Many investors have looked to growth stocks as they have trounced value stocks since the GFC. This episode of Investing Compass looks at the characteristics of growth stocks and the investors that they suit. We lean on insights from star fund manager and investor Phil Fisher, and his categorisation of growth stocks and how this can help investors understand what may suit them.

As part of this episode, we look at three of our best ASX growth stocks for the long-term, based on the following characteristics:

  • They land in the growth portion of the Morningstar Style Box.
  • Companies on this list have wide Morningstar Economic Moat Ratings. This means that our analysts believe that the company can sustain their competitive advantage for at least 20 years. This is particularly important for this list, when looking for stocks to buy for the long-term.
  • They are run by management teams that make smart capital-allocation decisions, with either an exemplary or standard capital allocation rating. 
  • Many growth stocks are sitting in overvalued territory. We focus on undervalued or fairly valued stocks.

Read the full article here.

Listen on:

Or watch below:

Get more of Morningstar's articles in your inbox

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: Okay, Shani, we've got an old school episode today. We are going to do, and I don't know the last time we did this, but we're going to do a stock pick episode.

Jayamanne: And we're going to go through three ASX growth shares for the long term.

LaMonica: But of course, because this is Investing Compass, we always want to make sure that investors in those shares have context and they can consider, of course, what's right for them and their goals. So first, let's talk a little bit about growth shares in general. So I'm going to ask you all the questions today. So what are they, Shani? What are the types of goals that they suit? And I don't know, I'll come up with some more questions, but we'll start with those two.

Jayamanne: We'll start with those ones, alright.So growth stocks have become increasingly popular as they have trounced value stocks since the global financial crisis. And they're not restricted to any particular industry, although you're more likely to find them in industries like technology. And a growth share is a company that investors have high expectations for growth in the future. And that means that investors are willing to pay higher valuations. And the hope of growth investors is that although a share may be more expensive on a relative basis, strong growth will more than make up for the high valuations.

LaMonica: So as Shani said, the key to evaluating growth shares, and I'd say all shares, is to focus on investor expectations. So nobody obviously has a crystal ball valuing any shares, relying on projecting growth into the future. It is an exercise in conviction in the prospects of the company. However, there are a lot of variables that can change the trajectory of a company, especially over such a long time horizon. Poor economic conditions, poor capital allocation, changing consumer tastes and preferences, increased competition, the list is endless. So if expectations get too high and they're not met, share prices generally head south. It is more often than not that high expectations do not eventuate.

Jayamanne: Okay, so we can turn to history because that's one of your favorite subjects, Mark. We can look for an example and we're going to talk about the Nifty Fifty. And there were some pretty disastrous consequences there.

LaMonica: Okay, so you're not going to make some sort of joke?

Jayamanne: I had to bite my tongue.

LaMonica: Okay, that's good. All right, so the Nifty Fifty was a name given to a group of U.S. growth shares, which surged in the 1960s and early 1970s. I should point out I was not alive during that time period. And they just became symbols of the bull market that was going on at that time. So the companies included household names that we still know, like McDonald's, Coca-Cola, Pepsi, Johnson & Johnson, and Pfizer. And they traded at very high valuations over many years. And as you could probably guess from some of those companies that were included, their product lines was everything from drugs to early computers and electronics to photography, food, tobacco, and retailing. Notably absent were anything that was cyclical. So those are industries like auto, steel, transport, capital goods, and oil.

Jayamanne: And they were all very strong companies. They were growing quickly and they had strong balance sheets as well. And as the bull market continued, they became known as one decision stocks, meaning that they could be purchased at any price and never sold. Expectations soared for these stocks and markets continued to climb along with valuation levels. Yet investors ignored high valuations because markets kept going up.

LaMonica: And by the end of 1972, the average PE or price to earnings ratio of the Nifty Fifty stocks was 41.9. So that was more than double what the S&P 500 was at the time, which had a PE of 18.9. So over one-fifth of those firms, so I'm not great at math, but do you know how many one-fifth of 50 is?

Jayamanne: No, tell me, Mark.

