Value versus growth: Forager Funds

This week’s fund manager interview is with Steve Johnson, the Founder and Chief Investment Officer of Forager Funds.

Forager is a nine-year-old fund that’s going pretty well, but Steve and Forager are value investors and value investing in general has had a hard time over the past few years — it’s been all about growth investing, which is to say buying expensive stocks and watch them get more expensive. 

Steve’s mantra, and has been all his life, is buying cheap stocks.  

He reckons that type of investing will definitely come back into its own, that the outperformance of growth over value will reverse at some point and who’s to say? I think he’s probably right. But I think it’s very worthwhile listening to Steve. 

He’s got very interesting and sensible methods of finding stocks to invest in. He talks about some of the stocks and he talks about some of his big themes. 

Here’s Steve Johnson, the Chief Investment Officer of Forager Funds. 

Steve, I first met you a long time ago when you were running Intelligent Investor with Greg Hoffman, and you said at the time that you and Greg were fanatical value investors, had been I think for quite a while before that even, and the problem is that the last few years have been not great for value investors.  How do you feel about your value investing mantra now?

Yeah, it’s actually been – I mean there were obviously lots of great opportunities coming out of the financial crisis but if you look at the overall numbers I think it’s actually been a very difficult decade or more.  I think you had value investing had a bit of a renaissance in that early 2000s and ever since then it’s been growth stocks that have delivered the goods on average, so it has been I guess a more difficult backdrop.  Really, though, I think if you do it right and you buy business that are going to pay you cash flow at the right price, you’re not dependent on the market rewarding those value opportunities. 

I think a lot of the excuses that are being made and a lot of the mistakes that have been made over the past 10 years, the reality is the businesses that people have bought just haven’t generated the profits or the cash flows that they expected and I think a lot of that has been real rather than just some market backdrop and there’s been a lot of changes to some traditional businesses out there that have done a lot of damage.  I think we’ve done relatively well over that period, there’s been enough opportunities for us to make money out of them and I’d prefer that the backdrop didn’t change that much to be honest with you, because if you want to find cheap stocks you need a bit of negativity out there.

That’s very interesting.  You seem to be saying that it’s not so much some kind of difference between value and growth and that value has underperformed, growth has outperformed, but it’s more that the companies you would have thought were cheap, turned out not to be cheap, is that what you’re saying?

There’s certainly been an element of that.   I think it has taken on a life of its own now that growth has performed so well that everyone has just wanted to buy growth stocks and there are some growth businesses out there at the moment that I think are very, very stupidly over-priced.  But I’m not sifting through the other end of the market and finding lots of screening opportunities which says to me the underperformance has partly been driven by some very real factors.  You look at the businesses that were what you’d call traditional value stocks, a lot of them are in places like the media industry that has been up-ended by the internet and you look back at it and you say, well you could have paid 5 or 6 times earnings for some of those businesses and done very poorly and on the other side of the spectrum you could have paid 20 times earnings for some businesses like REA and done very well out of it.  I don’t think the backdrop has obviously played a factor and I think it has taken on a life of its own of late, but I also think there’s been some real issues out there that people have missed and people have underestimated and we’ve made some of those mistakes ourselves.  We’ve certainly not immune to it and we’re constantly trying to improve the way that we do things.

In fact, I thought it was great the way you started your most recent quarterly report.  Maybe you do it with everyone, I’ve just read this one, and you started it with talking about your bloopers, which I thought was great.  I mean, nobody does that and it’s fairly, I think, instructive.  Before we get into the actual bloopers that you talked about, Technicolour and Thorn Group, you also talked about another factor which had dragged you down which was a large amount of cash in the funds.  Why was that there?

This is something that I think, we’ve got to work harder on is, the cash for us historically has just been a function of what we do elsewhere.  We haven’t historically sat there and said, “We want 35% cash…” But we’ve owned a portfolio and really in both our Australian and international funds we’ve had a huge year in the 2017 financial year, a lot of the stocks that we bought went up a lot and when they go up a lot and they’re not going to deliver the returns that we expect anymore, we sell them and the cash fell out of all of those decisions about selling individual stocks and we didn’t really sit there and say, we’re now at 25% cash.  Are we sure we want to sell this stock or is there something  else that we can do here in order to keep that cash weighting lower. 

