Lessons from the top performing ASX share
Chasing performance can lead to poor results but investors can still learn from top performers.
Mentioned: Altium Ltd (ALU), HUB24 Ltd (HUB), Pro Medicus Ltd (PME), Pinnacle Investment Management Group Ltd (PNI), Polynovo Ltd (PNV)
Pro Medicus is the best performing ASX share in our coverage universe over the past decade. It would be remiss to not state that past performance has no impact on future performance. However, it is worth examining why the share price performed so well to try and identify top performers in the future. Here is the list that Pro Medicus sits atop which represent the top 5 highest performers in our ASX coverage universe and the annualised return over the past decade:
These are eye-popping returns considering the ASX 300 returned approximately 8.25% a year over the same period.
Pro Medicus overview
Pro Medicus is a healthcare IT company specializing in radiology imaging software. Its main product, Visage 7, is a clinical desktop application that radiologists use to view, enhance, and manipulate images from any device and make a diagnosis. Its main customers are U.S. private academic hospitals.
Currently, Visage 7 is limited to radiology departments, but Pro Medicus is aiming to extend the product set to other specialty departments including cardiology and ophthalmology. In addition, when winning contracts, the firm has other product offerings such as Open Archive or Visage RIS that it can cross-sell to clients.
Pro Medicus initially listed on the ASX in October of 2000. However, the company started down the pathway to what it is today in 2009 when it acquired Visage. Prior to the acquisition it had a market capitalisation of $115 million. Today it is over $11 billion.
How does Pro Medicus compare to the ‘typical’ ASX share
Pro Medicus is different than many ASX listed shares. The ASX 300 index skews towards value. Pro Medicus is a growth share. Over 50% of the index is in the financial services and basic materials sectors. Pro Medicus is in the healthcare sector which makes up approximately 10% of the index. The index has one of the highest dividend yields in the world. Pro Medicus is yielding less than half a percent.
A history of high growth
Another difference between Pro Medicus and the typical ASX listed company is the rate of growth. Over the past 5 years the average annual revenue growth rate for Pro Medicus is over 35%. The average annual earnings growth rate is even more impressive at over 44%.
The growth is certainly a key reason for investor optimism. Yet the difference in revenue growth and earning growth demonstrates another positive trait about the company. Margins are increasing.
The net margin is the difference between revenue and profit. If there are $100 of sales and $10 of profits the net margin is 10%. When earnings grow faster than revenue the margin is expanding. And Pro Medicus has enviable margins. The net margin is 49% meaning almost half of every dollar of sales is profit. This compares to a median net margin of 6.55% for the roughly 200 ASX shares in our coverage universe.
In 2014 Pro Medicus had a net margin of 10.59%. This impressive expansion of net margin is one reason investors love technology companies - their ability to scale. And while Pro Medicus is a healthcare company it is really a tech company operating in the healthcare space.
Scalability in practice
We can compare Pro Medicus to a hypothetical bank and miner to illustrate scalability.
If a bank wants to grow revenue more money must be lent. That money has a cost which is either the interest paid for customer deposits or the cost of sourcing that money in the open market – borrowing it.
Bank investors are interested in the difference between the cost of funds and the interest rate received on loans. This is called the net interest margin. There are advantages to scale in banking as larger banks can spread fixed costs (branches, IT, etc.) over a larger revenue base. However, a bank cannot grow loan volume without growing the cost of obtaining the funds to lend out.
For a mining company to grow production they need to dig more ‘stuff’ out of the ground. Expanding production is costly. It takes more equipment and more employees to increase production. Developing a new mine site requires costly investments in infrastructure. Mines are typically remote which makes everything more expensive. In many cases these investments are needed just to maintain production as resources deplete.
A company developing software is different. Highly paid software engineers need to be hired to write the code. But once a product is launched that cost is the same if the software is sold to one customer or 1 million customers. There are no additional production costs for each new unit sold.
There are some ancillary costs around sales and support staff that may be needed as a company grows but that detracts little from the scalability of IT companies.
Operating performance
Pro Medicus' operating performance shows the other benefits of scalable companies. The return on equity (“ROE”) measures how efficiently a company generates profits. Pro Medicus has grown their ROE from 7.24% in 2014 to over 50%.
