Steve Johnson: What the market is missing about the AI boom

Equity Mates Investing Podcast

Steve Johnson, founder and CIO of Forager Funds Management, joins the Equity Mates Investing Podcast to explain why he is actively avoiding the AI trade despite acknowledging its transformational potential. He argues that AI stocks

Key takeaways

• Steve Johnson warns that AI stocks are in a narrative-driven bubble, noting the sector's heavy capital intensity contrasts sharply with historically profitable tech models like online advertising.
• Forager Funds Management recently underperformed due to self-inflicted mistakes on EML and Fiserv, but Johnson stresses that transparency and limiting drawdowns protect long-term compounding.

Main topics

• AI investment bubble and capital intensity
• Forager Funds Management counter-cyclical strategy

Notable quotes

Every single bubble has a true and strong narrative behind it and the stronger the narrative the bigger the bubble.

Conclusion

The episode provides a disciplined, contrarian framework for navigating market

Transcript preview

Speaker 4 (0:00) Everything you're about to hear is for education and entertainment purposes only. Whilst we are licensed, we're not aware of your personal financial circumstances. Any advice is general advice. Equitymates operates under Australian Financial Services License 540697. Speaker 2 (0:15) Every single bubble has a true and strong narrative behind it and the stronger the narrative the bigger the bubble. Look it's the theme driving life too isn't it? I think over the next 10 years I mean people that are at the coalface here are talking about it destroying humanity. A not insignificant probability. If that breaks that is the huge problem for Australian property. Speaker 3 (0:39) Welcome to another episode of Equity Mates, a show where we explore what's possible in the world of investing. If you've just joined us for the very first time, a massive welcome to our community. My name is Bryce. And Speaker 4 (0:49) I'm Ren, and today we're talking to one of the most candid fund managers out there. He recently wrote a letter to his investors telling them to expect underperformance. Gotta respect that. Gotta respect that. Speaker 3 (1:01) We love transparency in the industry. We are welcoming to the studio Steve Johnson. He's the founder and CIO of Forager Funds Management. He has an Australian fund and a global fund. And yeah, we start the conversation with his letter, as you said. And Speaker 4 (1:19) we should be clear, he didn't just say expect underperformance forever. He was talking about it in the context of the AI trade. And he said as long as the AI trade continues, his fund will underperform. So we start with... where he thinks the trade is at and how he's counter-positioning his fund against it. But then we go beyond AI. Speaker 3 (1:37) Yes, we talk what's going on in the world of small caps here in Australia, where he's finding opportunity beyond the AI trade. He brings a couple of stocks to the table as well that we go deep on. And then we get his thoughts on Australian property because back in 2017, he said he would always be a renter and that stocks will beat property. Nice. Speaker 4 (1:57) Love that. Well, without any further ado, let's get to our conversation. with Steve Johnson. Speaker 3 (2:04) Well, Steve, welcome to Equity Mates. Thanks. Good to be here. In your recent CIO letter, you wrote, as long as it, being the AI trade, goes on, you should expect both funds to continue their underperformance. Now, this is an unusually candid take from a fund manager. What was the response from investors? Speaker 2 (2:23) I think amongst our client base, it's a welcome. message to them. Most of our clients are using index funds or have the core of their portfolio in those big, large blue chip companies, and they are getting exposure to everything that's working in that space through that. And our job is to give them something different. And I think if anything, it's also just, I'd say over the past decade, we've not been as counter-cyclical as I would have. liked. And part of that is making too much money in the good times. I think to actually protect yourself in the downtime, you need to be willing to lose out on some of those opportunities. And we're trying to do a much better job of that in our portfolios. And I think that's what our clients want. And it's the message that they want to hear. So it was interesting. I saw that question on the list that you put forward. I haven't actually had one client. query about that as a concept. I think it's actually what they expect from us. That's our investment strategy and it's the product that they've invested in and they want to see more of that, not less. Speaker 4 (3:21) Well, we want to hold on the AI trade and we promise we're not going to just talk about AI for 35 minutes, but it is front of mind for everyone at the moment. It's the theme driving markets. We're coming up to almost four years since ChatGPT was first launched. What's your take on the AI trade today? Speaker 2 (3:39) Look, it's the theme driving life too, isn't it? I think over the next 10 years, I mean, people that are at the coalface here are talking about it destroying humanity. I know, I know. A not insignificant probability of it destroying humanity. So if that's going to happen, I want to be alive for it. And it's going to be an interesting decade ahead