Of course, it’s easy in hindsight, markets have rallied higher and you would have been better off having less cash, that’s very easy to say.  Historically, it’s worked well for us to sell into those very strong markets and then we’ve had periods of turmoil where we’ve been able to redeploy it.  But over the past 12 months it’s been a significant dragon.  I think ultimately people pay us to invest their money in the stock market and we want to be more considered about how much cash we end up with.  It doesn’t mean we’re not going to hold lots of cash, it just means I want it to be a conscious decision rather than just a factor of what’s happened elsewhere. 

That can be just little things, like we’re selling something here that was 4-5% of the portfolio.  There are a few places that we can increase our weightings by 1% so that our impact on cash is only 2% instead of 5%, and just being more disciplined about that sort of thing as the cash weighting gets up.  It’s something that I’m actually – and this a bit odd for a value investor, but I’m actually a very firm believer in being mostly invested most of the time and I don’t want us to end up in situations where we hold truckloads of cash and get paid fees on it over long periods of time.

But I suppose it’s to some extent a function of your view about most companies being over-valued and perhaps it’s just simply a reflection of the fact that you’re a value investor in a growth investing era?

Yeah, and that is, we want the flexibility to hold cash.  We don’t want to do away with that and say we’re going to be fully invested all the time.  The backdrop is, this is part of doing what we do but I also think there’s just making it a bit more of a conscious decision is not that difficult of a step and if you look at our international fund in particular, we’ve gone from 30% cash to 12% cash over the past 12 months.  The UK sold off a lot, Europe sold off a lot, we’ve found places to put that money to work.  It’s just making sure that you’re working on those ideas while you’ve got a fully invested portfolio as well and making sure that when it comes time to sell and move on, we’ve done the work… We’ve been guilty in the past of, okay, we’ve got a great portfolio here, we spend all of our time monitoring it.  It matures, you cash in some of those ideas and then you start working on finding the next ideas.  It’s just being a little bit more ready in terms of, we’re working on places where we’re going to deploy the money here once those ideas that we’ve got mature. 

Something that happened that hadn’t historically happened to us though was everything matured at the same time sort of 12 to 18 months ago, and that made it difficult to deploy that much cash in a hurry.  But, the past 12 months, even though markets have kept going up we’ve found plenty of interest in places to park the money internationally, and that says to me that we could have been working on some of those things earlier. 

You’ve got a chart in a quarterly showing value and growth performance.  I’m not quite sure over what period, but anyway it says, world value 10.3%, world growth 21.4%, ASX 200 value 1.7%, ASX 200 growth 15.3%; huge difference.   Is your sort of thinking that you’re just going to sit it out now and wait for those bars on that chart to reverse, so growth sort of goes into reverse and value has its day, is that your thinking?  Or are you just going to plug away at what you do?

I think that absolutely will happen.  I listened to a really interesting pod cast a couple of weeks ago actually, I was sitting on a plane and it was an anonymous investor who’s very active on Twitter was the Interviewee, and he was talking about that period 2000 to 2003, anyone in the value end of the spectrum dramatically outperformed because you’re coming out of the dot.com bubble, all of those growth stocks performed terribly and value outperformed dramatically.  That was almost the thing that killed it longer term because everyone started participating, everyone started saying, well investing works over the long-term and buying those stocks.  Maybe that is what has set us up for the more recent period of underperformance.  It will revert.  There is almost no doubt that, that it is going to revert over time. 

I think for us, sticking to your principles, making sure that the individual stocks that you’re buying are going to deliver the returns that you want over time is really important and not losing patience.  It’s not easy as a fund manager particularly when your competition is out there posting returns, buying the likes of Afterpay and WiseTech and it’s just looked very easy in that part of the market over the past 12 months and it’s been hard to sit on the sidelines and say, “We know hat our edge is and we’re going to stick to it, but that’s been the tried and true recipe for a very long period of time.  We’re not going to change our ways as long as we’re also constantly trying to improve the way we do things.

Could you tell us what that way is, how do you screen your stocks, how do you find them?

