3 high conviction ASX stock picks for the next 5 years

3 high conviction ASX stock picks for the next 5 years

This article first appeared in Livewire markets on 6 December 2024

Note: This interview was taped on Wednesday, 13 November 2024.

If you love high-conviction stock picks from right here in our own backyard, we have got a treat for you! In this episode of The Pitch, Casey McLean, the man behind the Fidelity Australian High Conviction Fund and its accompanying ETF Fidelity Australian High Conviction Active ETF will share some ideas and his views on today's opportunity set in the ASX.

As an active high-conviction fund manager, McLean's stock-picking process is as much about what you don't add to the portfolio as it is about what you do put into the portfolio. In fact, finding out what to exclude is often the first thing he does in his process.

"Our core belief is that loss avoidance is the cornerstone to good investment performance," McLean said. "So, when we're looking at a stock, the first thing we think about is what we don't want to buy."

From there, he looks at the company's growth prospects versus its current valuation. He does this by grading potential investments through the Five S's:

Sustainable competitive advantage
Structural reinvestment opportunities
Strong pricing power
Supportive industry structure
Superior management

And although McLean is long-term minded and the average stock in the Fund lasts about five years, he is far from a set-and-forget investor.

Tune into the rest of this episode to learn about his favourite stocks for the next five years, what he does with stocks that screen red flags, and the one Big Four bank he is overweight on right now. And no, it's not CBA.

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Edited Transcript

What are some non-negotiables when identifying opportunities?

McLean: The first thing we think about is that loss avoidance is the cornerstone of good investment performance. When we're looking at a stock, the first thing we do is think about the stocks we don't want to buy. Broadly speaking, these are low-quality companies. We assess them on a range of metrics such as leverage, value destroyers, and companies in earnings down cycle with highly volatile earnings.

The next thing we do is find the type of companies we want to buy that tend to score well on what we call the five Ss. That's companies with:

Sustainable competitive advantages,
Structural reinvestment opportunities,
Strong pricing power,
Supportive industry structure, and
Superior management.

If you score well on that, we then assess the companies on the growth versus valuation. We're looking for companies with medium-term earning growth or in an earnings up-cycle, and a reasonable valuation relative to that growth profile.

Warren Buffett’s favourite holding time is forever - what’s yours?

McLean: At Fidelity, we are fundamental long-term investors, but unlike Mr. Buffett, our holding period is not forever. We are active managers at the end of the day.

But since I've been managing the high conviction fund, the turnover has been about 20%. So that's just a holding period of around five years on average. But that average does hide a bit of the detail, and if you pull it apart, really we have two categories of stocks.

We've got the compounders where they're able to consistently grow their earnings above market growth rates, and we intend to hold those stocks for a very long period of time and kind of take an add-and-trim approach to those.

The second are the cyclical or growth opportunities where the growth opportunities are shorter in nature and those ones would have a shorter holding period overall.

What are some red flags you look out for to know when a thesis isn’t working anymore?

McLean: I think the first thing to understand when a stock is not working is - Has there been a cyclical or a structural change?

If it's a structural change, that's likely to be a thesis breaker and would need to exit that stock. If it's more cyclical, you need to understand firstly where we are in the cycle and is it that we've bought in too early before the trough in the cycle and we can be patient, wait that out and perhaps buy more on weakness. Or is it that we've held the stock, it's hit the peak of the cycle, and it's now starting to turn down? And if we see a deep cycle coming, that's probably another time to exit the stock.

Other indicators that we try and get a leading indicator on some of these changes are things like short interests. The guys that are shorting are smart and sophisticated investors. They're putting their money where their mouth is, so you need to think about what they know that I don't know.

Secondly and similarly, it's insider selling. They've got asymmetric information, what does that tell you about the stock? And we're also looking for divergent earnings estimates. That's where the range of earning estimates is widening, and that can be a leading indicator in both directions of upgrades or downgrades in earnings as well.

What are three businesses that you are excited about for the next five years?

