Steve Johnson does things differently. He views himself as an outsider in the investment community and, for most the most part, his small operation has flown under the radar. That all changed in 2015 with a blog post titled "Dick Smith is the Greatest Private Equity Heist of All Time."
The article went viral and with it came some negative as well as some positive consequences. In this deep diving interview Johnson tells us about the experience of dealing with the public scrutiny that bubbled over in the wake of his infamous article. We also delve into the investment processes that Steve and the Forager team apply in their two funds.
After a relatively inauspicious first year the Forager Australian Share Fund has delivered over 14% p.a since inception, while Forager’s global offering has returned in excess of 16% p.a. It's fair to say that Steve Johnson is willing to do things differently, in order to get a different result.
The interview is available as an edited transcript and links to the full podcast and video are at the bottom of this article.
Picture: Steve Johnson speaking at Livewire Live 2017
Back in 2015, you and your team published a damning article entitled "Dick Smith is the greatest private equity heist of all time." The company went on to collapse soon after that article, and you were really thrust into the spotlight. What happened and how did you deal with all that scrutiny?
Well the first thing I'd like to point out is we didn't actually predict the demise of the company, all we did was highlight what an extraordinary amount of money private equity had pulled out of it. Everyone knew that the float price was miles above the purchase price, that the way that private equity had funded that transaction, basically using the company's own cash to pay the purchase price, and then turning around and listing it, they put in 20 million and took out 500 million. That was roughly the metrics on that transaction, in the space of something like 18 months, was a very, very short turnaround. So, the article was mostly around how they did that, and some of the tricks that private equity used to get these businesses ready for float. They're really arbitraging the difference between what matters, which is cash, and what a lot of public market investors value, which is accounting earnings. They arbitrage those two things to make a lot of profit.
So, we wrote this article pointing out how they did that, and then the company, coincidentally, went bust after that. A lot of people saw in the article evidence that we thought it was going to go bust, which wasn't actually true, but it just went viral and it got read very, very widely and it caused quite a bit of controversy. We ended up both loved and hated in the media, and we didn't really expect that. We're a tiny team of people and we tend to keep to ourselves.
We're not that well-connected in the industry, so it was a bit of a shock to the system. Ultimately, though, I think in funds management brand awareness is really, really important. There's a lot of people out there thinking about what to do with their money, and they just don't know what to do. If your brand can be one of the ones that people think about, that they come and look at you when they're thinking about where to invest their money, then that's more than half of the battle. You need the right investors, you need the right performance and all those things, but I think just getting someone to look at you is a real challenge. So for us, that article generated 10 times the traffic we've ever had to our website came in the space of a month, so it was huge in terms of publicity. Ultimately, it's been very good for us, although we don't really like the controversy that comes with it.
“Ultimately, it's been very good for us, although we don't really like the controversy that comes with it.”
Are there any private equity backed companies out there at the moment that you think share similar characteristics?
Not really, no. I don't think I've ever seen anything that extreme, but I think understanding the motivations behind private equity floats is really important. I wouldn't say never buy one. Private equity funds tend to have a pretty fixed life of something like five to seven years, and when they're getting towards the end of that period, they're much more likely to sell things for reasonable prices than early on. But if you see something that they bought very recently and they're flipping it into a float, you have to understand that the incentives there are for them to get the maximum price they can. That applies to all floats, I just think private equity are particularly good at working out what the market's going to like, how to pitch it, and how to get the business ready for that float.
Let's wind right back to the start. How did you get interested in investing in the first place?
It was really a connection of a school friend of mine, Greg Hoffman, who I ended up in business with many, many years later. We went through school together and we ended up playing the ASX stock market game at school, and that was my first exposure to the share market. I went to Wellington High School out in country New South Wales, and I don't think finance featured heavily on the careers department's shelf in terms of where you could go with your career, so I was very interested in it and we loved that game. We came third in the state playing that ASX share market game, I wouldn't say by cheating, but by bending the rules is probably the best way of putting it. It was back in the disc days, there was no internet back then, so they sent you out a disc, and you had two weeks to send the disc back with what your new portfolio allocation was, but the prices were real, so you had prices that were two weeks old that you could then trade on and say, "Well, I'll put the whole portfolio into this stock, because I already know that it's gone up 30 or 40 percent." You question how we only came third and not first.