The return on invested capital (“ROIC”) measures how well a company is allocating capital to generate profits. Pro Medicus has growth their ROIC over the same period from less than 7% to close to 44%.
Over the last 10 years Pro Medicus has had amazing results. The gain in the share price reflects that fact.
Why has the share price gone up so much
The short answer is that more people have bought the stock than sold it. In the case of Pro Medicus a lot more people. We don’t know what motivated each buyer of the shares but many of the financial results and measures I outlined previously are a good indication.
What we can do is break down the components of returns. Shareholder returns come from three places. The first is dividends. In the case of Pro Medicus this is negligible. The dividend has risen quickly but has never even approached a 1% yield over the last 9 years.
The second component of returns are changes in valuation. A relative valuation multiple like the price to earnings ration (“P/E”) indicates how much an investor is willing to pay for earnings. If over time an investor is willing to pay more for a given amount of earnings the share price will go up.
In the case of Pro Medicus the P/E ratio has more than doubled. This accounted for roughly 20% of the rise in the share price over the last 5 years. Investors pay higher valuations when they have high expectations for the future.
As Pro Medicus continued to deliver strong results investors became more confident in future performance. This often happens as many investors exhibit recency bias. We expect what happened in the recent past to continue in the future. In Pro Medicus’ case that was strong growth and improving operating metrics.
The last component of returns is growth in earnings. What an investor is willing to pay for earnings is important. But the level of earnings matters. As discussed previously, Pro Medicus has grown earnings rapidly over the last five years. This earnings growth accounts for roughly 80% of the growth in the share price.
Is there anything to not like about the company?
The shares are expensive. The P/E ratio is currently over 150 although it is important to note they have never been cheap. Five years ago they were trading for 65 times earnings and ten years ago at 150 times earnings.
As a point of comparison, the median P/E of the roughly 200 shares in our Australian coverage universe is around 23.
High valuation levels indicate investor optimism. And there is a lot of optimism for Pro Medicus. How much of this optimism is based on a realistic assessment of the future and how much is pure hope is unknown.
As companies grow larger there is typically a natural decline in their growth rate. As a result, valuation levels generally start to come down.
This doesn’t necessarily result in a bad outcome for shareholders. If the rate of valuation contraction is less than the rate of earnings growth the share price will still rise. Dividends often rise after a company matures and can be an added sweetner.
Investors that purchase Pro Medicus today are unlikely to see a repeat of the last 5 years when valuation levels increased substantially and earnings grew rapidily. That hypothesis is not the result of an in-depth analysis. It is just common sense that valuation levels on a share trading at 150 times earnings are unlikely to increase substantially.
Morningstar analyst Shane Ponraj has done an in-depth analysis. His fair value estimate is $34.50 which makes the shares roughly 200% overvalued. He has awarded Pro Medicus a Narrow Moat Rating and the headline in his latest research report sums up his views “Not much to dislike about Pro Medicus' business model, but shares screen as expensive.”
What lessons can we take from Pro Medicus
The premise of this article was to explore the lessons we can take from the top performer in our ASX coverage universe. The simple answer is to find a scalable company that can grow revenue quickly while the P/E more than doubles.
And while that is glib it is also true. Spend some time thinking about what factors can lead to extreme revenue growth for a company. Think about the type of business the company is in and the impact on costs as revenue grows. Is it scalable and will margins and returns on capital and equity increase over time if revenue grows? If so, investors will respond and you may see rising valuation levels.
Finding these great companies before they become investor darlings is hard. Once discovered valuation levels will shoot up which will lower future expected returns no matter how much earnings grow.
You need to dig around for these companies in the small cap space which is not followed by as many professional and individual investors.
Pro Medicus was a small company ten years ago and not on the radar of a lot of investors. A 63% annualised return over a decade is not going to occur at large, well-known companies.
The final thing to note is the business risk for small companies with unproven products that may experience rapid earnings growth is high. That means for every Pro Medicus there are countless companies that don’t make it. I’ve written more on this topic here.
And finally, my colleague James wrote a great an article on finding 100 bagger which goes through more detail on what to look for.