LaMonica: Okay, we're going to have to work on some basic math skills. But over one-fifth of those firms sported price to earnings ratios in excess of 50 and Polaroid, which was new technology at the time, not retro like it is now, new technology at the time was selling it over 90 times earnings. So by the early 70s, as markets continued to rise, more investors of course, got in the game. It was easy for investors to get involved through managed funds. So between 1960 to 1965, assets of funds doubled. Then they doubled again between 1965 and 1970, peaking in 1972. So by the end of the 60s, there were seven times as many Americans that held shares during the height of the 1929 bubble.

Jayamanne: And at the beginning of 1973, conditions started to turn. So inflation started climbing and eye-watering budget deficits, swollen by the Vietnam War needed financing. And the market reacted poorly and headed south. 1973 and 1974 saw the worst downturn since the Great Depression. The S&P 500 dove 42% and it took almost six years for a full recovery. And this affected all global markets and some much more severely than the U.S. For instance, the UK didn't recover for about 13 years.

LaMonica: So the reason we did this long story and took you back to the 60s and 70s is because this is a prime example of how sky-high valuations combined with sky-high prices resulted in poor investing outcomes. So ultimately, most of these companies have continued to be successful and are still household names today. But the lesson here for investors is that the stocks were extremely expensive, given the future outcomes that they actually achieved. It took an extended time horizon for investment growth to return.

Jayamanne: All right, we're going to talk about Phil Fisher. And Phil Fisher was the author of Common Stocks, Uncommon Profits.

LaMonica: You said that like you know him.

Jayamanne: I do.

LaMonica: Okay, well, I guess I don't know who your friends are.

Jayamanne: He speaks about how to choose growth stocks that are right for an investor's situation. And he believes that the key for investing in growth stocks is finding quality at a good price.

LaMonica: And many investors know how important a long-time horizon is for building wealth. The same, of course, goes for companies. Fisher thinks that many companies are too focused on near-term earnings. This focus means that they may forego taking action that will benefit the growth of the company over the long term. And they're doing this to avoid a short-term hit to earnings. And a CEO's main job, which I've read about since I've never been one, is capital allocation. So they must decide where funds are being directed and for what purpose. There must be a balance between rewarding existing shareholders with immediate income through dividends, of course, and then investing back into the business to ensure that the business continues to grow.

Jayamanne: Fisher addresses the emphasis that investors place on this short-term reward that can and has come to the detriment of long-term growth for the company. And these pressures result in not investing in the business and instead keeping earnings and dividend payouts high, whether it is in the best interests of the business or not.

LaMonica: And one of the reasons the book from Shani's friend is so popular is because Fisher also goes on and he talks about how to choose growth shares that are right for your situation. So the book contains a list of 15 factors, but focuses in on what to buy and how to apply it to your own needs. So this is where he speaks about risk and return. He thinks investors should focus on stocks that have the highest profit comparative to risk. But of course, he acknowledges that circumstances differ from person to person and to invest according to your own circumstances, which sounds like what we say.

Jayamanne: That's why I'm friends with him.

LaMonica: Okay, common interests.

Jayamanne: Yes.

LaMonica: That's the foundation of a good friendship.

Jayamanne: Exactly. These circumstances that you mentioned, Mark, for growth stocks are separated into two broad categories. So we have larger, more conservative growth stocks. So an example of that would be Apple. And these stocks have temporary volatility like all stocks, but over time, they'll reward you with growth and decent dividend yields along the way. And then we have smaller growth companies, which is the second broad category. And these companies can be much more profitable as there's more room to grow. But with that, of course, comes risk. And these are the textbook growth companies that are reinvesting all their funds into the future growth of the business. And this means that they'll pay little to no dividends, but they may reward investors handsomely with stellar growth.

LaMonica: And Shani's friend, Phil Fisher, liked the latter. But he knows that not everyone is in a situation where they can forego income from their investments. So he understands why those larger, more conservative stocks do have a place in some investor portfolios.

Jayamanne: And the right investment to achieve your goals may be a combination of both those large and small companies. And you may invest the majority of your portfolio in blue chip shares and a portion on smaller companies that are riskier, but also have higher future potential.

LaMonica: And the other factor that investors can look for, which we talk about all the time at Morningstar and the two of us, is, of course, a moat or potential sources of a moat for smaller companies. Over long time horizons, moats have increased the safety of an investment, as businesses are able to maintain and grow their sustainable competitive advantages.

