Steve Johnson: Two small caps on a run and the uncovered gems that could be next

The appeal of investing in small caps is clear. The potential to find that overlooked gem that can burst onto the scene is real, and it is a corner of the market where active managers can exploit inefficiencies.

The opportunity exists for several reasons - stocks are often illiquid, creating a barrier for larger investors; there is less analyst coverage and not all investors are playing the same game - time horizons can vary greatly depending on the strategy of the investor.

But it's not all plain sailing, and value can be destroyed as quickly as it can be made. Most small-cap investors will readily chew your ear off with a long list of war wounds that come with the territory.

Nevertheless, it has proven to be a fertile hunting ground for stock pickers with a strong stomach and lured by the prospect of unearthing a future leader. Companies such as Pro Medicus (ASX:PME), Netwealth (ASX:NWL), Breville Group (ASX:BRG) and Pinnacle Investment Management (ASX:PNI) are examples of gems that have emerged over recent years.

However, success rarely comes easily, and the same attributes that make small caps appealing can also prove to be the biggest traps. Business models are often unproven, companies can be more exposed to economic cycles, and the volatility can be gut-wrenching.

Steve Johnson, Chief Investment Officer at Forager Funds, has experienced the highs and lows of small-cap investing over the past 14 years. Johnson made the leap to funds management 14 years ago after starting his investment journey with the Investment newsletter Intelligent Investor. On the surface, it sounds like a straightforward transition, but in reality, the move from researching and writing about stocks to managing a portfolio is fundamentally different.

"For me, funds management is more than half about portfolio management. Having the right weighting in the right stock at the right time is as important, if not more important, than just picking the right stocks to start with. And that's been the massive journey for me as a leader of the organisation and as an investor," Johnson said.

More volatility is coming

Johnson says he has been observing an increase in volatility around earnings over the past decade, particularly in the US. He believes that this trend is making its way to Australia as systematic traders respond in real-time to the latest results.

"It's been a really volatile reporting season in terms of share prices and certainly across my portfolio, both on the winner's side and the loser's side. I don't feel like the results have been as volatile as the share price reactions. So I think that's a feature that's come here."

Unsurprisingly, most of the pain has been in stocks where valuations were rich and expectations high. The positive surprises have come from stocks that have been beaten down in recent years, such as Nanosonics (ASX:NAN) and Peoplein (ASX:PPE), where expectations were low and the results proved better than expected.

Johnson says a common theme from management outlook statements is that the economic environment is stabilising and may have bottomed out. That's good news from a top-line perspective. However, there are lingering issues from the period of high inflation that we've experienced, and keeping a lid on costs has proven problematic.

"In the tourism space, for example, it's still not back to what it was pre-COVID, and a lot of companies are still dealing with wage inflation," Johnson notes.

High-flying small caps and the potential gems Forager has uncovered

The Forager Australian Shares Fund enjoyed a strong year in 2024, returning 27.43%, with stocks like Catapult (ASX:CAT) and Bravura (ASX:BVS) helping to drive these returns. Both stocks had caught Johnson's attention over the years but, in his eyes, were simply too expensive.

In a world that thrives on a diet of instant gratification, patience and long-term thinking remain one of the competitive advantages investors can harness.

Catapult, for example, was listed in late 2014 and promptly rallied from around 60 cents to a high of $3.88 in the space of 18 months. 

Johnson had observed the real-life application of Catapult's products - it was a real business, but the valuation, like the share price, had gone through the roof.

"I'd sit there and say, okay, people are excited about this business, and it's a real product. And it's interesting. I go and look at the financials and say, I just can't make that stack up from a valuation perspective, but the seed is planted," Johnson explained.

"And then we wait for the sentiment to get negative, and it doesn't need to be the case in every stock, but it happens often enough that these things go through the sentiment cycle that at the bottom of the cycle, we sit there and go, well, there's actually something right about what people were thinking at the top, this is a product that's got a lot of demand for it."

Johnson says buying a business at a point of maximum pessimism has become almost exclusively the approach of the team at Forager. That means there'll be a flaw or a problem that needs to be resolved with almost every investment the team makes, and they need to be convinced that there is a clear catalyst or pathway to resolve this issue.

So, what are some of the new opportunities the team has uncovered?

Labour hire business Peoplein (ASX:PPE) is one stock Johnson has identified that has been suffering in the post-Covid period. Peoplein's global placement business contributed more than half of the firm's earnings in 2023 and has subsequently all but evaporated. The other half of the business is labour hire, which Johnson describes as a much more reliable and stable business.

It's a small and illiquid stock - so not one to be piling into but Johnson expects it to earn $15 million to $20 million in cashflow this year with a market capitalisation of just $90 million.

Johnson also says uncertainty in the payments sector has put pressure on Tyro (ASX:TYR) and Cuscal (ASX:CCL) - both holdings in the Forager Australian Share Funds that he believes have the potential to become bigger weights over time.

"We've got government reviews and RBA reviews. There's a lot of uncertainty around what the future revenue model is going to look like there, but a lot of pessimism about the sector. So we've got some investments there that have the capacity to be larger if we get evidence that we're right," Johnson told Livewire.

A contrarian view on the US economy

As you might have gathered, Johnson isn't afraid of making a contrarian call. Right now, there is a prevailing narrative focused on US exceptionalism. These market narratives can be dangerous, and Johnson's view is that the widely held view that investing in the US is the path to riches has run too far. 

That's not to say Johnson doesn't like US companies, in fact, he believes US management and board teams are world leaders when it comes to realising value for investors. 

The glitch, again, is that optimism is high, and stocks look expensive.

"I think you'll do better out of other parts of the world than you do out of the US over the next 10 years simply because the starting valuations are far too high," Johnson said.

To learn more about the opportunities Steve and the Forager team are seeing, visit their website.