We ended up doing very well and getting some money out of that, and that worked well. I got interested in it, but never really thought about it as a career, so I started studying engineering at university, and that didn't go very well. I chucked it in after six months and went and got a job, that job just happened to be at the investment bank UBS, but it was pure coincidence. I just took any job I could get, and that was in the mailroom at UBS. I ended up getting to know a few of the guys there, everyone talks about those sorts of stories - it's a model for those banks to use the mailroom as a place to get young people in, and see what they're interested in, see what they like. I got to know a few of the traders, played a bit of touch footy with them, and they said, "Look, if you're interested in this and you like it, you need to get back to university." UBS actually put me through university. They were very kind to me, moved me into the accounting division and set me on a path of finance and investing.
Outside the investment banking that I was doing as a career, I was always a fanatical value investor and I'd been introduced to Buffett and Graham by this friend of mine, Greg Hoffman. I didn't have very much money at the time, but I did a pretty poor job of investing what I had. I got addicted to this concept that you're buying businesses on the stock market, and if you can work out which businesses are worth substantially more than their share prices, you can do very well out of it.
“I got addicted to this concept that you're buying businesses on the stock market, and if you can work out which businesses are worth substantially more than their share prices, you can do very well out of it.”
Aside from Warren Buffet and Charlie Munger, who else do you really rate out there in terms of thought leadership? Who do you look to for inspiration?
I'm largely self-taught. We bought a business called Intelligent Investor when I was 25 years old, and I haven't really worked under anyone in the investing space that taught me the ropes and showed me around. That's probably why we made some of the mistakes that we did make, but it's been books and conferences and reading people's reports rather than direct exposure to people that's had a huge influence on me. I got a grad job at Macquarie and I spent four years working at Macquarie as a grad, I think in terms of my ability to build a business and ability to back myself in the funds management world, that experience at Macquarie was massive for me.
You come from a small country town and you end up working in investment banking, it's a pretty intimidating world, and Macquarie was the place that showed me that you could do it, and that you needed to back yourself, and that there are few limits if you're prepared to really apply yourself to what you want to do, so that experience I think really set me up to say, "Well, you can buy a business, and you can start a funds management business, and you can do all of these things." And who cares whether you're 25 or 30 or 40, the opportunity is out there and you can go and do it. So, some of those individual people at Macquarie probably had a bigger influence on me than any big name fund managers.
After Macquarie, you had the experience of moving across to Intelligent Investor, and then the Intelligent Investor funds business obviously became Forager. One of the seasoned market professionals I often talk to said to me that as far as he's concerned, you're the only fund manager they remember who had a tough first two years and then was able to come back from the darkness and become a success. Can you tell me a little bit about that experience
Stepping back from that, I started the funds management business within Intelligent Investor in 2009. We started thinking about it in March 2009, which would have been great from a timing perspective, but by October the market was already up 50 percent when we actually launched the funds management business, but we had had a near-death experience through the financial crisis at Intelligent Investor. That business shrank from 10,000 subscribers down to 5,000 subscribers, and you get the cash upfront, and the revenue gets booked as you deliver subscriptions in that business. So we were still paying tax bills on 10,000 subscribers, and we're only collecting the cash from 5,000. We went through some very difficult times there.
Looking into the abyss for me was a very good experience, because I sat there and I said, "You know what, if this all falls over, I've got my friends and I've got my family. I'm generally a happy person, and I’ll still be a happy person."
“I came through that experience not being defined by the business that I was working for and the business that I owned. That's been very useful in funds management, particularly in that first couple of years when our performance was pretty woeful.”
