Where Steve Johnson is finding individual value in expensive stock markets

2024 was tipped as the year for small caps, but has it played out? Forager Funds Management’s Steve Johnson notes that in aggregate, small-cap indices haven’t done that well, but then again, arguably much of the market outside the Magnificent Seven hasn’t either. Perhaps a fairer assessment is that 2024 has been the year of the stock picker instead.

“If you own the right stocks, they have been performing very well. 

And the lack of homogeneity in returns means there are still plenty of opportunities to recycle capital back into some of the more prospective under-performers,” Johnson says.

Johnson notes that not only are large caps trending expensive relative to history, but they are, on average, pricing for mediocre longer-term returns. There’s more to like in the small-caps space which is relatively cheap and Johnson is confident there remains a good relative decade ahead of them.

“I would estimate that you will get returns of 8-10% on average in small caps – consistent with historical equity market returns,” he says.

In this Rapid Fire interview, Johnson discusses the macro themes he is watching, the opportunities he is watching in Australian and US tech stocks, as well as why he aims to shed at least 10% of his portfolio each year. He also shares one of his early investing lessons.

What are the three biggest macro concerns you are monitoring in the portfolio? How have you adjusted your portfolio for these?

The number one concern for me is the Chinese economy and what impact a long-term slowdown might have on the Australian economy. I have been worried about that for 10 years but the problem is worse, not better. They are far too dependent on construction to drive economic growth and need to shift the focus to domestic consumption.

India’s economy could be where China was two decades ago and might pick up a lot of the slack, but it could be a bumpy ride for iron ore and coking coal – Australia’s two biggest exports.

We haven’t changed anything dramatically as this is a long-term concern, but we are very wary about those two commodities in particular.

Second, I think markets will start turning their attention to structural fiscal deficits around the world. The US is close to full employment yet is running a government deficit that has only been seen in war years before this. I think people start to worry about this and the US dollar at some point.

And then I would throw housing into the mix here in Australia. I don’t see how it gets resolved but it’s not healthy to have a system where the only people who can buy their first home are the ones with rich parents.

2024 was tipped as the year for small caps. How has this played out?

I’d say it is going very well so far. Both of our Funds are doing very nicely year to date. Although small-cap indices haven’t been great in aggregate, if you own the right stocks, they have been performing very well. And the lack of homogeneity in returns means there are still plenty of opportunities to recycle capital back into some of the more prospective under-performers.

What valuations are you seeing across the market for large caps compared to small caps?

Large caps are expensive relative to history. Small caps are relatively cheap. Less so in absolute terms but I am very confident small caps have a good relative decade ahead of them. I would estimate that you will get returns of 8-10% on average in small caps - consistent with historical equity market returns – whereas large caps are priced for mediocre long-term returns from here.

It has become self-fulfilling given the amount of money flowing into passive funds but the current valuation for Commonwealth Bank (ASX: CBA) will be very hard to live up to.

If you take the S&P 500 and compare it to the All Ordinaries Index, it is clearly a lot more expensive. At close to 26x expected earnings, the US benchmark is trading near all-time highs. 

If you look at the components, though, the US has a much heavier weighting to growing tech companies, versus our index which is heavy on banks and resources companies. If you look at the sub-sectors, there isn’t much difference between valuations there and here. 

We are buying some discretionary retailers in the US that are dramatically cheaper than the equivalent business here. Therefore, I wouldn’t read too much into the aggregate.

Technology is one of the biggest sector positions in the Australian shares portfolio. Where do you see some of the key opportunities in the Australian tech space and how do you evaluate such investments?

Forager doesn’t treat tech stocks any differently than other types of companies. We work out how much cash the business is going to generate and try and buy them at significant discounts to the present values of those cash flows. We usually expect tech companies to grow a lot more. And the good ones can generate very high-profit margins. But we use exactly the same valuation methodology for the mining services companies we own.

Our most fruitful tech investments have been in enterprise tech.

Years ago, we did well out of GBST (ASX: GBT) and Hansen Technologies (ASX: HSN). More recently, mining software company RPM Global (ASX: RUL) and utilities tech company Gentrack (ASX: GTK) have been great investments for us.

The good thing about enterprise tech is that the sales cycles can be long and one or two contracts can impact investor sentiment. While the underlying business is usually rock solid, investor perception of these companies can change dramatically from year to year. This has meant we have been able to pick up some great bargains and, when sentiment swings the other way, make profits of several times our investments.

Catapult (ASX: CAT) and Readytech (ASX: RDY) are two of our largest current investments and I still think there is plenty of appreciation to come.

What key themes do you like in US tech and can you share 1-2 stocks you have invested in?

To be honest, it has been a hot sector and we are finding better value elsewhere.

One space where there is some pessimism is green tech. Investors are fearful of the impact of a Trump presidency on this sector and share prices have tanked. One of our most prospective investments is Nextracker (NASDAQ: NXT), a US company that provides solar tracking hardware and software to solar farms. It’s cheap, and we think that sector keeps growing irrespective of who is in the White House.

Have you sold any holdings in the last year in either portfolio because the investment thesis changed?

Yes, we try and do that every year. 

It’s my view that you should try and cut at least 10% of your portfolio each year. 

Especially when taking a differentiated or contrarian view of the market, it’s important to recognise that you are going to get it wrong regularly. 

Being wrong isn’t a failure, it is a normal part of business and the earlier we can recognise it the better.

For us, that has been the case in the health sector recently.

Cost inflation has severely curtailed the value of these businesses and we cut our investment in Integral Diagnostics (ASX: IDX) as a result. And we have had a good cleanup at the small end of our international portfolio. 

The COVID-related bust-boom-bust cycle made forecasting sustainable earnings difficult and we made the mistake of assuming some companies could hold on to their elevated profits into the future. There is still plenty of this to unravel – witness the auto dealerships here in Australia – but we cut US power sports company RumbleOn (NYSE: RMBL) and oversized menswear retailer DXL Group (NASDAQ: DXLG) once we realised 2025 would look a lot more like 2019 than 2022.

Can you share the strangest thing/most interesting fact you’ve ever heard/learnt about investing/your investment style?

When I was in my mid-twenties and writing research for Intelligent Investor, a client sent us a letter that said “I have never met you, but I know that you are young and that you are male. Only a young male could be that confident”.

That letter always stuck with me. I have learned the hard way that overconfidence is a killer in the investment business. 

Great investment ideas are rare, but they are not so rare that you need to risk an irresponsible percentage of your portfolio on any one of them. The inherent uncertainty in life means there is no such thing as a sure thing. 

Learn more about how Forager seek meaningful long-term returns from investments in unloved, under-researched and undervalued stocks here. 

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