Forager is adding back an overlooked ASX software stock and deploying cash - here's why

As far as market disruptions go, the SaaSpocalypse has been one for the ages. In the apocryphal words of Winston Churchill, you should never let a good crisis go to waste. 

That's part of the thinking of Forager Fund's portfolio manager Alex Shevelev, who has been on the hunt for quality ASX software stocks that have been unfairly caught in the crossfire. 

With a wealth of those opportunities on offer recently, it's therefore no surprise the Forager Australian Shares Fund has gone from 19% cash to 5% in a matter of months.

In this week's Inside the Portfolio, Shevelev takes us through the big recent changes to the fund - including the small cap payments company that's now the biggest holding in the fund and the under-the-radar ASX software stocks making waves right now.

What was the most notable addition to the portfolio this quarter and why?

Over the last few months we’ve added Gentrack (ASX: GTK), the utilities and airports software business, back to the portfolio.

The Fund first invested in the business in early 2020 when the share price was around $2 and sentiment towards its UK utilities business was on the floor. Over the following five years the investment thesis played out, with the share price rising above $9 before we sold out.

The business briefly became an investor favourite and topped out at $13 per share. Ongoing delays in new contract wins and higher costs drove a big earnings downgrade in May, and the stock plunged 38% in a single day to less than $3 per share.

While the market is focused on weaker non-recurring revenue and margin pressure, the business still provides mission-critical software. Around three-quarters of revenue is recurring and very sticky. That makes it much less susceptible to AI threats than some other technology businesses.

Expectations have reset significantly while the market is once again pricing the business at distressed valuations.

What was the most notable sell or downsize in the portfolio this quarter and why?

While we are always making changes to the weightings of stocks in the portfolio, there isn’t anything notable to call out here. Mostly, we have spent the past few quarters deploying the cash that the portfolio held towards the end of last calendar year.

The portfolio started the calendar year with about 19% of cash (including a company in the latter stages of a takeover). With more interesting opportunities on offer now, that number is down to 5%.

What’s your most notable overweight and why?

Cuscal (ASX: CCL) is the largest investment in the Fund. The business sits behind Australia’s payments system, providing the infrastructure that enables transactions for mostly smaller banks and fintechs.

That gives the business an attractive combination of recurring transaction-driven revenue, structural growth and high switching costs. Solid organic transaction growth should lead to margin expansion, especially as the business cuts losses from a small unprofitable segment. 

The recent acquisition of Indue further strengthens its competitive position, with synergies from this acquisition coming through over the next few years. And another acquisition in New Zealand, at a very attractive valuation and paired with a capital raise, has finally attracted more eyes to the business.

What’s your most notable underweight and why?

Perhaps our most notable underweight sector in the small cap universe has been resource stocks. We prefer to invest in businesses we can value. And it helps when those businesses can mostly control their own destiny.

This raises the bar for resource stocks relative to other businesses not so dependent on the often wild gyrations of commodity prices.

Forager’s preferred investments usually have more control over their product pricing, plenty of recurring revenue and strong market positions. While the past few years have been kind to resource investors, the experience of many past cycles suggests resources turning points can be abrupt.

What’s been one of your most notable performers over the month/quarter?

Readytech (ASX: RDY), a vertical software business serving education, workforce, and government clients has been a difficult investment for the last few years. 

While some questions remain, there has finally been some good news. Readytech has won the contract to supply the Victorian TAFE network, where the company already has some long-standing customers. It’s a meaningful contract, and one that shows that the company’s products are trusted to take on more large enterprise customers.

The valuation the business had been trading at has also attracted the interest of a potential acquirer. The Canadian-listed bidder sees the strength in the company’s mission-critical products and low-churn recurring revenue. There is also the opportunity to remove costs with the use of AI.

We are in agreement on all those points and welcome the attention. Whether the deal is consummated or not, this shows the strength of the business and that there is opportunity to reduce costs and materially improve the cash generation of the business.

What themes and trends are dominating discussions right now?

It’s hard to go past the continued impacts of AI on markets around the world, including ours. Alongside that has been the rise of the SaaSpocalypse narrative.

AI has rightly forced investors to reassess software valuations, but the market has become overly pessimistic by treating all SaaS businesses as equally vulnerable.

Rather than avoiding the sector, we are looking for businesses with durable competitive advantages. Specifically, high value software available to users at low cost, software that has significant structural switching costs, and moats that a business has beyond just the software.

These characteristics make replacement difficult even if AI reduces software development costs. The opportunity lies in distinguishing genuinely disrupted businesses from quality companies whose share prices discount an overly bleak future. 

Managed Fund

Forager Australian Shares Fund

Australian Shares

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