Jayamanne: All right. So today, we've looked at a couple of these factors and features, and we've run an investment screen on to find three growth stocks for the long term. And our best growth stocks to buy for the long term share a few qualities. So they'll land in the growth portion of the Morningstar style box because they're growth stocks. And the companies on the list do have a wide Morningstar economic moat rating. So this means that our analysts believe that the company can sustain their competitive advantage for at least 20 years. And it's particularly important for this list when we're looking for stocks to buy for the long term. Then we also have that they're run by management teams that make smart capital allocation decisions. And they either have an exemplary or standard capital allocation rating. And many growth stocks right now are sitting in overvalued territory. So we tried to find ones that are either four or five star stocks.

LaMonica: All right. And that, of course, denotes just so people know that they're undervalued. Yeah, just thought I'd add that. All right. So we have our first pick, another opportunity where we do need the drumroll sound effect that we've been asking for. Literally, we've been asking Will.

Jayamanne: You should just learn how to beat box Mark.

LaMonica: Okay. I'll add that to the list of skills I want to acquire. But the first pick is PEXA. So PEXA operates a virtual monopoly on digital property settlement and lodgement in Australia. And when we say virtual monopoly, we mean it 99% market share of digital transactions and close to 90% market share of total transactions. So the remaining market share consists of paper based conveyancing in some of Australia's smallest jurisdictions and functional niches. So given this widespread adoption of PEXA's platform by stakeholders, our analysts expect this remaining market share to eventually move to PEXA's digital platform as well.

Jayamanne: PEXA's wide moat rating is primarily supported by network effects. In Australia, property transactions require the involvement of numerous stakeholders. The benefits created by all these stakeholders using a common platform creates a pull effect across the ecosystem. Digital competitors to PEXA will also be faced with high switching costs. And this is because switching to a different solution would require the integration of technologies and retraining of people, which incurs direct financial costs, opportunity costs, and business risks involved with the switching process.

LaMonica: So as we explained, PEXA kind of has Australia wrapped up at this point. So they are shifting their strategic focus to overseas expansion into the UK. So PEXA's exchange business is mostly saturated in Australia, of course, with 99% and 90% market share of those two different categories we talked about. So really the only way they can grow is of course to move overseas. The issue of course is PEXA does not enjoy an equally supportive environment in the UK as it did in Australia. So in Australia, the country's largest banks co-own PEXA at one point and with a legal mandate from state governments to move on to these digital platforms. So this of course helped drive adoption. PEXA will therefore have to invest heavily in product development and especially sales and marketing to drive adoption of its platform by a sufficient number of market participants for those network effects that Shani mentioned earlier to kick in.

Jayamanne: And we see the highest risk in PEXA's expansion into the UK market. PEXA is currently investing heavily in product development and sales and marketing in this market and success will be a binary outcome in the view of our analysts.

LaMonica: So we do see low risk from competitive pressures due to the moat that we mentioned. So the Australian business being well protected by those network effects and switching costs. And we do think that even if at some point a third party is allowed access to the network, we don't really expect competitors to be financially viable in this space.

Jayamanne: We do rate investment efficacy as exceptional. Although we don't view PEXA's recent acquisitions into adjacent products and services as valuable, PEXA has managed to secure a 99% market share in digital transactions as Mark said, which we view as an exceptional achievement. And we attribute this at least in part to PEXA's investment in the economic moat of its Australian exchange business and rate the efficacy of these investments highly. If I got 99% on a test.

LaMonica: First of all, we all know that you got 99% on most of your tests. Remember when you showed me all those medals that apparently they just give out to school children in Australia for, I guess, being great at something?

Jayamanne: They were principal's medals.

LaMonica: Okay, I don't know what that means.

Jayamanne: It meant I was a brown-noser, that's basically what it meant.

LaMonica: Okay, well, there we go. Something has obviously changed because I work with you and you're really mean to me. But let's get back to PEXA. So on October 28th, the shares are trading at a 20% discount to our fair value. So they're 20% undervalued in the opinion of our analysts and the fair value is $17.25.

Jayamanne: Okay, so the next one is Auckland Airport.

LaMonica: Which we've heard about.

