Chasing performance can lead to poor results but investors can still learn from top performers.

Pro Medicus PME 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.

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. Mark has written more on this topic here.

James Gruber has also written an article on finding 100 bagger which goes through more detail on what to look for.

This episode goes through the full analysis of Pro Medicus as a company, why the share price has gone up so much and the lessons that we can take from Pro Medicus.

Listen to the full episode below. Alternatively, read the full article here.

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You can find the transcript to the episode below.

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.

So, Mark?

Mark LaMonica: Yes, Shani.

Jayamanne: I don't know if you believe in a higher power, but – this is starting very intense – but someone has been listening to us, maybe not a higher power, maybe a restaurateur in Sydney, because you live in Surrey Hills.

LaMonica: I do.

Jayamanne: And there is a restaurant that they are going to start serving Gidley burgers there, right near your house.

LaMonica: I know. I have mixed emotions about it.

Jayamanne: Okay, why? I feel like this is the jackpot.

LaMonica: Well, because it's – I don't know. It's The Gidley. I like going to The Gidley. It's not that far away from my place.

Jayamanne: Okay. Well…

LaMonica: But then according to you, God has brought the Gidley burger to Surrey Hills.

Jayamanne: Yes. So, I think you should give it a go.

LaMonica: Well, there we go. And speaking of food, we start recording this podcast at 2 pm on a Thursday and Shani has eaten her lunch and dinner already.

Jayamanne: Yes, I'm very hungry. Anyway, let's move on.

LaMonica: Okay. So today, we're going to talk about the best-performing ASX share in our coverage universe over the past decade. And of course, we're going to start this podcast with another disclaimer besides the one that Shani just said, past performance has no impact on future performance. But it's worth talking about why the share has done so well and see if it helps us to identify similar opportunities in the future.

Jayamanne: All right. So, let's talk about the share.

LaMonica: Well, we can't just talk about the share right away. We have to add a bit of suspense. And this is where once again, we need the drumroll sound effect that Will continually refuses to do. So, we're going to go through the top five shares and their annualized returns over the past 10 years. So, Shani, you go first. Give us number five.

Jayamanne: All right. So, five is PolyNovo with the ticker PNV. It achieved 32.91%.

LaMonica: It's pretty good.

LaMonica: Four, we have Pinnacle Investment Management with the ticker PNI, and it achieved 36.66% per year.

Jayamanne: Three is Altium with the ticker ALU, 39.93%.

LaMonica: And number two is Hub24 with the ticker HUB, and it came in at a whopping 47.53%.

Jayamanne: All right. And number one is Pro Medicus. Pro Medicus had a 62.98% annualized return over the past 10 years, which is an astonishing return. But the top five are all astonishing compared to the ASX 300, which returned 8.25% a year over the same period.

LaMonica: Yeah. And if we had a time machine, we could go back, start this podcast, and release it 10 years ago and tell people to buy Pro Medicus, and we would probably have the most popular podcast in Australia.

Jayamanne: If only.

LaMonica: Exactly. Okay. So, let's talk a little bit about what Pro Medicus does. So, it is a healthcare IT company specializing in radiology imaging software. So, its main product is called Visage 7, and it's a clinical desktop application that radiologists use to view, enhance, and manipulate images from any device and make a diagnosis off of that. So, its main customers are US private academic hospitals.

Jayamanne: 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.

LaMonica: So clearly, Shani and I are pronouncing this product differently.

Jayamanne: We do have different accents.

LaMonica: Yeah. But I think we're just pronouncing it differently.

Jayamanne: Okay.

LaMonica: I don't think this is an accent thing, but I'm going to stick with my version. And this goes back to what we talked about, stupid names for things. Anyway. Visage 7, when they win contracts with this difficult to pronounce software, the firm has other products that they cross-sell the clients off of this.

Jayamanne: Pro Medicus listed on the ASX in October 2000, but they looked like a completely different company. It was only in 2009 when they acquired Visage that they started to look like the company they are today. Prior to Visage, it had a market capitalization of $115 million. Today, it's over $11 billion.

LaMonica: Okay. So how does Pro Medicus compare to the typical ASX share? Well, we would assume it's different, right? Because the performance has been very different.

Jayamanne: Well, it is. When we look at the ASX 300 Index that skews towards value, Pro Medicus is a growth share. Over 50% of the index is in financial services and basic material sectors.

LaMonica: And of course, as we said, Pro Medicus is in the healthcare sector, which makes up about 10% of the index. And it wouldn't surprise you to know that the index has one of the highest dividend yields in the world. Aussie investors do love dividends. I love dividends. And the market, of course, loves to provide them to us. When we look at Pro Medicus, it is yielding less than 0.5%.

Jayamanne: Another difference is the rate of growth. Pro Medicus has a history of it. If we compare a typical ASX-listed company to Pro Medicus, we can see what we mean by that. So, over the past five 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%.

LaMonica: And this growth, of course, is one of the main reasons that investors are optimistic. And the difference in revenue growth and earnings growth demonstrates another positive trait about the company, which is that margins are increasing. So, let's talk about that for a second and explain what that means.

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.

Jayamanne: In 2014, Pro Medicus had a net margin of 10.59%. So again, in 10 years, it has gone from 10.59% to 49%. This is pretty impressive to say the least. And it's one of the reasons investors love technology companies, it's their ability to scale.

LaMonica: So, while Pro Medicus is technically a healthcare company, as I said, that's the sector it's in, it's really a tech company that operates in the healthcare space.

Jayamanne: Okay. So, let's look at this scalability in practice by comparing Pro Medicus to a hypothetical bank and miner.

