The right time for stock picking (and an ASX company we believe is oversold)

Passive investing is currently all the rage. This is in large part due to the strong performance of the US stock market, which very few active managers have outperformed in recent years, and which passive investors can get exposure to at low cost through an ETF.

At the time of writing, the S&P 500 total return index is up 18.0% year to date. It has annualised 15.9% over the last five years. The largest S&P 500 ETF, the State Street SPDR S&P 500 ETF Trust, charges a fee of just 0.0945% per annum. According to Morningstar, what’s more is that less than 20% of active asset managers in the US have outperformed the S&P 500 in 2023 and year to date in 2024. 

What is going on? Why has passive investment performance been so strong? And does this void an argument for backing active asset management?

We think it is useful to start considering these issues by thinking about the ideal circumstances for a passive investment in a market capitalisation-based, or size-weighted, index. Such an index has its biggest exposure to the largest companies. So, a passive index exposure is going to be a great investment when the biggest companies in that index are growing their earnings faster than most other companies in the index.

If we look at the S&P 500 Index, its largest weights are currently Microsoft (7.2%), Apple (7.0%), Nvidia (6.7%), Alphabet (4.3%), Amazon (3.8%) and Meta (2.4%), because these are the largest companies in the US. These six companies account for 31.4% of the S&P 500 Index. They are also companies that are growing earnings a lot faster than the broader market, and faster than most of the other companies in the Index. This can be seen in the chart below.

Passive US index exposure in recent years has given investors low-cost overweight exposure to a group of companies with significant earnings growth. So significant is the earnings growth and corresponding stock market performance of these six largest companies in the US that less than 25% of individual companies are outperforming the S&P 500 Index, a record low number over at least the last 40 years.

In such an environment, a passive index approach is very difficult to beat as an active manager. To do so, a manager needs to find stocks that will outperform the index by a margin that exceeds their management fees. If strong earnings growth continues to be a feature of the largest companies in the US market, we suspect it will continue to be a very difficult market for active managers to outperform. We should note for completeness that the multiple of earnings investors are willing to pay for these large companies and the broader market has also increased recently, aiding index performance.

On the other hand, we suggest that certain conditions make an ideal environment for active investing. These conditions include an index that is materially overweight large companies that are likely to exhibit low, or even negative, earnings growth over future periods. This is particularly the case when the particular market has plenty of other companies that should see strong earnings growth over time.

The argument for active management in Australia appears to us to be as strong as the argument for passive investment has been in the US. Australia does not have large technology companies dominating the domestic stock market. The largest weights in the ASX 200 are the Commonwealth Bank of Australia (9.3%), BHP (9.3%), CSL (6.3%), National Australia Bank (4.8%), Westpac (4.1%) and ANZ (3.8%). Australia’s largest six companies, four of which are large banks, account for 37.6% of the ASX200.

If we focus on the four retail banks, collectively they account for 22% of the Index, yet they have failed to grow earnings meaningfully over the last decade. With the large banks continuing to display a more risk-averse approach to lending, facing increasing competition in residential mortgages and business lending with the emergence of private credit providers, and having to deal with rising cyber security, information technology, compliance and employee costs, we struggle to see tailwinds for material earnings growth in the future.

All four banks have recently experienced strong share price appreciation, but this largely appears to be a function of the market paying a higher multiple of earnings for these companies than representative of a lift in their earnings growth. In fact, analyst forecasts suggest the market expects anaemic earnings growth for the big four banks over the next five years.

We are firmly of the view that the Australian economy is well placed to experience growth as strong as any developed economy on a go-forward basis. This is likely to be driven by structural advantages which include:

• strong population growth;
• an abundance of natural resources that will continue to be in demand globally through the energy transition;
• proximity to the growth of the emerging nations in Asia;
• a sound democracy with an established rule of law and firm private property ownership protection;
• a solid Government fiscal position;
• an educated population and a business culture with a track record of innovation and entrepreneurship.

We continue to believe that the domestic economy will present great opportunities for investment over time. Indeed, there are currently many companies in the mid-cap universe that are significant in scale with strong competitive advantages, have a high return on capital metrics and plentiful opportunities for organic growth. This should lead to these companies experiencing strong earnings growth over time.

What does this mean? We think investors should expect their long-term return from investing in equities to approximate the sum of the earnings growth and dividend yield delivered over time. 

A passive investment in an Australian index appears to us to be overweight many companies that will struggle to grow earnings at attractive rates. Such a market is one in which active management should outperform over time if that active management is based on identifying businesses that are reasonably priced and will grow their earnings at healthy rates by reinvesting capital into attractive opportunities. 

We see many such opportunities in the domestic Index, particularly in the mid-cap space. One such opportunity that we have invested in over the last year is ResMed.

ResMed (ASX: RMD) and the risk posed by GLP-1s

Investors would be aware that ResMed became a significant position for the Auscap funds in the second half of 2023. It is a founder-led business that sells CPAP (continual positive airway pressure) devices to sufferers of obstructive sleep apnoea (OSA). Following a recall by its major competitor, Phillips, ResMed is the dominant player within its sector, having grown earnings per share by 15% per annum for the last decade with a consistent return on equity above 20%.

ResMed sold off in the last year due to the perceived potential impact of a class of drugs referred to as Glucagon-Like Peptide 1 agonists, or GLP-1s, which assist patients in losing significant amounts of weight. There is a strong correlation between OSA and weight.

GLP-1 drugs could potentially reduce the number of patients that suffer from OSA thereby reducing the size of its market. However, the evidence is far from conclusive. 

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. Significantly, demand trends for the CPAP sector remain extremely strong. 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, an under-diagnosed condition, which is increasing the number of patients looking for a solution. 

ResMed management estimates the current global OSA market to be roughly 1 billion people, and in FY23 ResMed had just 23.5 million connected devices in the market. Awareness is likely to increase further with Samsung’s new Galaxy Watch which detects signs of sleep apnoea.

ResMed is currently trading on a forward price to earnings multiple that is a 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. We see a significant runway for earnings growth for ResMed over the coming years. 

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