The secret sauce of good growth stocks (and 2 that tick all the boxes)

Given interest rates remain at decade-long highs, and hopes of cuts continue to be pushed out into the future, it may be surprising for some that growth companies have continued to go from strength to strength. 

The S&P/ASX 200 Growth Index, for example, has risen 7.76% over the past 12 months. In comparison, the S&P/ASX 200 Value Index has lifted just over half of that at 4.71%. 

According to OC Funds Management's Aaron Yeoh, this is because a lot of companies have readjusted to a higher interest rate environment and have had a closer look at their cost bases, meaning earnings are now more sustainable for growth companies. 

Similarly, Datt Capital's Emanuel Datt believes it's because valuations within small-cap growth opportunities still remain compelling compared to their large-cap counterparts, and in addition, can help investors earn higher returns to keep up with or exceed inflation.  

So in this episode, Livewire's Chris Conway sat down with Datt and Yeoh for their tips and tricks for identifying good growth companies on the ASX. 

They analyse the financial factors, management requirements, and competitive advantages that they believe are important to winning growth stocks, and each select a stock that ticks all these boxes and more. 

Note: This episode was recorded on Monday 6 May 2024. You can watch the video, listen to the podcast, or read an edited transcript below. 

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Edited Transcript 

Chris Conway: Hello and welcome to Livewire's Buy Hold Sell. My name is Chris Conway and today we're taking a deep-dive into growth investing. We'll be learning what financial, management, and competitive advantage factors are important when selecting awesome growth companies. And to do that, we're joined by Datt Capital's, Emanuel Datt, and OC Funds, Aaron Yeoh. Welcome, gents.

Aaron, I'll come to you first. Why should our audience consider investing in growth stocks, and why now?

Why growth stocks, why now?

Aaron Yeoh: We like to consider things from a balanced portfolio perspective, and we see growth companies having a solid footing within a broader balanced portfolio. At OC Funds, we're small-cap investors, and from our perspective, the small-cap space is generally a pretty good hunting ground for the next great growth company. I think from a macro perspective as well, growth both globally and also here in Australia domestically has actually held up reasonably well. And it's interesting with regards to the interest rate environment, things are still very volatile, but despite this, I think you've seen a lot of companies actually readjust to a higher interest rate environment, i.e. having a closer look at their cost bases. So earnings are actually at a more sustainable footing and the outlook actually looks really good for growth companies.

Chris Conway: Emanuel, what about you? Why should the audience consider growth stocks?

Emanuel Datt: At Datt Capital, growth is really attractive to us for three primary reasons. The first being that investing in growth with the right manager can ultimately provide you returns over the long-term, generally at a rate in excess of inflation, which is very important. Secondly, we also like the ability to pick idiosyncratic returns - so returns that are detached from the market - by picking great growth companies. And thirdly, I believe now is the time because we're seeing such compelling valuations in terms of the divergence between valuations between the large-caps and the lower or the smaller end of the market. Whereas historically, small companies are typically valued more highly than large-caps. We're seeing the opposite effect at the moment.

Financial factors

Chris Conway: Emmanuel, I'll stay with you. What is one financial factor that every growth company that you look at needs to have?

Emanuel Datt: One very important financial metric that we look at is top-line growth. It's not purely top-line growth that you have to be focused on, because there's a lot of aspects in growth companies that are non-financial. And I think in many cases, the financial outcomes can be a result of great things that are happening fundamentally in non-financial metrics as well.

Chris Conway: Fantastic. Aaron, I'll come to you.

Aaron Yeoh: I think Emanuel's actually stolen my thunder here. I was going to go with sales growth as well. I think it depends on what stage of its life cycle a company is at. I think for a more mature business, typically more earnings growth-driven measures are what we look at. But for all companies, I think you have to have strong sales growth. That sort of sales growth helps with that earnings growth as well. So if there was one metric, I'd go top-line growth.

Chris Conway: Aaron, I'll stay with you. We're going to shift the conversation to management now. From a management perspective, what must growth companies have to make it into your portfolio?

Management factors

Aaron Yeoh: Management with skin in the game and alignment with shareholders with regards to having a reasonable ownership and incentive structures in place that align with the performance of the share price and for returns for shareholders is probably the one must-have from our perspective.

