How to find “explosive growth” stocks outside the ASX 20

Among ASX mid-caps and the smaller end of large caps ­is where Antares Capital Partners sees the best equity investment opportunities.

The common view that among small caps is where you’ll find the best returns is a myth, explains John Guadagnuolo, Antares’ head of fundamentals and portfolio manager

“There’s a couple of problems in small caps, which have a much greater dispersion of returns. But on average, returns in small caps are much lower than in mid-caps,” he says.

Guadagnuolo also points to the higher reliance on equity raises to fund growth in the small-cap segment – which in turn dilutes growth and reduces the important compounding effect.

He also highlights problems at the other end of the spectrum, among the biggest of the large caps.

“They run into the problem of saturated market share, mature markets, and they’re mature businesses, so they struggle to grow their earnings per share,” says Guadagnuolo.

That’s why the Antares Ex-20 Australian Equities Fund avoids the 20 largest ASX companies.

In the following video, Guadagnuolo explains how his team filters the Australian equity market down to a high-conviction list of between 15 and 30 names. The interview reveals details on how they sift stocks as either core or tactical exposures.

He also describes how this approach was successfully applied to the purchase – and exit – of stock in a well-known property firm. This enabled investors to benefit from the “explosive growth” period from 2015, when returns were consistently around 20%, before exiting when the company joined the ASX 20, and its returns dropped by more than half. Watch the video or read the edited transcript below to find out more.

Watch the video or read the edited transcript below to find out more.

Edited transcript

Why does your mandate preclude investing in the Top 20 ASX companies? Why have you decided to invest that way?

We like this space. We think it offers a much better aspect of capital growth for our investors. If you think small-caps, which people associate often with higher returning companies. There's a couple of problems in the small-cap space. There's much greater dispersion of returns. But on average, returns in small-caps are much lower than mid-caps, and mid-caps have much higher returns also than the large end of the market. And why is that? It's because they have the growth. So in small-caps, you can get growth, you can get revenue, profit growth, but that often comes at the price of equity raisings to fund that growth. Share prices reflect earnings per share ultimately in some way, shape or form. And so when you're having to raise equity, you're issuing shares, which is diluting the growth. So you're not getting that compounding effect.

Obviously at the other end of the market you've got large companies. Large companies run into the problem of saturated market share, mature markets, mature businesses, so they struggle to grow and therefore grow EPS. 

Mid-caps have that sweet spot where they still have that growth runway in front of them. But because they're more mature as businesses than small-caps, they typically don't need to raise as much equity. 

You don't get the dilution and therefore you get compounding EPS, and that drives better capital growth. We don't think you invest in this space for dividends. We like companies to pay a small dividend because it's capital discipline, but it's not about the dividend. This strategy is about capital growth, and that's part of the attraction I think for us and why we like it.

How do you filter the ASX 200 ex-20 down to those 15-30 names you hold?

We have a team of nine analysts and other portfolio managers, so they're continually assessing their sectors. They've all got sector responsibilities. We cover the whole universe. And their job is to find new ideas, new opportunities, as well as to identify threats and to keep their eye on the valuation of all our companies to make sure that we're not owning things that are overvalued. 

We also divide our investible universe into what we call our core stocks and our tactical stocks.

And our core stocks are, as the name might imply, long-term holdings. They're typically GDP+ businesses, high barriers to entry, good industry structure, good governance, typically higher returning. If they're not one of those, they're the tactical opportunity, which are much more short-term in nature. And so they present themselves in different ways. Tactical stocks have a much higher turnover, core stocks have a much lower turnover, but it is driven by valuation to an extent.

The thing with a core stock is if it's got a good business model, you typically have a lag in the valuation, whereas tactical stocks are much more price-sensitive. And so our team is constantly reviewing all of that, looking for the opportunities and threats within that space. And that's where a lot of the ideas come from. And then vice versa, we as the portfolio management team, we push back onto the group and say, "Well, have you seen this? Have you thought about that?" So there's a two-way conversation that goes on. Obviously we're experienced market participants and we're aware of the market generally.

What’s one stock holding you’d highlight as a longer-term case study?

The Goodman Group (ASX: GMG). So the strategy's now seven and a half years old. Goodman Group was an initial holding. It was a core stock. We thought it had long-term competitive advantage and we held it all the way through until it went into the top 20. And we liked it because, I guess, my own perspective having been a consumer and transport analyst, I could see the competitive advantage that Goodman was building for distribution. I think there was a mistake made by many in the market to think of industrial real estate as just sheds, whereas these were more about fulfilment, which is a retail type of thing. So if you think about how Westfield used to pick all the best sites for its shopping centres, and that was their competitive advantage, Goodman has something similar. Because if you think about this type of logistical approach, you need to be in the spot where you are close to the population but close to transport routes and you can supply and flow out with certain amount of ease and infrastructure requirements.

They were good at that. They were able to raise capital through third parties to facilitate all of that. The market, I think, just thought, "Oh, it's just industrial. It's just sheds. You can build them anywhere, who cares?" But that wasn't the case. It was a very strong performer for us from the time that we owned it. 

Our strategy commenced in May 2015 and it entered the top 20 in, I think, June 2019. It returned around 20% per annum compared to the broader markets return through that period of about 3.5%. 

So I'm using the broader market, not our specific index. It's moved into the top 20. And what's really interesting is that it has slowed. It's still a good business, it's still returning well, but the returns now, having a look at it since it entered the top 20 are only about 7% per annum from 2019 till now, as against the broader market, a bit over three. So it's still doing well, but it has slowed.

The time to own it was when it had that explosive growth period through... Now it's maturing and people understand more about it, so you lose that explosive growth that our space can enter. And that's the ideal thing that we're trying to find, because we still like the business. As I said, it's still a good business, but as a top 20 Australian company, clearly that's telling you that it's a much more matured business than it was when it was number 65 or 70 or what have you. That's the difference. Interestingly, when James Hardie's (ASX: JHX) went into the top 20, we sold it straightaway because of the rising rates issue. So just different reasons for doing different things.

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The Antares Ex-20 Australian Equities Fund is an actively managed, concentrated portfolio of Australian equities that have the potential to offer significant long-term capital growth. For more information, please visit the fund profile below. 

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