HOW TO FIND QUALITY ASX STOCKS


This guide adapts quality investing principles for the Australian Securities Exchange (ASX). While the ASX offers unique opportunities, the fundamental principles of quality investing remain universal.

Quality investing has proven to be one of the most successful investment strategies globally, and these principles apply equally well to Australian companies.

How to find quality ASX stocks

Quality investing is one of the best investment methods in the world, and the ASX has numerous quality companies that meet these criteria.

Globally, quality companies have outperformed significantly. The same principles apply to finding exceptional businesses on the ASX.

What is a quality company?

For legendary quality investor Terry Smith, quality investing is based on 3 metrics:

  • Buy good companies
  • Don’t overpay
  • Do nothing

Chuck Akre’s three-legged stool also offers a great framework for quality investors:

  • Buy good, very profitable businesses with a wide moat
  • With capable and aligned management
  • Which can reinvest a lot of free cash flow in organic growth

Examples of quality ASX companies include CSL, REA Group, and Macquarie Group.

Characteristics of quality ASX companies

Look for companies with: wide moats, aligned management, low capital intensity, strong capital allocation, high profitability (FCF margin >15%), proven growth, and exposure to secular trends.

1. Wide moat (competitive advantage)

What it means: A ‘moat’ is a sustainable competitive advantage that protects a company from competitors, like a castle moat keeps enemies out. Companies with wide moats can maintain high profits for years because competitors struggle to take their customers.

What to look for: Market leaders with strong pricing power, high customer loyalty, network effects (where the product becomes more valuable as more people use it), or high switching costs (where it’s difficult or expensive for customers to change to a competitor).

ASX examples:

  • CSL (CSL.ASX) – Global leader in blood plasma products with specialized expertise and long-term donor relationships
  • REA Group (REA.ASX) – Owns realestate.com.au, the dominant property portal. Agents must advertise there because that’s where buyers look
  • Cochlear (CCH.ASX) – Leading hearing implant manufacturer with high switching costs (patients rarely change brands once implanted)
  • Transurban (TCL.ASX) – Owns toll roads with exclusive long-term concessions (literal monopolies)

2. Aligned management (skin in the game)

What it means: Management teams who own significant shares in their own company have ‘skin in the game’ – they benefit when shareholders benefit, and lose when shareholders lose. This alignment of interests means they’re more likely to make decisions that create long-term value.

What to look for: Look at the annual report’s ‘Director’s Report’ section to see how many shares directors and executives own. Meaningful ownership is typically several years’ salary worth of shares, or family control of the business. Be wary of executives who regularly sell large portions of their holdings.

Why it matters: Studies show companies with high insider ownership outperform by 3-4% per year on average. Owner-operators think long-term and are less likely to chase short-term bonuses at shareholders’ expense.

ASX examples:

  • Premier Investments (PMV.ASX) – Solomon Lew and family control ~45% of the company
  • Lovisa Holdings (LOV.ASX) – Founder Brett Blundy has significant ownership
  • Pro Medicus (PME.ASX) – Founder Dr Sam Hupert owns ~30% of the company

3. Low capital intensity

What it means: Capital intensity measures how much money a company needs to invest in equipment, buildings, and infrastructure (CAPEX) to generate sales. Low capital intensity businesses require minimal ongoing investment to operate and grow.

What to look for: Target companies where CAPEX (Capital Expenditure) is less than 5% of sales. You can find these numbers in the annual report’s cash flow statement.

Why it matters: Low CAPEX businesses generate more free cash flow that can be returned to shareholders or reinvested for growth. They also need less capital to grow, meaning higher returns on invested capital. Think software companies vs. mining companies – software barely needs new investment to serve more customers, while miners must constantly invest in equipment and mines.

ASX examples:

  • REA Group (REA.ASX) – (~2% CAPEX/Sales) – Online property platform requires minimal physical infrastructure
  • Seek (SEK.ASX) – (~3% CAPEX/Sales) – Job advertising platform, mostly software
  • Xero (XRO.ASX) – (~1% CAPEX/Sales) – Cloud accounting software
  • WiseTech Global (WTC.ASX) – (~2% CAPEX/Sales) – Logistics software platform
  • Computershare (CPU.ASX) – (~2% CAPEX/Sales) – Share registry and financial services

4. Good capital allocation

What it means: Capital allocation is how management decides to use the cash the business generates. Good allocators invest in opportunities that generate high returns, while poor allocators waste money on bad acquisitions or projects that destroy value.

