see you running for the hills?

Joe McCarthy: Probably the first one, and it's pretty similar to what David said, but just the transparency side of things. So when that starts to get worse, it makes you ask what are they not telling us? And then secondly, it's probably more about what's driving it. So if it's industry or macro hype that's really driving that business, it's generally it's not persistent and it can turn very quickly and it can cause problems.

Guest picks

Hans Lee: Okay. Well, let's put all this theory into practice. We've asked our guests to bring along one of their top growth stocks for 2025. Joe, let's start with you. What have you got for us?

Sonic Healthcare (ASX: SHL)

Joe McCarthy: So I've got Sonic Healthcare. It's a pretty simple thesis where you've got great management leading that business, good organic and inorganic growth prospects, and also just a really strong balance sheet. In the last couple of years they've had a bit of a tough time with the COVID testing revenues rolling off very quickly, and you've had revenue going down fast on costs and earnings going the wrong way. But we look forward and we can see that at the most recent update where you've got the organic growth coming through, they've got the cost under control and we can actually see the margins expanding. So we're looking forward to the upcoming year for them.

Hans Lee: Right. Joe, so yours there, Sonic Healthcare. David, how about you? What's your growth stock for the year ahead?

ResMed (ASX: RMD)

David Wilson: For us, Hans, it's ResMed. We think that EPS and revenues will grow at 8-12%. They continue to take market share because of the problems of their major competitor, Philips. To give you some sort of perspective, five years ago, their market share was 55%. That has actually grown to 75% over the course of that time. They continue to generate a lot of cash, management is well-installed, so it's a stock that we think can continue to grow at those sorts of rates.

Joe McCarthy: We agree on ResMed, actually. We think it might be at a bit of an inflexion point where it's such an underpenetrated market. But with the Apple Watch and GLP-1's being a great catalyst for people to come in to see a sleep therapist, we think it actually might be the next leg of growth for them.

Hans Lee: There you go. You got a double thumbs up for ResMed.

All right. Well, these gentlemen will be back next time for more Buy Hold Sell. That's on Friday. We hope you enjoyed the episode today. If you have, you can leave us a like. And subscribe to our YouTube channels as well as the Livewire Market's website where there's great content to be found all the time. Till we see you Friday, take care and thanks for watching.