Why this fund manager is waiting until Afterpay hits $40

Managing a fund that’s returned 18% so far in 2021, Steve Johnson sees some good things in small and mid-cap stocks.

Forager Funds chief investment officer Steve Johnson. Picture: Britta Campion

Steve Johnson says there’s a “bit more realism” creeping back into the market as the spectre of an eventual rise in interest rates starts to challenge high-priced growth stocks.

And for his part, the $450m fund manger won’t touch Afterpay until it falls below $40 a share. The tech payments darling closed at $86.52 on Tuesday, down on its February peak of $158 a share.

While a sustained rise in inflation is “still a relatively low probability” the impact on financial markets which are priced for interest rates to stay low forever will be “pretty dramatic.”

The chief investment officer and founder of Forager, who once played a season of under 19s rugby league for the Bulldogs while working at UBS, is looking to recycle money from successful takeover bets to value opportunities in any exaggerated selloff in “COVID winners” and potentially the broader market.

Afterpay and Xero are among Australia’s large COVID winners that have come unstuck this year amid jitters over rising inflation and the implications for interest rates and central bank liquidity from bond buying that boosted the valuations of growth stocks in the past year.

But their valuations are still too rich to show up on Forager’s radar.

“For COVID beneficiaries, good results now aren’t making the slightest bit of difference,” he said.

“Some of those posting weak numbers – like Red Bubble and Adore Beauty – are down a long way.”

“People are worried about interest rates because you’ve had such a strong recovery to a record high in the market, so that already anticipates improving numbers.”

“But this environment is creating opportunities…some of these businesses that are still really well and that are growing in fair valuation – you’ve got their prices down 30 or 50 per cent.”

“Afterpay is probably the poster child for growth…the numbers they are posting are extraordinarily good…it’s just that the share price rose so much during COVID.”

Johnson wouldn’t seriously look at buying Afterpay unless it was trading under $40 a share.

“Xero is a bit the same…it has come back a lot and it’s a business that I absolutely love, but it’s a long way down still from here where I think a conservative estimate of the future can justify owning it.”

He says it’s becoming harder for highly valued share prices “to react positively to good news.”

“I think you’re seeing share prices reflecting optimism more accurately now than 12 months ago.”

While still recovering from double-digit losses in 2018 and 2019, Forager added 19 per cent in 2020 versus 3.6 per cent for its benchmark S&P/ASX All Ordinaries Accumulation index.

The fund has also risen 18 per cent so far in 2021 whereas the index is only up 8.1 per cent.

Many have struggled to outperform in both years amid a massive transition from growth to value.

But while Forager, has seen a net inflow of funds this year, value funds generally are yet to take much of the flow away from the growth funds that have done so well from falling interest rates.

“People have stopped redeeming from the value end of the spectrum, but I don’t think we’re yet seeing significant inflows,” Johnson says. “All the growth guys are still saying ‘this is a great buying opportunity’ and I don’t think it’s yet broken in terms of a thesis, but that may happen.”

The fund added 18 per cent in April alone, albeit mostly due to a single stock – Mainstream Group – the funds administration firm that’s been subject to a takeover battle that pushed its share price up 120 per cent that month.

Another successful mergers and acquisitions bet for Forager in the past year was the Australian listed advertising play WPP.

WPP surged 76 percent in late 2020 and has since been taken over by its British parent.

“There has been a lot of takeover activity in our portfolio in the past year,” Johnson says.

“You rarely see it at the bottom of the market, but as share prices start to recover and shareholders start to breathe a sigh of relief, that’s when the corporate action starts.”

Australia’s share market has been extremely volatile since the COVID-19 pandemic hit last year.

The S&P/ASX 200 index fell as much as 39 per cent as COVID hit in February to March 2020 and lockdowns occurred, then rose 63 per cent from there to a record high close of 7172.8 points this month amid unprecedented fiscal and monetary policy stimulus and vaccine developments.

The rebound was initially led by defensive growth stocks and COVID winners in particular.

But growth stocks have long since been overtaken by an exceptionally strong rise in value stocks.

An increasing number of value stocks have been subject to corporate action.

“Over the 11 years we’ve been running this fund I would say 50 per cent of the stocks that we’ve exited have been because of takeovers,” Johnson says.

“Often we will be buying something because we see a strategic value in it that’s not necessarily obvious or in the numbers. That was the case with Mainstream.”

Johnson is the first to admit that the jump in Mainstream covered up a few bad performances.

He says the recent selldown in COVID winners is “a sign of a bit more realism creeping into the market.”

“We’re fundamentals-based investors rather than thematic, so for every single company we invest in, we sit down and do a DCF (discounted cashflow valuation) for them.”

“It’s not necessarily deep-value – most of our companies are growing and we expect them to keep growing – but we take a conservative view of how much they will grow.

“Generally we want a bit of a track record that gives us confidence that growth will come and then we want to pay a low price for it – so growth at an attractive price rather than growth at a reasonable price –and that has been pretty hard to find over the last few years.”

The big growth stocks arguably left any semblance of “value” behind when central banks cut interest rates to effectively zero and ramped up their money printing last year.

“We own RPM Global in our portfolio – a mining software company – and we think that is exceptionally cheap and has plenty of growth ahead of it, so there are exceptions out there, but as a general rule, the market has been very expensive and we have made our money out of more traditional types of businesses, albeit ones that have some bright prospects we think,” Johnson said.

Forager does have some larger cap stocks – like Star Entertainment – which it bought last year to help liquidity, but it’s mostly focussed on small-to-mid cap stocks.

Star Entertainment shares have risen 42 per cent in the financial year to date.

As for recent share floats, Johnson “prefers to pick over the carcasses” than participate in IPOs.

But he’s “very interested in the Adore (Beauty Group) story”.

“I think that is a sustainable, long-term business that is going to grow.”

“It was a COVID beneficiary and they listed on the basis of six months of hyper-growth and now everyone is running for the exits, but I think the structural story there is a good one.”