Forager's Steve Johnson on how to beat the market and the rotation out of US stocks

Distortions in the small-cap market

Over the 12 months to March 31, the Forager Australian Shares Fund has returned 21.7% before fees, to beat the returns of 123 other equity managers in the Mercer tables by a decent margin, and smash the 2.6% return from the S&P/ASX 300.

However, the Australian fund manager tells Livewire the small-to-mid-cap end of the local market is being distorted by new dynamics that all share market investors should take into account. 

First, he says investment funds are being drained from small caps as more retail money switches into large-cap passive funds that track indices like the S&P/ASX 200. 

A consequence of the small-cap liquidity drain is that it's creating lots of cheap valuations from which to profit. However, it's also making small-cap stock picking harder, as less liquidity creates more volatility or wild share price moves, he says. 

As an example, he points to the recent underperformance of the S&P/ASX All Ordinaries Index of Australia's top 500 companies, versus the top 200 companies in the S&P/ASX 200 Index. 

"So you've had all of this natural selling in the small-cap part of the market as well, and that's created overall depressed valuations," he says. 

The trend of more money going into large-caps is part of the broader phenomenon of passive index-tracking investing that's changing markets in other ways, according to Johnson. 

"I think pretending this passive trend is going away is just sticking your head in the sand. It is going to be with us forever and overall it's a wonderful thing for investors," he says. 

"The amount of fees people save is significant and I think it's a good thing and it will continue. So, for us, I'd say in that small-cap space, it's led us to focus on unloved and under-appreciated businesses. So we want to buy them when nobody else is interested in them."

In the video, Johnson also talks about a couple of formerly unloved small-cap stocks he still likes, including Catapult (ASX: CAT) and Plenti (ASX: PLT). The latter, he suggests, may get added to an index over the medium term to produce a share price tailwind on the assumption that its operating performance remains strong. 

How to get ahead of the market

Another new trend related to passive investing is that successful companies made members of larger indices will get big valuation uplifts because index-tracking passive investment funds must then buy shares in those companies. 

"We've had a lot of success over the past couple of years trying to identify the company that can get itself out of one [index] bucket and into the other where those passive valuations and flows start to apply," he says. 

Johnson's Australian equities fund is one of several regularly near the top of the performance charts as pragmatic fund managers embrace new phenomenons and profit from the index-tracking money distorting stock valuations. 

And it's not just his Australian shares fund performing well. Forager's International Shares Fund has returned 15.7% per year after fees for the past five years as at March 31. He says the consistent returns are down to Forager sticking to its core investment philosophy and other old-fashioned principles. 

"Well, five years of really hard work," he puts the success down to. 

"And, I'd say our portfolio management team has been together now for seven years. So, collectively, we've put a lot of work into improving our processes and all that portfolio management stuff you and I've been talking about."

 If you are an investor who is keen on discovering stocks before they are included in an index, subscribe to Forager's monthly and quarterly reports to find out more.