How to make the most of the coming small cap rally

Without further delay, let's welcome our first speaker this afternoon, Stephen Johnson, the Chief Investment Officer and one of the founders at Forager Funds.

Steve lives in Sydney, enjoys marathon running, and regularly appears on Auspice, the ABC, CNBC, The Fin Review, and The Australian.

His presentation topic today is how to make the most of the coming small cap rally.

Welcome to the presentation, Steve.

Thank you very much for having me on and hi everyone.

Yes, that's exactly what we're going to talk about today.

There's a lot of people out there talking about the opportunities in small caps.

I'm going to take that as a little bit of a given and move on to how best to make the most of the opportunity that is out there.

Before I kick things off, today's presentation is general advice only.

It does not take into account your personal circumstances and you should seek professional advice where necessary.

I started Forager back 14 years ago now and it's been a marathon itself, that 14-year period with plenty of ups and downs for markets throughout the period.

It's probably been one of the more

volatile periods in history so lots of fun and lots of opportunities along the way as well.

We run two funds one of them invests in international equities only that's our Forage Australian shares fund about $210 million and the Australian shares fund $152 million at the moment and I'll touch a little bit on both of those funds later in today's presentation.

but as you can see they were up to $360 million.

Both funds are more than 10 years old and most of our clients have been with us for most of the life of the firm really and grown their wealth alongside our returns.

We have a very long-term focus and we tend to attract clients who feel the same way about the world.

What do we do here at Forager?

I think a lot of people talk about the long term but we've really worked hard to set our business up so that we can actually genuinely be long term.

We've already touched on attracting the right sort of investors.

It is super important if you're a fund manager and your clients are going to pull money out in difficult market times it makes it very hard for you to focus on anything other than the next couple of months.

We are very capacity conscious as a firm.

I think it is the number one factor that kills returns for fund managers is that they get too big and they can no longer do what has been successful for them as a strategy.

The number of companies that you can invest in falls dramatically as you get bigger in terms of funds under management.

We closed our Australian fund back in 2016.

We think our international one can be bigger, but it still needs to be relatively small so that we can keep investing in that smaller end of the market.

I and we are naturally contrarian.

We have been fully invested at every market bottom, usually too early, but every market bottom over the past 14 years.

I like buying things when share prices are down and when everyone else is pessimistic about them.

And that is the crux of a strategy that has worked for us over that period.

And we are now an experienced investment team.

I was 30 years old when I started this business and still young.

That had some advantages and some disadvantages as well.

But we now have a team of people that we've built up over that time.

We've all been working together for a long period of time now.

And it's more than just me, which is a great thing, both for our portfolio management and our idea generation as well.

that creates a focus on smaller companies.

We can and do own big companies.

People do get pessimistic about them from time to time.

Companies like Meta have fallen by two-thirds and then tripled over the course of the past 18 months.

So it happens at the big end of town as well, but there are a lot more opportunities at the small end.

We run small portfolios.

Our clients expect us to change them quite dramatically.

We are not

a small cap quality manager.

We will buy quality small cap companies when the price is right and we will buy banks and deep value opportunities when the price is right on those.

So our portfolios do adapt and change to the opportunity set that's in front of us at any particular point in time.

And we have put a lot of work over the past 14 years into distilling what was in my head as an investor into a process that we can execute on as a firm.

The ideas are plentiful.

They come up a lot.

There's a lot of due diligence and work that needs to go into working out whether that idea is something that is a great investment or it's just an idea that needs to remain as a thought bubble.

and our job is to deliver long-term performance that is in excess of what you can get from investing in index funds.

I have been kicked out of the active investors club in Australia for suggesting that index funds are a very sensible core of people's portfolios.

It's our job to do better than that.

That has been very hard over the past five years we're about to talk about because

large cap big companies have done very very well relative to small ones but it has not been impossible and I think over longer periods of time and in the future there are lots more opportunities for active management at the smaller end of the market.

As I touched on we are contrarian I think

The what is more important than the why when it comes to investing.

And that means looking for great setups out there in the market.

So I always actually start with why might something be cheap before I go and do the analysis on it.

And I've said publicly, I think you could generate

returns, good returns on the stock market without ever looking at a P&L and a balance sheet, just by being an expert on investor psychology, buying things when everyone is being overly pessimistic and selling them when they're being overly optimistic.

That is the crux of what we do here.

We do it within sectors, within specific companies and within the whole market as well.

And then we have these pockets of expertise, industries that we've had a lot of experience with over the years that have done really well for us.

we've been able to execute on things like airport investments in different markets in different places around the world and at different points in the cycle time and time again because we had that experience and people have brought that experience to the team.

All right so where do we sit now this is a chart of the small ordinaries index versus the all-ordinaries index over time.

If we wound this back 20 years

less so in Australia but particularly globally small cap stocks have actually done better than large cap stocks.

They've typically had more growth in terms of their earnings and you typically get paid for the fact that they are more volatile so the historical returns have been higher but you can see on this chart the past five years it's been pretty horrendous in terms of small cap performance.

In fact up until that rally that we saw in November and December

you'll barely break even on small cap stocks over the past five years, while if you'd been in the All Ordinaries Accumulation Index, heavily weighted towards large cap stocks, you're up 40% over that same period.