McLean: I think in the large-cap space we like CSL (ASX: CSL). It is one of those compounders that I talked about. If you look at their history, they're able to compound their earnings at about 20% over 30 years. That's been driven by their innovation and R&D spending. We don't think anything has fundamentally changed there. They should be able to grow their earnings around the mid-teens, we think over the long term.

At the moment, that's driven by that core plasma business - CSL Behring - where we're seeing collection volumes increase. Their yields are also improving through some initiatives they're putting in place like the new Rika bed rollout and individualised nomograms, where they can adjust the amount of plasma that you take based on your height, weight, and red blood cell count. Donor fees are moderating in the industry as well as some of their competitors are under a bit of pressure. We can see margin improvement there.

This comes at a time when the recent acquisition they made, CSL Vifor, is not performing that well. But we still see those businesses have the potential to grow their earnings by double digits over the longer term as well.

You've always got this emerging pipeline of innovative drugs at various stages of approvals as well that are coming through to support those earnings. So it's a stock we think can grow at 15% for the medium term and trades on about 25 times earnings. And when you compare that to some of its large-cap peers, it looks quite attractive.

In the smaller cap segment of the market, we are like a company SiteMinder (ASX: SDR) which is a channel management software provider for hotels. The value proposition there is to maximise hotel revenues by getting the best price for your room, but also your costs by taking out the manual processes that they use to do that.

They're targeting to grow at 30% over the long term through a combination of user growth and getting more hotels where they're still quite low penetrated. And also increasing the ARPU (average rent per unit) by rolling out new products.

They have a couple that are coming to market at the moment. Dynamic Revenue Plus, which is a price optimisation engine, allows hotels to get the best price per room, and also, Channels Plus, which allows them to automatically connect to a range of online travel agents as well.

It's a company that's just broken even but we think its earnings are going to grow much faster than its revenue. And it trades on around about six times EV to sales. But if they do hit those 30% growth rates, which you could see potentially in a few years, there is scope for a further re-rating there.

Another one we like in that smaller cap space but in a different segment is Polynovo (ASX: PNV), a biotech company. They have a product called Novo Orb, which is a biodegradable polymer used to treat severe burns. It's a pretty large market. It has an approximately $1.2 billion TAM, and they're in the fairly early stages of penetrating that market. They've got a market-leading share in countries like Australia, the UK, and Germany.

But the growth is about rolling out to more hospitals in the US, which is the largest market, and penetrating deeper into those hospitals.

Plus, also rolling out into new markets like India and the rest of Europe as well. But what we also like about this company is that we consider it a platform technology. So they're able to use this technology in multiple different applications like trauma, hernia surgery, breast reconstruction, diabetic foot ulcers, and they're in the very early stages of penetrating that as well.

It's a company that's just broken even. We think their earnings have been growing at around 60% rates. Revenues continue to grow at a fast pace and it has a pretty attractive market to grow into.

You hold CBA and NAB - they are two of the top five positions in the portfolio. How bullish are you on the outlook for the big banks?

McLean: I think the context there is that we are underweight the banks. NAB (ASX: NAB) is the only bank that we are overweight in the portfolio. The reason that we prefer NAB is because they have a bigger weight towards business banking. Business banking is the only part of the banking landscape that can generate a good return. They're making around mid-teens ROE in this business, and they're far more overweight in that than the other major banks.

We've seen that they've been able to grow that business by really focusing on the whole of the customer. It's become the first choice bank for these businesses. They can do their lending, their payments, their transactions, and their cards as well. It means you're able to grow your lending in line with the deposits so you have the cheapest source of funding, but also it gives you the data and analytics into these customers because you see their cash flows coming into the accounts.

Ultimately, it means you're able to have better insights into their credit and risk profile as well. And then the other thing we like about them is their focus on the proprietary channels. That's loan origination outside of the mortgage broker channel, and that comes at much higher returns, and that's a key focus for theirs as well.

It's a company that has the second-highest returns in the market out of the major banks and is sort of the emerging and increasing quality bank amongst the Big Four.

09 December 2024

Active ETFs Australia

Casey McLean

Casey McLean

Portfolio Manager, Fidelity Australian High Conviction strategies

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