Jayamanne: We're moving on.

LaMonica: Yeah, we are moving on, but we've heard about this on our episode with James.

Jayamanne: Yes. Have you been to Auckland Airport?

LaMonica: I haven't. I've been to Wellington, but then every other time I went to New Zealand, I went to the South Island.

Jayamanne: Okay, well, there you go. It's the primary gateway to New Zealand, apparently. But Auckland Airport is set to benefit from rising air travel to the island nation. We were just discussing we're both from island nations.

LaMonica: That is true. Taiwan and Sri Lanka. Yeah.

Jayamanne: Auckland Airport is the largest airport in New Zealand and Auckland is by far New Zealand's most popular city. No other airport in the country is likely to outdo Auckland as an international hub. We expect the airport to capture good medium term growth from further airline capacity expansion to and from New Zealand. And we forecast total passengers handled by Auckland to grow to more than 25% above pre-COVID levels over the next decade.

LaMonica: Do you know who loves going to New Zealand?

Jayamanne: You do.

LaMonica: Okay. Well, fine. That's not what I was going for. Americans.

Jayamanne: There you go.

LaMonica: I was in the States a couple of weeks ago. Every American you talked to, where are you from? Australia. Oh, isn't that close to New Zealand?

Jayamanne: I mean, you are kind of American.

LaMonica: I have an Australian passport and it's October 31st.

Jayamanne: You're talking like they're a different crowd.

LaMonica: I am because I'm Australian now, at least as long as I pay my taxes today. I've not done them.

Jayamanne: It's the 31st of October today.

LaMonica: Yes. So I need to do that desperately. Anyway, let's get back to Auckland Airport where I might be flying if I don't complete my taxes. So we do think that it has a wide economic moat and that's basically due to the fact that it's an airport and is a near monopoly position in a very stable regulatory environment. So we don't think that a second major airport is likely to emerge anytime soon, which of course means Auckland Airport's expansion potential to accommodate that continued growth in passenger numbers, a lot of which are Americans, will protect its position for decades to come.

Jayamanne: And Auckland Airport has no looming competitor, unlike Sydney Airport, which must contend with the scheduled 2026 opening of Western Sydney Airport. Rival airports in New Zealand are currently unsuitable as international landing points. While Auckland Airport is undergoing a significant capital investment program, it has relative earnings confidence with the regulated business to earn a suitable return on investment. Should passenger numbers disappoint, the firm has flexibility with capital deployments to reduce the risk of overcapacity.

LaMonica: And of course that, it makes sense, that's the primary risk. That basically air travel to and from New Zealand drops due to hopefully not another pandemic, but there could be terrorism, geopolitical tensions, climate risk, economic risk, all of those. Also the fact that every American that tells me they're going to New Zealand, I say come to Australia instead.

Jayamanne: To visit you.

LaMonica: No, not necessarily. That's not really the selling point to the country, but I think people should come to Australia.

Jayamanne: Okay.

LaMonica: The other thing, of course, that can impact this higher fuel prices. That could be passed on to passengers in the form of a fuel surcharge, and that could also dampen air travel, given the fact that New Zealand is very remote. So over the long run, that latter factor is likely to be offset by aircraft that can travel faster, further or more efficiently, making New Zealand a more accessible destination. Although I will say, I've been hearing for a very long time that aircraft are going to go faster.

Jayamanne: We're going to get the Concorde back.

LaMonica: I don't know. Nobody's making a faster plane. I don't know why.

Jayamanne: I don't know. Couldn't tell you. We assign Auckland International Airport a standard Morningstar Capital Allocation rating, and that's based on our assessment of balance sheet risk, investment efficacy, and shareholder distributions.

LaMonica: You know, we had somebody send me an email the other day that said we should do an episode on airports.

Jayamanne: This is one of them.

LaMonica: Yeah, there we go. All airports, all the time on Investing Compass. One thing, of course, not of course, one thing that our analysts don't love about Auckland Airport is the balance sheet is weak. So these debt metrics are appropriate, obviously, we think for the type of business it is, but most of the company's investments in expansion are completed under a regulated scheme, which they are then allowed to generate suitable returns on a capital that's invested in the airport. We do think shareholder distributions are appropriate. Company covers its dividends with free cash flow, and that's, of course, adjusted for capital spending needs.