The same has been true internationally.

This is US stocks, and this is a valuation, so a PE multiple rather than overall index level.

You can see historically small caps traded at a PE premium to the larger end of the market,

That has not only come back to average but is trading at record lows in terms of the valuation difference between small and large cap stocks.

You've probably seen a lot about this over the past few months.

A lot of small cap fund managers and maybe we're a bit guilty as well making excuses for their performance by painting this picture of small cap underperformance.

I do think it is going to change I think we've already seen the start of that change but I actually want to spend more time today talking about the types of stocks that I think you can already do well out of and that you're going to be able to do well out of in future.

So this is GEMTRAC I don't know if you're familiar with the company or not it's an ASX listed stock it's actually listed on the New Zealand Stock Exchange and a Kiwi business.

It went through a really horrible period back in 2019-20

the share price was down to near a dollar you can see our purchases of that stock we often have to wait a long time as you can see on this chart we did not make returns for a very long period of time but that share price has gone from a dollar fifty to this morning seven dollars fifty over the course of the past 18 months and it's done that because it's been able to turn its profitability around and it's growing the top line and

I think this is the recipe for small cap performance at the moment.

The market is actually putting pretty full valuations on businesses that are profitable, generating cash, and growing.

And if you're not ticking those three boxes, then you need to start ticking those three boxes if you want your share price to go up.

And I think there's a lot of opportunities identifying those companies that were like GenTrak two years ago, not profitable, people very worried about the growth line, able to turn that around, and then the market is putting very full valuations on you.

You can see what's happened here this is the share price against them the consensus view of earnings for this company 2023.

You can see that the people expected it to be loss making back at the September 2022 so this is looking forward a year by the time that year it actually run its course people were expecting it to be making 10 cents a share in profits and now the expectations are that that is going to keep growing from there.

So

You grow the earnings, you beat people's expectations and the share price is going to follow and I think that's where the opportunity is.

Lots of stocks in our portfolio are meeting this criteria at the moment.

RPM Global, the largest investment that we've got, it's gone sideways share price wise for three years.

The company is delivering on growing earnings revenue and cash flow and you're now starting to see that turn up in the share price there as well.

So I think that is the opportunity out there.

We've got a portfolio very heavily skewed towards small cap stocks at the moment and really focused on those businesses that we think are on the cusp of the transformation.

There's no point buying the expensive gen track today.

It's all about finding the stock that can transform itself into a gen track over the next couple of years.

And we own quite a lot of them.

We've also put out an announcement.

Our Australian shares fund is listed on the stock exchange.

It's a closed ended vehicle at the moment.

It's been trading at a big discount, as you can see on this chart, for a lot of the past four years.

And we've put out an announcement saying it's our intention to put a proposal out there to delist this.

This is an opportunity for people at the moment.

You can still buy the vehicle at a discount.

You can participate in this small cap outperformance over the next five years.

And also, we think a portfolio of stocks that's going to do better than that small cap index as well.

Our international shares fund like I said small cap performance has been bad relative to large cap performance globally as well.

You can see here our funds returns so that index that Morningstar has put us in because we own mostly small cap stocks is the small and mid cap index.

It's done 10.4% over the past five years

the fund has managed to do 12 per cent per annum against that index.

Again, as I showed in the earlier charts, I think the environment is ripe for a period of small cap catch-up here in terms of performance.

That's a wrap of my 10 minutes and we'll move on to questions.

Thanks for your presentation, Steve.

Meta, Nvidia, and some of the other large tech businesses are great companies.

Therefore, what do you think it will take to change the large-cap outperformance?

I think it's fair to say they are as good a business as we've ever seen the large-cap companies at the moment, and they have better growth prospects than large companies typically have.

And I'm not, as I've said in this presentation, I'm not betting that that has to revert to the mean.

But I think what has happened is the quality of those businesses has become self-fulfilling.

The share prices have become very full relative to the earnings that we can see them making, whereas there's a lot of value at the other end of the market.

I also think as I said earlier investors can get exposure to those big blue chip companies through the core of their portfolio and I think they should actually be doing that in a very low cost way.

If we can deliver people double digit returns as a satellite and it comes at a bit different times from when those large caps are performing then I think that is in addition to people's portfolios whether or not that catches up or not over time.

As there's often less available data or broker coverage on small cap stocks

What other methods do you use for research?

Yeah, I mean this is the opportunity in small cap stocks.

I think knowing something that is widely known by everyone else is never going to make you a lot of money in the stock market.

It's all about finding information that other people don't have.

So for me that is actually scouring the details in annual reports.

I like reading them cover to cover and trying to find things that are not in the presentation.

And then we use expert networks so they're expensive but available to institutional investors.

You can effectively hire people that work in particular industries.

I use my own contacts a lot like that my LinkedIn our own client base we have 1400 clients

lots of them are doctors and business owners and people that work in particular sectors and it really is a mosaic of trying to pull all of this disparate information together into a thesis that is simple and that makes sense.

Thanks Stephen, it's great to see you.

Thanks so much Angelina, it's been great being on.