For us, it’s an absolute focus on cash flow.  I’m buying this stock, part of a business listed on the stock exchange.  How much return is that business going to give me over time.  One of the really important things for us is making sure that you’re focused on what’s going to come out of that business, rather than just what you think – I think a lot of value investors fall into the trap of, well this business owns all of this land and it’s worth twice the share price and therefore I’m going to buy it.  The question for us is, well if it owns all that land, where is the return on that land going to come from and when is it going to come back to us.  The magic of that approach is, if you get it right, you buy this stock and it delivers the cash that you expected it to deliver.  You are not dependent on the market to generate your returns over time.  99% of the time, the market ultimately recognises that cash flow stream and you sell your shares to someone else and make money out of it, but it’s not the reason we bought it.  We buy, because we think the business is going to generate us returns.  We tend to screen for places where people are likely to be selling something cheap, and that can change but really there are only two reasons why people sell something cheap.  Number one is that they don’t understand as well as you understand it.  We call that some sort of informational edge.  My first job out of university was working for Macquarie Bank on their purchase of Sydney airport and it was an asset class that I immediately saw the wonderful economics of. 

You own a regulated asset but then you have this unregulated part to it which is retail and car parking in particular that grows faster than passenger growth over periods of time.  I saw that in Sydney Airport, I’ve owned that stock three times in my life.  When we started the international fund, a few of the first investments we made were in airports and they’ve done very well for us.  That’s just an asset class that we know very well.  It’s becoming widely known so there’s less edge there than there was 10 years ago.  But it’s just an asset class that if I see an airport that’s listed, I think, well I’m going to know this asset as well as anyone else. 

The other bucket is what I’d call psychological edge and this is often buying from someone who’s a forced or irrational seller.  They’re not really sitting there thinking I’m selling this business because I think it’s worth less than I’m selling it for.  They’re selling it because they’ve got withdrawals, they’ve got redemption.  They stock’s come out of an index and they can’t own that anymore.  Or more commonly in retail land, the share price has gone down and people don’t react well to share prices going down so they just dump the stock.  All of our ideas come from one of those two buckets. 

When we’re filtering, we’re sitting there thinking, well, find me all of the stocks that have fallen 50% because once it’s fallen 50% often people do stupid things or find me all of the airports in the world – you know, focus on those areas of – we start with the question, ‘Why might something be cheap?’ rather than finishing with that, and we focus all of our time looking in areas where we think we’re likely to have an edge rather than thinking we can out-analyse everyone and every single stock.

Do you tend to look at all the stocks that have fallen a lot, such as an among like 50%?  You look at all of them and figure out why that’s happened?

Correct.  That’s one filter that we might run.  We might run a filter that says give me all of the businesses that are trading at a big discount to their asset backing and lots of it’s going to be rubbish, but maybe somewhere in there we can find a gem that’s very cheap.  Give me all of the stocks where there’s been a significant broker downgrade in the past 12 months.  A lot of people like to buy upgrades, we like to look amongst the downgrades to see, was there something here that people have overreacted to this short-term piece of information.   We often just run filters looking for good businesses as well.

Does that sometimes result in you chasing a dog down?  I’m thinking of Thorn Group in particular here. 

Yeah, it does.  We’ve had a number of debacles over the years and most of them have been in that space.   The trade off is, it’s also been where our biggest successes have come from.  We own a stock called McMahon which is the biggest holding in our Australian fund at the moment and it’s share price is up 6 or 7% over the past couple of years and at the lows, everyone was telling us that that business was going out of business and that it was a dog.  When it happens you look really, really stupid because you tend to be buying when the consensus view is that a business is fatally flawed.  When that fatal flaw actually works out to be true, you look very stupid.  But when they turn and when that perception changes down the track it’s also where we’ve made huge amounts of money.  The trick for us is to try and use it as a filter – okay, it’s a prospective area, there might be opportunities here, but not get sucked in to thinking that they’re all bargains just because the share price is down, just because it’s at a discount to assets.  I think that is particularly risky in today’s market.  You’ve got a market where there’s a lot of money out there looking for a home.  Most stocks are particularly well picked over and I think you need to be very careful about buying lower quality businesses in a market like this.  My experience pre-financial crisis was that was a very, very dangerous place to be, because a lot of those businesses when the economic cycle turns, they’re actually the ones that go out backwards. 