What to look for:

  • ROIC (Return on Invested Capital) > 20% – This shows the company earns $20+ for every $100 invested
  • Companies that reinvest most free cash flow into organic growth (expanding the existing business) rather than large acquisitions
  • Disciplined M&A – When they do acquire, they have a track record of successful integrations
  • Sensible share buybacks when the stock is undervalued, not overpriced


Why it matters: Even a great business will deliver poor returns if management makes bad decisions with the cash it generates. A company with 20% ROIC that reinvests all profits will double your money every ~3.5 years through compounding.

ASX examples:

  • CSL (CSL.ASX) – Consistently reinvests in R&D and plasma collection centres, driving long-term growth
  • REA Group (REA.ASX) – Invests in product innovation and selective Asian expansion
  • Pro Medicus (PME.ASX) – High ROIC software business with minimal capital needs
  • Macquarie Group (MQG.ASX) – Known for disciplined capital allocation across economic cycles

5. High profitability

What it means: Profitability measures how much actual cash a business generates from its sales. The Free Cash Flow (FCF) margin shows what percentage of revenue becomes cash in the bank.

What to look for:

  • FCF margin > 15% (preferably > 20%) – If a company sells $100 and has a 30% FCF margin, it generates $30 in cash
  • FCF conversion > 90% – More than 90% of reported profits should convert to actual cash

How to find it: Look at the cash flow statement in the annual report. Calculate: (Operating Cash Flow – Capital Expenditure) ÷ Revenue = FCF Margin

Why it matters: Cash is king. Some companies report impressive ‘profits’ but generate little cash due to working capital needs or aggressive accounting. High FCF margins mean the business is genuinely profitable and has cash to reinvest, pay dividends, or buy back shares.

ASX examples:

  • Pro Medicus (PME.ASX) – (FCF margin 40%+) – Software business with minimal costs and upfront customer payments
  • REA Group (REA.ASX) – (FCF margin 30%+) – Digital platform with high margins
  • WiseTech Global (WTC.ASX) – (FCF margin 25%+) – Software-as-a-service model with recurring revenue

6. Attractive historical growth

What it means: Don’t invest in unproven ‘story stocks’ or the ‘next big thing’. Quality investors want companies that have already demonstrated they can deliver exceptional returns to shareholders over many years.

What to look for: Companies that have generated 15%+ annual returns (CAGR – Compound Annual Growth Rate) for shareholders over at least 5-10 years. This proves the business model works and management can execute.

How to find it: Use stock screeners or financial websites to see historical share price performance. Remember to account for dividends in total returns.

Why it matters: Past performance doesn’t guarantee future results, but a long track record of success indicates durable competitive advantages, capable management, and a proven business model. It’s far less risky than betting on an unproven concept.

ASX examples (companies with 15%+ annual returns over extended periods):

  • CSL (CSL.ASX) – Has delivered ~20%+ annual returns over 20+ years
  • REA Group (REA.ASX) – ~25%+ annual returns since listing in 2006
  • Pro Medicus (PME.ASX) – ~30%+ annual returns over the past decade
  • Cochlear (CCH.ASX) – Consistent compounder for decades
  • WiseTech Global (WTC.ASX) – Strong growth since IPO in 2016

7. Secular trends (long-term tailwinds)

What it means: A secular trend is a long-term pattern or direction that continues regardless of short-term economic cycles. Companies riding powerful secular trends can grow for decades as the trend plays out.

What to look for: Companies that can grow organic revenue (revenue from existing business, not acquisitions) by 7%+ per year for the foreseeable future, driven by structural trends rather than cyclical factors.