I came through that experience not being defined by the business that I was working for and the business that I owned. That's been very useful in funds management, particularly in that first couple of years when our performance was pretty woeful. Under the old model, that would kill a funds management business, but we were selling direct to investors. I think that was the big thing that let us survive and let us get through that period, and has let us deliver the performance since, because I wasn't that stressed about it. I thought, "If this doesn't work, I’ll give people's money back and I'll go on and do something else with my life." I think I could be happy doing lots of different things. I'm particularly happy doing this, but if I was an engineer building bridges, I'd be pretty happy with that as a life as well. I'm not defined by this.
I didn't have a track record, I'd never run a funds management business, so the people that put their money in were doing so because they believed in the philosophy. They were prepared to commit for a long period of time, and they saw something in me that they trusted and liked. Almost exclusively they stuck by me. I remember one month we had $300,000 of outflows. We didn't get a lot of money coming in through that bad period, but it also wasn't going out. That was pretty important in terms of us sticking to philosophy and doing things for the long term.
“We didn't get a lot of money coming in through that bad period, but it also wasn't going out. That was pretty important in terms of us sticking to philosophy and doing things for the long term.”
The difficult times also forced me to define our process a lot more. I did some really stupid things in that first couple of years, and I think if the performance had been great, we would have just stuck with, "Here's a stock that we like and I've read the past five annual reports and we’ll go buy it." Making some mistakes forced us to sit down and think about, "Well what is the process? What is the checklist here that stops us making some of those mistakes?" We've worked really hard to try and define that and make sure that we go through it and we've probably got the same number of winners that we were having even way back then, we've just got a lot less mistakes and less portfolio exposure to those mistakes. We still take risk, but we're not having 10 percent swings at things that can go to zero, and that's been a very healthy consequence of that early bad performance.
Can you shine a little bit of a spotlight on how deep you go with some of these processes? Can you share a few examples of processes you've got in place at Forager?
We have a very clearly defined checklist; a piece of research will typically run to 35 to 45 pages. That will include; what does the industry structure look like? How many players are there? Do you think this company has pricing power? We run through Porter's five forces. We run through a competitor analysis. We look at the individual company's history. What do the management incentives look like? What do the historical financials look like? All of that comes together into an idea, so there is a lot of work in that. If you know the stock and you've already done a bit, you can pull it together in a week though. I think it's important that we do in-depth research. We make sure we check all the boxes on these stock ideas, the actual idea itself needs to be simple, though. You need to be able to say in a page of work, "Here's what the stock is and here's why I like it." Because if it gets too complicated, complication means there's more things that can go wrong.
“You need to be able to say in a page of work, "Here's what the stock is and here's why I like it." Because if it gets too complicated, complication means there's more things that can go wrong.”
The idea is simple and the work is due diligence for us, saying "okay, you've got this idea, it's a good idea, it's a simple idea, let's go and check that you're right." I've never researched myself into an idea. I've only researched myself out. The idea is simple. You pick it up and you look at it, you think this is good business and it's trading at an attractive price, and then you go and do the work to see whether that's right or wrong.
So, your natural starting point is, "it's a no"?
Well, the natural starting point for me is I'm excited about this and it could be a great idea, and then I do more and more work, and it leads toward a no. We have different people in the business and some people are very good at being the sceptic straight up. I tend to be a pretty excited, enthusiastic sort of person that comes up with lots of ideas. That balance for me is the people going, "Okay, Steve, you might want to think about X, Y, and Z." And yes, that is right. That's why the process is so important. Your subconscious is really powerful. Your ability to ignore things that might contravene the case that you've already made works at a very subconscious level. It's not something that you sit down and think, "Well I'll ignore that piece of information." You don't even look at it, because your subconscious is going, "If you look at that, it will disprove the case that you've got over here." So, I'd say the opposite for me; I start with a ’yes’ and I research my way to no.
How do you stop yourself from becoming emotionally attached to an idea?
I think experience helps a lot. I'm 39, but the experience with Intelligent Investor of running a business and then starting a funds management business and going through all of that, I feel like I'm about 60 in some ways. So, I think experience helps, and I think you just have to be wired for it. It's one thing that I've never could teach people; to not let your emotions take over. You're either an emotional person and you probably shouldn't be doing this as a job, or you're someone that is well-built to do this type of thing, and you can teach everything else. You can learn how to find stocks and you can learn how to do the research, that side of things can be taught. How do you react to a share price falling, does it cause you to panic, does it get you excited? That's very, very hard to teach.