Your question was about one in particular, which is Thorn Group, and I actually think that there is the crux of a good business at the heart of that and that’s really the key for us, is to try and sift through the things where the perception is horrible but where there is something real there.  I think that Radio Rentals business for all of the problems it’s had over the past few years, I think they’ve done a very good job of turning it around and fixing it up and improving the offering and I think that there is a place in the world for people that can’t access credit elsewhere to be able to buy some of these products.  I think it is a business that will be perceived differently in a few years’ time. 

They also own an equipment finance business that I don’t really like, so I would like to see them potentially dispose of that at some point in time but the retail Radio Rentals business is something that I think has a future.

I suppose one of the things you were saying before is that a lot of the time, a business share price falls 50% is simply because it’s gone from 100 times PE to 50 times PE and is still expensive?

Yeah, that’s certainly the case at the moment and I think we’ve had this divergence of performance.  There are a lot of highly priced growth stocks out there that could fall more than 50% and I wouldn’t be the slightest bit interested.  There’s not any earnings and in some cases there’s not even a clear path to revenue for some of these businesses and they’re trading at crazy valuations.  It’s certainly not a fail-safe thing.  At the other end of the spectrum, sometimes a share price can be up 50% and a situation can be really, really interesting.  Because again, you get people selling sometimes in that scenario for reasons that are not related to value. 

A business might be performing really well and you’ve got a fund manager like me that had 5% of their portfolio in it, the share price is up 50%, they’ve now got 7.5% of their portfolio in it and they think, well that weightings to high for me, so even though I like the business I’m going to sell the stock.  It’s not out of the question that a share price can be up and something still be really good value, it’s just that for us and our style, we more often find things in the down bucket than the up-bucket, but rule something out just because the share price is up.  That’s as silly as ruling something out because the share price is down.

After you do the initial screen, like is it an airport and is it down 50%, what are the numbers that you first look at it?  Is it – would it be fair to say it’s free cash flow, do you look at that?

Yeah, over time.  So, it really – I mean we’ve got a heuristic or number of rules of thumb around a particular type of business, how are we going to value it.  If you take airports as an example, most of the opportunity has been there over the years because the accounting earnings are not very reflective of the cash flows that the business produces.  The reason for that is pretty straightforward.  You build an airport, you depreciate that asset over say a 50-year period, but once you’ve built it, you don’t spend much money on it.  The depreciation tends to be dramatically higher than the actual amount of capex you need to spend maintaining the asset, so the cash flow – and this is true of toll roads and a whole heap of infrastructure assets – the cash flow, we would use, say, as a metric, instead of using accounting earnings we would use EBITDA, less maintenance capex and that’s going to typically give you a higher number than accounting profit in those assets.  That is a model or a heuristic that we have for valuing those types of assets and it just depends on what the type of asset is for how we’re going to value it.  If it’s a business that we think is going to grow for a long period of time, then we might actually build a DCF, an Excel spreadsheet, and try and value the cash flows of that stock over a period of time. 

More often than not, there’s a simple rule of thumb around growth and price to earnings ratio that you think you’re comfortable with for a particular type of business.  We’re often looking for something though where we think the earnings are going to change dramatically and that’s when we buy these discounts to assets it’s because we think those assets are going to generate a higher amount of earnings in the future.  Simple PEs of what we think are sustainable earnings are usually a tool that we’ll use to value something.

Just on the subject of cash flow and in particular free cash flow, talk to us about Rolls Royce, because you sold out of that but after you sold they’ve released a very aggressive free cash flow target.  Have you looked at that, do you regret selling?

Definitely not, actually.  It’s just a business that, one thing that we’ve worked really hard on over the years is trying to make sure we don’t just stay in an investment because we were in it start with.  We’ve got a thesis, we’ve got an investment case and if, as we go along, things are not unfolding as we had anticipated, then we want to sell the stock and move on, rather than justifying the situation that we’re in.  It’s really as an investor to say, well I bought it for this reason, that hasn’t happened but the share price is down or the business is still going to be worth more than today’s share price. 

But if your thesis was wrong it’s really important to move on and we’ve just found with Rolls Royce that everyone is valuing and buying the business based on the amount of cash flow that management says they are going to deliver in 2020 and beyond and we just got uncomfortable that our whole valuation was based on what someone has told us rather than the actual financial statements that the business has delivered historically.  If you go back over its historically it’s historically delivered very poor cash flow and the reality hasn’t lived up to what management have promised. 

