The stocks headed for the ASX 20 (and 2 on the way out)

Meanwhile, two-thirds of the ASX 20 - Australia's largest listed businesses - are either major banks, reliant on China's iron ore demand, or exposed to the declining long-term outlook for oil and gas. 

So in this episode, Livewire's James Marlay was joined by Riordan and Mumford for a look at two companies that could push these incumbents out of the ASX 20. 

Plus, they also provide a deep dive into the mid-cap segment of the market, the positive factors that investors should look out for, and some of the red flags to have on your radars. 

Note: This episode was recorded on Wednesday 27 March 2024. You can watch the video, listen to the podcast or read an edited transcript below. 

Tim, I'm going to start with you. No growth, tired old businesses in the top 20. We keep being told we need to move out of there. The small cap index has only done about a bit over 4% over the long term. Why are mid-caps the point of interest in the Australian market?

Why mid-caps? 

Will Mumford: Well, I agree with everything that Tim said. And there's a few ways you can define midcaps, but most people would say maybe outside the ASX 20 down to say the 100. But for example, if you were to look at the midcap index, which is 51 to 100, and like Tim said, over five, 10, 15 or 20 years, that's come first, large-caps have come second and small-caps have come third in terms of performance. And actually, the only exception to that is the last couple of years where large-caps have outperformed due to a really strong 2022, which perhaps creates another opportunity for midcaps. 

I think there are two reasons here. The first is quality. So, if you were to look at the All Ords and divide it up by the 10-year average statutory historical ROE, the ASX 100 is where you've got the highest ROE on average. And that includes both the large and midcaps. 

So, the small-caps, you can obviously have these huge winners, but at the same time you've also got businesses that are unproven, pre-profit, and aren't leaders in their field and are perhaps at a competitive disadvantage. So, on aggregate, that index underperforms, even though it trades at a PE premium. But the real reason for mid-cap shine is earnings growth. 

So, over the last decade, midcaps have grown earnings at about 7.5%. That's more than double both large and small caps. And like Tim said, if you look at the ASX 20, two-thirds of that index is either a major bank, exposed to Chinese iron ore demand, or exposed to the flat to declining long-term profile for oil and gas.

Positive and negative signals in mid-cap stocks 

Will Mumford: Well, like I said, the mid-caps over-index in businesses that are consistently profitable, have good financial metrics, and have earnings growth. So, I think if you can fill a portfolio with stocks with those characteristics, and then be mindful of insider alignment, balance sheets as well as valuation, I think you're off to a huge head start. In terms of issues to avoid, well, I think it's important to have a high bar. So, I'd be avoiding stocks with the opposite characteristics, and also, stocks where, one, I'm not confident in the long-term growth outlook for that sector. Secondly, where the company has a history of operational challenges and not meeting its own forecasts. And thirdly, companies where they might be large, but they're still at a competitive disadvantage, perhaps to an even larger peer.

Tim Riordan: So, quality's our key driver. From that perspective, we're really trying to hone in on what we think are the highest-quality companies in the universe. And so, using a scorecard approach would basically just focus on the top quartile. We focus on a lot of the characteristics Will mentioned. We're looking for high margins and strong returns from a financial characteristics perspective. And then, when you drill down into the fundamental research, the things that pop up, that percolate for us in terms of trying to build a concentrated portfolio, these sorts of businesses with alignment in terms of the way the management runs the business. And often, that comes through with innovation in terms of culture, people who really believe in the business, and you'll often see really low levels of turnover.

Tim Riordan: I always go back to CAR Group (ASX: CAR), so that's always been solid for us. And again, the same as Will, the opposite is true for the red flags. What are you not looking for? If we're seeing inconsistency in terms of the attributes that we're looking for, that makes it harder for us to stack that up. 

I think one of the key learnings we've learned over time in looking for high-quality businesses is really seeing businesses that are in the third and fourth quartile from a quality perspective. We might, as an analyst, come up with a story around how they're going to improve over time - this big turnaround thesis. 

The number of times we've got that right versus the number of times we've got that wrong is way on the wrong side of the ledger. It's really reinforced just focusing on the very high-quality businesses and it's just a lower probability. 

Tim Riordan: It's hard work.

Management: Founder-led versus agency CEOs

Tim Riordan: It's probably a nice-to-have. So, I would say we are happy to have a little bit from column A, and a little bit from column B in terms of founders, not founders. It really goes back to alignment. So, can we see from the board, through management, in the strategy, the alignment with the way the strategy is presented and what's likely to be achieved? And are we feeling aligned as a shareholder? I think the key things that can tie that together are often a shareholding or some line of sight to some major reward through an LTI and the like. But does it have to be a founder? No, I don't think so. But maybe that's just an easier starting point.

Will Mumford: I agree with Tim. Founders and alignment are huge for us. So, the majority of both of our portfolios on a weighted basis are either led by a founder or have an executive or board member with at least $10 million worth of stock in the company, which compares to maybe a quarter for the broader index. 

It's really because we want management focused on the long-term earnings outlook and the competitive position for the business. We don't want them focused on the next half's EPS upgrade or downgrade or pursuing M&A, so they can have a bigger empire. And I think the best way to do that is to have someone there, a decision maker, who has a large part of their net worth focused on the long term.

Will Mumford: Could be.

2 stocks headed for the ASX 20

Tim Riordan: You mentioned Xero before, that's mine. Xero at the moment is 25th on the list. So, it's there or thereabouts, but index-wise, it's probably got to outperform by about 50% to be promoted, possibly more. So, how does it do that? You mentioned historically led by a founder. And Rod's just recently gone off the board. So, what's changed is that over the last couple of years, the new CEO has established a broader management team around a change in philosophy. 

Effectively the guiding light is the rule of 40. Effectively, the growth rate in revenues and the free cash flow ratio add up to 40%. So, they're looking for both revenue growth plus earnings growth and growth in free cash, which hadn't been the case before. 

The management team have just recently reviewed and confirmed opportunity is rich in the US and I think that's a pretty interesting place for us to be. But having said that, the growth in the business together with a push for profitability leaves it with that sort of plus-50% outperformance, that's a non-zero probability.

2 stocks on the way out 

Tim Riordan: So, we don't spend a heap of time up there, but the one we were thinking is probably South32. Feels like it's been a tough road. They've had some poor luck, weather and the like, never great when you get too much rain when you're a miner. But capital allocation is probably the issue we have. And the most recent example is selling Illawarra Coal. It's a decent-returning asset. Coal's on the nose, I get that. So, there are some peculiarities around that transaction. But if you're going to funnel that money into what we think is a negative IRR zinc mine just to be part of the new metals halo, I'm not sure that makes sense.

Will Mumford: Yeah, equally, this isn't something we spend a huge amount of time on, but if you had to push me, I'd go with Santos. Firstly, it's towards the bottom end of the 20. If you look at their own numbers, the long-term outlook for oil and gas demand is flat to negative. Also, a significant amount of their cash flow is either going out as dividends or going back into CapEx to achieve fairly modest production growth. So, I can see a scenario where its market cap might move sideways and some of the businesses with more structural growth could overtake it. There's also been some corporate interest there, and so that's the other way it could end up out of the 20.