"You can learn how to find stocks and you can learn how to do the research, that side of things can be taught. How do you react to a share price falling, does it cause you to panic, does it get you excited? That's very, very hard to teach."
Through your experience with Intelligent Investor and Forager you've arguably had more conversations with investors than anyone in the market. What do you think is the core bias that is letting the typical SMSF investor down?
The first thing is that funds management is a much better business than subscription newsletters. One of the main reasons for that is that in the subscription business, if we produced a good idea and it made money for people, they thought, "Well I'm a really good stock picker, and what a great idea and I've done well for myself." The ones that go wrong, they blame you for. So you only get the credit for the ones that go wrong. In funds management, we deliver a number at the end of the year, and if people are happy with it, then they're happy with you, even though there are the same number of mistakes and successes.
I think the biggest issue is what's called the narrative fallacy. I think people are very susceptible towards believing a story rather than thinking about the value of a business. Fund managers are guilty of marketing their funds management businesses based on stories as well; we do it and everyone else does it. People come up and they say to you, "I've got this great idea." Someone walked into the office this morning and said, "People are just getting fatter and fatter." I was on the train this morning, how do you take advantage of that as an investor? And someone walked into and says, "Well the population's getting fatter and this business plays to that theme, and it will grow tenfold over the next ten years." People just love hearing that story, where the most important thing is; "Well, what price am I paying for that? What is the competitive dynamic going to be? What stops a lot of capital coming into that industry that's got a great story behind it and competing away the returns?"
I think that's the biggest issue that I see time and time again, and it never goes away, and it works both ways. We make a lot of our most successful investments in stocks where the narrative is really bad. People just don't want to buy the stock, because the story is not good and therefore the price more than compensates you for that bad story.
"We make a lot of our most successful investments in stocks where the narrative is really bad. People just don't want to buy the stock, because the story is not good and therefore the price more than compensates you for that bad story."
So simple story, poor narrative?
How are you feeling about how the valuation of the markets? Does this remind you of another time in history?
This is a different opinion from a lot of value investors, but I don't think the Aussie market in particular is stupidly overpriced. We started our funds management business October 2009, so that's coming up to eight years, and the market return including dividends since then is 7.5% per annum. That's not crazy bull market returns. You're including dividends in that return. It's not capital appreciation. So I think the overall market hasn't performed that well over a long period of time. It's not bad. It's exactly what you should expect from owning equities over a long period of time, but I'd say over that period, it's started fairly priced and it's stayed fairly priced.
What's made life difficult for us is that the playing field has really levelled out. Over that eight-year period, I would say most of the time there was one sector or one type of business or a few companies that everyone hated and didn't want to own. There was this pessimism about and conversely, up until August 2016, all this money coming out of the big end of the market wanted to buy the latest hot growth stocks, which were trading at stupid prices. We were buying mining and mining services companies at crazy prices at the same time. I don't see that diversion of valuation in the market at the moment. It's pretty even. Most things I look at, they're not stupidly priced, but they're also not screamingly cheap. That's making life difficult for us.
It's true globally as well. We've been very successful in Europe over the past couple of years. That market has run very hard, particularly these good quality growth companies that we were buying at really attractive prices 12 and 24 months ago. They're gone, they're not cheap anymore. So, I don't think it's time to put all of your money in cash or short the market because it's all going to fall over, but I think people's expectations around outperformance and the ability to outperform should be curtailed.
Where are you investing today?
We've got a broad mix for exactly that reason. I think the opportunities that we're finding are not in a specific space or place. There are quite a few ‘fallen angels’ on the ASX at the moment. These are businesses that people were in love with a year ago, which have failed to deliver on those expectations. In some cases, I think they’re oversold.
"There are quite a few ‘fallen angels’ on the ASX at the moment. These are businesses that people were in love with a year ago, which have failed to deliver on those expectations. In some cases, I think they’re oversold."