We really liked the management team and the reason we originally bought it was we thought he was going to be able to cut costs out there, but as they started coming out with all of these engine problems – they’ve got a new engine out on a whole bunch of aircrafts that’s causing them lots of issues – we just started to think, what does this actually mean for the future?  What if this program that they’ve promised us is going to deliver all these cash flows as problems like we’ve seen on these latest engines.  We just couldn’t get comfortable enough.  I really hope the stock works out well and I want to see it perform well, it’s just not something that fits the portfolio that we’ve got in front of us today.  I touched on this earlier, but we’re finding lots of opportunities in the UK and Europe and most of them simpler theses than that one.

Yeah, and in fact, just on the subject of UK and Europe, one of the headings in your quarterly was, I think, was something like, ‘Lots of Opportunities in Brexit.’  And I suppose what it means is that with your approach to value investing, it’s not just about stocks that are beaten up, it’s about themes and countries and geographies that get beaten up and that’s certainly the case with Europe and UK at the moment.

Yeah, and the attraction there is that the whole market has been thrown out because people are nervous, and rightly nervous, about what’s going to happen with Brexit.  But it’s been indiscriminate and the trick for us is to try and sift through that indiscriminate selling and say, where is this not justified.  That’s meant a number of businesses that are listed in the UK that have absolutely nothing to do with Brexit or the UK economy where the share prices are down quite a long way.  We are in an oil and gas services business, its operations are in The Middle East and then they construct some windfarms in North Sea as well.  It happens to be listed in London but the business as it has zero exposure to the UK economy or to Brexit and yet the share price has not behaved the way the rest of the oil services market has behaved because people are not focused on that particular part of the world. 

Four of our top five positions are listed in the UK and of those four, three of them don’t have that exposure into that part of the world.  It’s quite a good insight into the way we think about things, because okay, let’s go and look there because that’s where there’s likely to be a lot of pessimism, but also, let’s not try and outsmart everyone about what Brexit is or isn’t going to do.  Let’s try and find opportunities there where we don’t even have to take on that risk.  We’ve been able to do that in a quite exciting way to be honest with you, it’s the best portfolio that we’ve had in some time at the moment in terms of some of the small businesses and small stocks that we’ve got in there that we’re really excited about the quality of where we’re normally forced to fish in ponds of lower quality stocks.  They’ve been able to find some good ones listed in the UK. 

And what about Italy, you own a bank there, are you worried about Italy?

Yes.  We own a bank – I mean, we’ve still made money despite what’s happened over the past couple of months on our holding, it’s called UBI Banca.  The bank is performing very, very well.  They’ve got a management team there, just coincidentally the guy who’s running it, run Westpac out of the commercial property disaster of the early 1990s here in Australia.  He’s done bank restructuring before, they’ve got a very clear plan, they’re a little bit ahead of schedule actually in terms of fixing up the balance sheet, returning that business to growth and it’s been going very well.  The issue there is that the government problems have caused Government bond yields to spike a lot and that actually has big implications for a bank because their funding costs are based off their government funding costs.  You’ve got a 2% increase for a bank is very, very significant. 

Now, obviously they’ve got a lot of their funding locked in at much lower rates, so it’s not an immediate impact on the profitability.  They own a lot of government bonds, so they’re going to mark those to market.  It’s hard to say what’s going to happen in that country, we don’t have a strong view on how things are going to work out.  You’re buying a bank, I think a well-run bank that’s got a clear path to improvement at less than half its asset banking.  If you compare that with Australian banks that trade at two-times asset backing or more, it looks very, very attractive.  But the macro environment is important and for that reason we are keeping the portfolio weighting very sensible there.