LaMonica: Okay. So, 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, basically just borrowing it.

Jayamanne: 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. So that's over branches, IT, et cetera, over a larger revenue base. However, a bank cannot grow loan volume without growing the cost of obtaining the funds to lend out.

LaMonica: For a mining company to grow production, they need to dig more stuff out of the ground. Expanding production is costly, 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.

Jayamanne: A company developing software is different. Highly paid software engineers need to be hired to write the code, but once the product is launched, that cost is the same if the software is sold to one customer or a million customers. There are no additional production costs for each new unit sold.

LaMonica: And of course, there are some ancillary costs around sales and support staff that may be needed as a company grows, but that is only a minimal detraction from the scalability of IT companies.

Jayamanne: Let's move on to operating performance because it's also related to benefits of scalable companies. The return on equity, or ROE, measures how efficiently a company generates profits. Pro Medicus has grown their ROE from 7.24% in 2014 to over 50%.

LaMonica: And we can look at another measure, the return on invested capital, or ROIC, measures how well a company is allocating capital to generate profits. Pro Medicus has grown their ROIC over the same period from less than 7% to close to 44%.

Jayamanne: Over the last 10 years, Pro Medicus has had amazing results. The gain in the share price reflects that fact. So why has the share price gone up so much, Mark?

LaMonica: Well, Shani, more people bought the shares than sold the shares.

Jayamanne: Wow.

LaMonica: And in the case of Pro Medicus, probably a lot more people. But the point of saying that is we don't really know what motivated each buyer of the share, but many of the financial results and measures that we outlined previously are pretty good indication.

Jayamanne: But 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 nine years.

LaMonica: The second component of returns are changes in valuation. A relative valuation multiple, like the price to earnings ratio or P/E ratio, 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.

Jayamanne: 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 five years. Investors pay higher valuations when they have high expectations for the future.

LaMonica: And of course, as Pro Medicus continued to deliver strong results, investors became more confident in future performance. So, 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's case, that was strong growth and improving operating metrics.

Jayamanne: 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. And as we went through before, Pro Medicus has grown earnings rapidly over the last five years. And this earnings growth accounts for roughly 80% of the growth in the share price.

LaMonica: So, this all sounds great, of course. And of course, we sound very pro-Pro Medicus. But is there anything to not like about the company?

Jayamanne: Well, one of the keys to successful investing is buying quality companies at a reasonable price. And there's an issue with Pro Medicus here. The shares are expensive. The P/E ratio is currently over 150, although it is important to note that they've never been cheap. Five years ago, they were trading at 65 times earnings and 10 years ago at 150 times earnings.

LaMonica: And just as a point of comparison, the median P/E of the roughly 200 shares in our Australian coverage universe is around 23.

Jayamanne: So, what do high valuation levels indicate apart from the stock being expensive?

LaMonica: Well, I think, as you said before, high valuation levels indicate investor optimism. And there's a lot of optimism for Pro Medicus. How much of this optimism is based on a realistic assessment of the future and how much his pure hope is unknown.

Jayamanne: As companies grow larger, there is typically a natural decline in their growth rate. And as a result, valuation levels generally start to come down.

LaMonica: And this doesn't necessarily result in a bad outcome for shareholders. 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 that can be an added sweetener.

Jayamanne: So, if you are an investor looking at Pro Medicus now, you are unlikely to see a repeat of the last five years when valuation levels increased substantially, and earnings grew rapidly.

LaMonica: And this hypothesis isn't from some in-depth analysis that we, our analysts have done. It's just common sense that valuation levels on a share trading at 150 times earnings are unlikely to increase substantially.

Jayamanne: But let's talk about what our analysts do think. So, Shane Ponraj covers Pro Medicus. He has done an in-depth analysis and believes the fair value estimate falls at $34.50, which makes the shares roughly 200% overvalued.

LaMonica: He has also awarded Pro Medicus a narrow moat rating, which means that he believes they are able to maintain a sustainable competitive advantage for at least the next 10 years.

Jayamanne: And the headline in his latest research report pretty much sums up his views. Not much to dislike about Pro Medicus' business model but share screen as expensive.

LaMonica: Okay. But the point of this, remember, is yes, to talk about Pro Medicus, but to try to take some lessons from it to identify shares in the future that could do the same thing. So, what are some lessons?

Jayamanne: All right. So, the simple lesson is to find a scalable company that can grow revenue quickly while the P/E more than doubles.

LaMonica: Okay. So obviously, that's a little glib on Shani's part. She has had two meals in the past hour-and-a-half, so maybe she's feeling a little cocky. But really what we want investors to do is to 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.

Jayamanne: 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.

LaMonica: You need to dig around a little bit for these companies. And that's probably in the small cap space, which is not followed by as many professional investors and individual investors.

Jayamanne: Pro Medicus was a small company 10 years ago and not on the radar of a lot of investors. A 63% annualized return over a decade is not going to occur at large, well-known companies.

LaMonica: And 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.

Jayamanne: Ultimately, these stocks exist in a space of high risk for a small potential of high return. It can be part of a long-term investment strategy as long as it is diversified with investments with lower risk and return profiles that match your investment strategy and the financial goals that you're trying to achieve.

LaMonica: All right. Are you motivated to go find the next Pro Medicus?

Jayamanne: No, because I'm very full.

LaMonica: Okay. Well, maybe after Shani has digested, she will be out there looking for the next Pro Medicus and maybe that's something that you'll want to spend time doing. So, thank you very much for listening. We would love any comments or ratings in your podcast apps.