Steve Johnson: "A lot of really stupid shit happens when interest rates are 0%"

I have always liked Steve Johnson's market commentary. As far back as my first media appearances in 2015, he was someone that I looked up to and admired, both for his knowledge and the way he talked about markets.

In my experience, Johnson is someone who always speaks the truth, allowing him to get away with saying things others can’t… or at least shouldn’t try.

So, whilst the headline and direct quote from Johnson above wasn’t a surprise, it was also equal parts entertaining and insightful given what we have seen in markets of late.

For context, Johnson was talking about the failure of SVB and the distortions created in markets due to record-low interest rates, but the comment is also an insight into the way he and his team manage money.

They don’t take untoward risks, they have a long-term perspective, they don’t mind being contrarian if the evidence stacks up, and they know that things can and do change – often rapidly.

The Forager Australian Shares Fund has the mandate to invest in 20-40 stocks across all market caps, to simply take advantage of the best opportunities.

Here are some of the other key insights, from the recent Forager webinar, the recording of which is below. 

Reporting Season Takeaways

• Wage inflation continuing: Companies are struggling with a very tight labour market, having difficulty filling open positions, having to pay more to retain staff. Lumpy across different industries
• Discretionary consumption environment is weaker: waning appetite for big-ticket items: housing, furniture, vehicles, white-goods
• Continuation of higher inventories: Supply chain problems have not gone away completely. Many management teams cautious about keeping enough inventory on hand, in case things deteriorate from a supply chain perspective
• Interest costs up and set to continue rising: will continue to be a feature in the second half of 2023

"Trying to establish the sustainable level of earnings for businesses is as difficult as it has ever been", says Johnson.

Key holdings in the Forager Portfolio

Tourism Holdings (ASX: THL)

• High yields on recreational vehicles
• Fleet constraints – not enough vehicles available for the demand
• Apollo merger to drive higher yields and ROE
• Results were solid and the combined business provided forecasts which were stronger than the previous individual (pre-merger) forecasts
• On track to achieve $27-31 synergy target with some upside on North America.
• Very dominant position in Australia and New Zealand

Qantas (ASX: QAN)

• Strong 1H23
• Record profits and cash flow
• Have been taking some off the table as the stock grinds closer to Forager’s fair value
• Might look cheap on 5x ’23 earnings but the earnings conditions are quite benign
• Whilst some structural changes made through covid could make the business more profitable long-term, the current macro conditions make things very difficult

RPM Global (ASX: RUL)

• Business transition from upfront licenses to ongoing subs hiding true business profitability
• Sticky customers – high switching costs lead to reliable, predictable revenue
• Added $3.4m of annual recurring revenue (ARR) in the first six months of the year and there is a big pipeline for 2H
• Confirmed guidance for $14.2m of EBITDA for FY23 despite reduced low-margin revenue

Integral Diagnostics (ASX: IDX)

• Established, mature and defensive diagnostic imaging business with strategic appeal
• Revenue recovering as COVID impacts abate
• Volumes recovering throughout the year
• Upcoming Medicare indexation an important catalyst for the business – last year was 1.6% which was very little considering broader inflation and the business’ increased costs. New number should help margins and close the gap.

Forager's Outlook

• The coming tsunami of fixed-rate mortgage expirations is a concern: In 2023, 50% of fixed-rate mortgages in Australia are due for refinancing or change to a floating interest rate
• Another 20% will occur in 2024
• The average fixed mortgage is currently paying 2%. Those rates will need to be refinanced somewhere between 5-6%.
• This does not bode well for consumer discretionary stocks

"It is very clearly going to be a very difficult, perhaps extremely difficult, year for some segments of the Australian consumer. We’re not seeing share prices that reflect any sort of distress about the long term earnings capacity of these businesses. It seems like the sort of environment where we can get a lot more pessimism about these businesses than we’re seeing at the moment."

These sentiments are all reflected in the way the portfolio is currently constructed.

The Forager Australian Shares fund over the past three years has reduced the percentage of sub-$200 million market cap companies from around 44% of the portfolio, to just 21% of the portfolio today.

Furthermore, the percentage of $200 million-$1 billion market cap companies has increased from 41% in 2021, to 58% in 2023.

The fund also currently holds around 11% cash (this will rise to approximately 14% once the Nitro takeover goes through) – the highest cash level, by far, in the past three years – although some of this has been driven by takeovers (as noted above) and profit-taking.

"There is still a lot of skittishness out there amongst investors and I think it’s the type of environment – with so much uncertainty about the consumer – where we are going to see opportunities to deploy that capital at highly attractive rates of return," Johnson added.