Last question on a specific stock.  iSelect – talk to us about iSelect, which is down 70% from its peak and have you lost faith in that company?  The CEO’s gone, guidance slashed… 

We’re fortunately new to the register there, so we are feeling much better about it probably than the rest of their shareholders.  We got a bit fortunate with this one because we’d done all of the work on it.  We actually were looking at it very closely when the share price had fallen from $2 to $1.  We did all of our research and just couldn’t get comfortable that there was enough value there and then they had another profit downgrade and the share price fell from a dollar.  It was down into the 30 cents at some point, so from $2 down to 30 cents was a dramatic fall.  When we did our research, they’ve got an asset on their balance sheet which is their commission that they’re going to receive from policies that have been written in the past.  At 30 cents you can make a pretty compelling case that just the cash on the balance sheet and that trail asset were worth significantly more than the share price at that time.  We were buying pretty aggressively at that 40 cent level on that thesis that you were getting an ongoing business here for less than free.  We think there is a real business there.  At today’s price you need it to be a real business and you need it to be sustainable.  We, I guess, are 50/50 about that.  We think there is a place for comparison websites in the market.  We spend a lot of time talking to their customers like NiB and this channel is very important to those guys.  The costs of going up, the costs of marketing in particular are increasing and they don’t offer the full suite of products.  It’s probably my number one concern, that you go to them as a comparison site and they don’t offer you a blooper as a product, so it’s not really a true comparison.

But look, I think there’s enough there to certainly justify today’s price, we think a premium to that and you’ve had Compare the Market, who’s their main competitor come onto the register, they’ve recently just bought 20% of the stock.  We think the case for putting those two businesses together is compelling.  You would say the huge amount of costs and stocks competing with each other like crazy for the same customers.  We would like to see something happen there in terms of a merger of those two businesses over time and if those two things can come together, then you’re going to have a share price well north of today.  It’s actually one of the opportunities that we’re more optimistic about in the portfolio at the moment.  

What do you think the per share value of those trailing commissions is?

Well, that and the cash that’s on the balance sheet combined are about 55 cents.  So, you are paying something now for the rest of the business and I think, being realistic about this, if you actually went into a wind down you’re not going to get that much and we’ve seen that time and time again with different businesses out there on the market.  There’s something on the balance sheet.  That assumes that this is a going concern.  So, we’re not sitting there saying this thing is going to be run down, we’re going to get that much.  If it goes really bad, you’ll probably get less than that.  But it’s an asset, it’s cash flow that’s coming in that they’re currently using to try and grow the business and fund dividends and things like that.  As long as you have a business that goes on that 55 cents should be value that comes through to shareholders and we think they can grow it over time.

Just finally, Steve, just the big picture here – I read something by Nouriel Roubini yesterday that said the world economy is going to crash in 2020, and he gave 10 reasons for that.  Half of them had to do with Donald Trump, the trade war, the fiscal stimulus which is over-stimulating the US economy…  What’s your general sense of things now, are you worried about what’s going on or not?

My number one concern is asset prices.  I think the case for being invested in real assets over long periods of time is compelling.  You and I were running similar businesses through the financial crisis and there was so much to worry about and we all thought we were going into a great depression and despite prices being up so much, it was harder to invest back then than I think it is now.  I just think you need to keep that backdrop in mind.  The case for investing in real assets versus cash, cash is certain to depreciate over long periods of time, so to take your assets, just put it in the bank rather than hold real assets over long periods of time, you need to be very, very convinced that something very bad is going to happen.  I don’t feel like things are that bad at the moment. 

I think it’s a time to be careful, like I touched on earlier.  I think it’s a time to make sure you don’t own low quality businesses.  But I also look at equity prices and I think if I just bought today and I held for the next 20 years, I’m going to do a lot better than cash in the bank.  So, I’m really, really reluctant to listen too much to people who are constantly screaming that the sky’s going to fall in and everything’s going to be terrible.  They will be right one day but by the time they’re right, you’re going to have a lot more money being invested in real assets.  I think if interest rates go up you’re going to see huge amounts of pressure on some asset classes and some parts of the equity market.  Like I touched on earlier, you’ve got crazy valuations in some growth stock part of the market but I also think you can put a sensible portfolio of good businesses together at the moment at perfectly reasonable prices.  We don’t own it because we tend to focus on higher returns.  But you look at a business like Caltex for example, and I think you’ve got a good management team and a good strategy and a good yield and a business that people are probably going to keep using their services for a very long period of time to come.  I wouldn’t be scared out of being invested in equities at the moment.

Well that’s a good note on which to end, Steve.  Really appreciate your time, thank you.

No problem at all, thanks, Alan.

That was Steve Johnson, the Chief Investment Officer and Founder of Forager Funds.