Chris Conway: Emanuel, what about you? From a management perspective, what must the company have?

Emanuel Datt: So the way we look at it is we categorise it basically into a range of characteristics, and I like to call it the three I's. So the first I is integrity. So a track record, the experience at the management level and board level that they've been there, done that before. The second one is intelligence, which is also a very important characteristic. The ability to make the right decision at the right time in a prudent impartial manner. Thirdly is incentives. So we like to see strong alignment, whether it be via shareholding or some other mechanism as part of the overall proposition.

Chris Conway: Emanuel, I'll stay with you. We talk competitive advantage now. What does that mean to you?

Competitive advantage factors

Emanuel Datt: Competitive advantage to me means scarcity. Scarcity in itself could be intellectual property, whether it be culturally or whether it be legally, via patents. Or it could be via commercial agreements that provide exclusivity. In the resource space it could be a unique orebody or project. And the list can go on and on.

Chris Conway: Aaron, what about you? Competitive advantage, what does that mean to you?

Aaron Yeoh: I think it really depends on the business that the company is in, maybe where it is within its life cycle as well. And it can come in various different forms. I think good examples of that would be scale. Maybe you see it in some of the retail names that we look at. If you look at say a business like Lovisa, for instance. Because of the scale of its business, it's able to get good terms with its suppliers and pass it on to consumers in the form of attractive prices. Or it could be similar to Emanuel's commentary about a scarce orebody, an asset that is hard to replicate. I think a good example of this would be the diversified industrial business Maas Group. They've got quarries in attractive regions within Regional Queensland, New South Wales, and Victoria that if you were to go out there and try and look for a permit to start one, it's pretty much next to impossible. So I think that's an example of what a competitive advantage is to me. It's a factor that helps a business out-compete its competitors, in essence.

Guest picks

Chris Conway: Here's where the rubber meets the road. We've asked the gents to bring along a stock that meets all three of the criteria that we've just talked about. Aaron, I'll stay with you. What have you got for us?

HUB24 (ASX: HUB)

Aaron Yeoh: So my stock that meets all these criteria is the wealth management platform, HUB24. HUB24, firstly, from my perspective, their key competitive advantage is their product. They've invested in it over the last decade, and it's always top of the pops in terms of product functionality. In terms of the market, its services, both the financial planner and everyday consumer market. I'd say from a financial planner perspective, compliance is an increasing burden for those guys, and it really helps them operate their businesses more efficiently. So there's a real demand and unmet need that these guys are fulfilling.

In terms of management, the long-standing CEO within that business is a gentleman by the name of Andrew Alcock. He's got significant skin in the game, he's been in the business for a long time, and he's as passionate today as he was the first time I met him five years ago. He's looking three to five years ahead, always looking to innovate and reinvest in his business. So I think he's an example of a CEO we really like.

And then bigger picture-wise, I think HUB's barely scratched the surface in terms of the growth opportunity. Even though it's experienced rapid growth, it's only at between 6-7% share of the broader platform market. And this compares to the larger peers at between 10-15% share at present still. So there's a huge opportunity ahead of it. We're really positive and think it can continue to grow well in the double digits for the next three to five years.

Chris Conway: Thanks, Aaron. Share price is up 12% year-to-date. Emanuel, what have you got for us? What stock ticks all those boxes?

Clarity Pharmaceuticals (ASX: CU6)

Emanuel Datt: One that comes to mind is a stock called Clarity Pharmaceuticals, trading on the ASX under CU6. So, Clarity is a clinical stage radiopharmaceutical company. It has a whole suite of defensible novel IP, focused primarily on oncology - the treatment of cancers. What we really like about this is that there's a global TAM associated with it. The most advanced program is actually focused on the treatment of prostate cancer. So of course it's a very major issue that they're trying to treat. It ticks all our boxes in terms of the ability to grow rapidly through de-risking over time through the various clinical trials, as well as significant partnerships potentially. And the management team have great alignment being large holders of stock in the company as well.

Chris Conway: It's up 76% year-to-date, and it did rally sharply recently. So, well done. That's all we have time for today. We hope you enjoyed that episode of Buy Hold Sell. If you did, why not give it a like? And don't forget to follow our YouTube channel, because we're adding lots of great content every single week.

Which growth stock ticks all your boxes? 

Let us know in the comments section below.