We haven't pulled the trigger on many of them, but there's a couple of new additions into the portfolio that fit that mould. In Europe, our focus has shifted quite a bit from these high quality, cheap growth companies. It sounds like a contradiction, but it wasn't a contradiction over there for a while. Our focus is now on cyclical businesses that we're still very optimistic about. The economy in Europe is going much better than most people anticipate at the moment, and I don't think that has yet translated into the share prices for some of these cyclical businesses. So we're still finding some cement companies and financials in Europe that we think are very attractively priced.
You talked about the level playing field, and obviously a couple of opportunities there. What are you avoiding at the moment?
Anything that's got ‘FinTech’ in the name. I think there are a few bubble-ish sectors out there at the moment and I think FinTech is one of them. I have no doubt that space is going to be very active and that they're going to erode the big banks' dominance of financial services in Australia. Whether they can actually make money out of it is a different question, and I think that's a really important concept to think about. You don't just need to deliver a valuable service, you need to be able to deliver that service at a lower cost than what people are prepared to pay for it.
"You don't just need to deliver a valuable service, you need to be able to deliver that service at a lower cost than what people are prepared to pay for it."
I'm still concerned about the Chinese economy over the next five to 10 years, so we're still thinking about the blowback from that on commodities stocks and on the wider Australian economy. It's a risk that has been there for the past 10 years and it hasn't blown up, but Australian housing is something that everyone should be thinking about. It doesn't mean you don't have any exposure to it, but think about your portfolio. How robust is it to something going wrong here? Because the risk is real. I don't want to get into the debate about whether it is or it isn't going to happen. I think you want to apply a probability to it, and everyone should be thinking there's some chance that this unwinds - it could be a long unwind. It could be over 20 years, but what will that mean for consumption and household balance sheets in this country?
What probability do you assign to that?
It depends what timeframe. From 2% net rental yields on housing at the moment, I think the chances of you getting further capital appreciation over the next 20 years are very, very low. Put that at 10 percent. So people are not going to get a great financial outcome out of paying these prices for residential houses. Is it going to fall off a cliff or is it going to take 20 years for incomes to slowly grow while house prices go nowhere? I don't know, that's probably a 50-50 trade-off in my view.
If I gave you the opportunity to put a quick phone call through to that teenage boy in Wellington named Steve who was playing the ASX trading game, what piece of advice would you give him about how to invest?
I wouldn't change a lot, to be honest. I love that Yogi Berra quote, "When you come to a fork in the road, take it." And I think that's really important in life, and it's important in investing as well. You want to set these principles around your portfolio that stop you from completely blowing things up. I think outside that, you want to try things with a limited amount of capital and learn from experience. As long as the mistakes are not too big, they can be the most valuable things further down the track. When you've got three grand or five grand or 10 grand, it's actually the best time to make mistakes. I think if you're young and you're thinking about getting into the space, you shouldn't be investing with a fund manager like me. You should be out there trying to pick three or four stocks yourself, maybe you just pick two stocks yourself, and put your $10,000 into those two stocks. You will probably lose it, but the money that you make from that lesson is going to be worth a lot more than the money you lose from the $10,000 you put in.
If you are interested in hearing more from Steve and the team at Forager, you can register to receive the quarterly and monthly reports here.
Click here to listen to the interview on Soundcloud or watch the video interview below.
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Took out a subscription with Intelligent Investor in 2004 and invested using their insight learning all the time. Went with Steve with the Australian Fund then the International and have done well. Like the philosophy and believe in the long term. Does great work and avoids the hubris.
Good refreshing interview
that's a fantastic article and great insights into the way you think. Thanks for sharing Steve!
I remember Steve talking about WHC at 40c "you could make 5x your money or you could loose it all" . He seems to have a great attitude to investing, making mistakes .... life in general and one of those guys that would be great to work with.
Agree, very genuine guy with ethics.
We speak with a lot of fund managers and it is fair to say Steve is as authentic and transparent as they come. Willing to talk about failures but fiercely motivated to become a better investor. He's at the forefront when it comes to communicating with his investors. It's great to see the funds performing well, hopefully it continues. (disclosure: not invested in Forager Funds)