Jayamanne: And at the 28th of October, Auckland Airport was 10% undervalued with a wide moat and a fair value of $7.30.

LaMonica: All right, last one, Shani. This has been a long episode, and I'm very old, so I'm going to have to take a nap or something after this. But our last pick is The Lottery Corp. So our analysts expect The Lottery Corp. to thrive now that it has been unshackled from Tabcorp's comparatively challenge wagering business. So regulation limits competition via compulsory licensing, bestowing Lottery Corp. with a near monopoly on long dated licenses in all Australian states and territories except for WA because they like to be different out there, right? The only significant license due to expire before 2050 is the Victorian lottery. And so that's going to happen in 2028. So mark your calendars.

Jayamanne: The Lottery Corp. has just three digital only competitors with an estimated combined market share of around 5%. None of the digital competitors have the same brand strength with the 50 year history of The Lottery Corp.'s brands, physical retailers, range of games and televised lottery draws all aiding in its brand equity. We think a lack of brand recognition will prevent digital competitors from gaining sufficient market share due to their relative obscurity.

LaMonica: And in a non-related fact, Shani loves scratchies.

Jayamanne: I do love scratchies. Just the thrill, you know, the relatively cheap thrill.

LaMonica: It's relatively cheap because I buy them for you. So you get that cheap thrill and then a lot of disappointment afterwards, which is generally the experience people have with me. So one key we think is digitizing lottery products. And we think that's a real opportunity for The Lottery Corp. So it already conducts around 40% of lottery and 13% of Keno sales online.

Jayamanne: Have you ever played Keno?

LaMonica: I have not. Please explain to people why you're laughing.

Jayamanne: I don't know.

LaMonica: Are you implying that a certain demographic that I fit into plays Keno? She is.

Jayamanne: Just draw from that what you will, Mark.

LaMonica: Yes. Well, you make the same joke every episode. So I think people get it by now. So we do think that the lower commission margin paid on online sales more than offsets the impact from the closure of any retail outlets such as Newsagents.

Jayamanne: The Lottery Corp. enjoy a wide economic moat by virtue of its intangible assets, including that brand equity that we spoke about and regulations which limits competition via compulsory licensing. We forecast return on invested capital to remain above 30% over the next decade, comfortably exceeding the firm's 7% weighted average cost of capital.

LaMonica: And one thing I like about The Lottery Corp. should be clear that I do not own it. It has an uncertainty rating of low. So that's a result of some of the things we talked about. Those long dated licenses with an average weighted length of roughly 30 years for lotteries and 24 years for my favorite game Keno. And that provides kind of infrastructure likes, so sort of like Auckland Airport's qualities to this company. However, that Victorian license, which will expire in 2028, we do think that there's a strong likelihood that a second lottery provider will be granted a license. But we do not expect The Lottery Corp. to forego the license completely. And the impact is immaterial to our fair value estimate.

Jayamanne: We assign The Lottery Corp. as standard capital allocation rating based on our assessment of balance sheet risk, investment efficacy and shareholder distributions.

LaMonica: Well, there we go. And we do think that the balance sheet is in sound condition. Earnings have proven relatively resilient throughout economic cycles because people want to gamble no matter what is happening in the world, including during the GFC and the COVID pandemic, which makes sense because if you're stuck in your home, you might as well play the lottery, right? So right now, October 28, it is trading within a range we consider fairly valued. It's trading at $4.97 and our fair value is $5. So we did it.

Jayamanne: We covered the three.

LaMonica: Well, we covered the Nifty Fifty. So technically, we covered 53 shares, although we didn't name all of them. And then we talked about Shani's mate, Phil Fisher. So I think that's enough for today.

Jayamanne: Does he play Keno? Do you know?

LaMonica: Why don't you ask him next time you guys hang out? I think he actually died a couple years ago. Which you should know as his friend. But anyway, if he is still alive and listening to this, I apologize. I'll check afterwards. Quick trip to the internet, Shani. But anyway, thank you guys very much for listening. We appreciate it. Any questions or comments, send them to my email address, which is in the show notes, and we would love a rating in whatever podcast app you use.