Key Australian secular trends:

  • Ageing population: Australia’s population is getting older, driving demand for healthcare. Examples: CSL (CSL.ASX) – (blood products), Ramsay Health Care (RHC.ASX) – (hospitals), Sonic Healthcare (SHL.ASX) – (diagnostics)
  • Digital transformation: Businesses moving from paper/manual processes to software. Examples: WiseTech Global (WTC.ASX) – (logistics software), Xero (XRO.ASX) – (cloud accounting), Pro Medicus (PME.ASX) – (medical imaging)
  • Asian middle class growth: Rising wealth in Asia creates demand for premium products. Examples: Treasury Wine Estates (TWE.ASX) – (premium wine), A2 Milk (A2M.ASX) – (premium dairy), Macquarie Group (MQG.ASX) – (financial services)
  • E-commerce and online marketplaces: Shift from offline to online continues. Examples: Seek (SEK.ASX) – (online jobs), REA Group (REA.ASX) – (online property), Carsales (CAR.ASX) – (online auto)

Why it matters: It’s much easier to grow when you have a strong tailwind. A company in a declining industry must fight for every percentage point of growth, while a company in a growing market can ride the wave upward.

Valuation

For quality investors, the quality of the business is more important than the valuation.

In the long run, your return as an investor is equal to:

Return = FCF growth per share + shareholder yield +/- multiple expansion (contraction)

The longer you invest in a company, the more important the FCF per share growth will become. When you can buy a great business at a fair price, great things will happen.

Note on franking credits: Australian investors benefit from franking credits on dividends, which can enhance after-tax returns. However, don’t let franking credits override quality considerations – the best compounders often pay minimal dividends, reinvesting for growth instead.

ASX-specific considerations

Market concentration

The ASX is heavily weighted toward financials (banks) and resources. Quality investors should look beyond these sectors to find compounding opportunities in healthcare, technology, and consumer businesses.

Smaller market size

Australia’s smaller domestic market means the best ASX companies often need to expand internationally to maintain high growth rates. Look for companies with proven ability to succeed offshore (e.g., CSL, REA Group in Asia, Xero in multiple markets).

Franking credits

While franking is valuable, high-quality growth companies often pay low dividends as they reinvest for growth. Don’t sacrifice quality for franking – the best returns come from capital appreciation.

Liquidity considerations

Some quality small and mid-cap ASX stocks have lower liquidity than US equivalents. Build positions gradually and consider this when determining position sizes

Examples of quality ASX companies

Here are some ASX companies that historically have demonstrated quality characteristics:

Large caps (ASX 20)

  • CSL (CSL.ASX) – Global biotech leader with pricing power and R&D reinvestment
  • Macquarie Group (MQG.ASX) – Diversified financial services with disciplined capital allocation
  • Goodman Group (GMG.ASX) – Industrial property with structural tailwinds from e-commerce

Mid caps (ASX 50-200)

  • REA Group (REA.ASX) – Dominant property portal with network effects
  • Cochlear (CCH.ASX) – Global leader in hearing implants
  • WiseTech Global (WTC.ASX) – Logistics software with high switching costs
  • Xero (XRO.ASX) – Cloud accounting platform with network effects
  • Seek (SEK.ASX) – Leading job portal in Australia and Asia

Small caps (outside ASX 200)

  • Pro Medicus (PME.ASX) – Medical imaging software with exceptional economics
  • Lovisa Holdings (LOV.ASX) – Global costume jewellery retailer
  • Audinate -(AD8.ASX) Audio networking technology (Dante platform)

 

Does this strategy work on the ASX?

Quality investing has proven successful globally, and the ASX has produced exceptional quality compounders.

Companies like CSL, REA Group, Cochlear, and Pro Medicus have delivered 15-30%+ annual returns over extended periods by exhibiting quality characteristics.

The ASX offers opportunities to find quality businesses, though the smaller market size means fewer options than the US. Focus on finding the best companies and be patient for the right valuation.

The Bottom Line

As a quality investor on the ASX, you want to invest in the best companies Australia has to offer. Quality ASX companies have the following characteristics:

  • A wide moat (competitive advantage)
  • Aligned management with skin in the game
  • Low capital intensity
  • Good capital allocation
  • High profitability
  • Attractive historical growth
  • A secular trend / optimistic outlook

When you can pick up these companies at a fair valuation, you will end up with excellent results over time.

The ASX may be smaller than US markets, but it offers genuine quality compounders. Focus on finding them, be patient, and let compounding work its magic.

Compounding can be beautiful.

 

Important disclaimer: These are examples only and not investment recommendations. Always conduct your own research and consider seeking professional financial advice.

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