as all of that unfolds. And I am a big user of the product. I think this is a genuinely transformational technology. I don't know that it's that much more transformational than... electricity or than sewerage works back in the early days. There's been a lot of things that have changed life as we know it dramatically, combustion engine being another one. Maybe this one is faster, and that's been a trend with technology is that these things get quicker and quicker in terms of the impact that they have. But it is a genuinely transformational technology. We're using it in our business more and more. We're on a race, really, to try and keep up with what everyone else is doing to start with. it is doing a lot of things that we used to do ourselves better than we used to do them. So I think the technology is amazing and it's only going to get better. Every model that comes out is better than the one before it. Speaker 3 (4:43) You said in your note as well, we often run out of tokens or usage capacity at Forager within the first few hours of the day. We've started to ration the use. Speaker 2 (4:52) What are you using it on? Research mostly, and building models. And I think part of that message that I was writing about in the letter is, I think this is a really, really useful technology for certain types of activities. It can do a very wide range of activities, but I don't think it's the right tool for a lot of those other activities. And we actually had a consultant come into our business and they were just talking about little things like the unit price every day, how do we calculate that? And this consultant said to us, look, anything that's actually determinative and you need an exact correct answer every time, you're actually better off building a piece of technology that can do that calculation from start to finish in order to get you the right answer. Perfect. AI can do that. It's really slow. It's really inefficient. It needs to go and work out how to do that every time. And it actually just costs a lot of money. The technology is expensive. Speaker 2 (5:46) You're paying for tokens and we're still really not paying the economic cost of it. That cost goes, okay, this is going to take our 10 minutes. That's going to cost me a certain amount of money. I could actually build a piece of tech here that can do that correct all the time. So I think that's a really important thing to recognize about it. It's a probabilistic, I think at the moment, mostly a content type tool. So you want to code, right? There's a bucket load of content out there that it can go and look at and say, well, I've seen someone else has done this. I'm going to take it and I'm going to show you how to do that over here. If it is, I want to know what's happened with the CEO of this company yesterday, or, you know, in our world, small cap companies where there's not a lot of information about them, it's probably wrong 30 or 40 % of the time to the point where it's become almost useless for me to do research with that as a tool because it doesn't have enough information to work with. So I think we're going through this phase of, wow, it's amazing. It can do all of these things. The next step is, well, what is it? economical for it to do relative to, I can get this done by someone in India, I can do it myself, or I can build something else to do it. And I think as we go through that process, and as all of this capex that is being spent needs to earn a return, and we start paying the economic cost of it, there's actually going to be a lot of activities where you go, well, it can do it, doesn't mean it should. Speaker 4 (7:01) Yeah, yeah, yeah. So I guess, you know, you're using it a lot, you're seeing like the transformational benefits on one hand, and yet from an investing point of view, you're steering clear of it as a theme. How do you reconcile those two views? Like if it is truly world changing, surely there's some winners that you want to ride. Speaker 2 (7:20) And look, we've made some money. I wouldn't say it was necessarily this is the AI trade and we're Speaker 4 (7:24) going Speaker 2 (7:24) to make some money off it, but we own some stocks that did very well over the past sort of 18 months. One US HVAC installation company, they are doing a lot of... data center work. In the US, that share price has gone up four or five fold. And as that started to unfold, we recognized that was a tailwind for that business. And we held that for a long period of time. I would just say now the prices for almost anything that's associated with the space have become so disconnected from what I think those businesses are going to earn in profits that we just don't want to own them. And I would say every single bubble has a true and strong narrative behind it. And the stronger the narrative, the bigger the bubble. You need the story. Jeremy Grantham's written some really good stuff about this recently. You need a story and you need a story that the average person on the street can understand. Because you need to be able to, you know, you're using this product. Look at how amazing it is. That's how you sell the... why don't you go and invest in this business on the back of that? And, you know, what's happened, I think, is you are just seeing prices for some of this stuff that is absolutely crazy. And I think back to what we were talking about before, the economic model is not clear here that this is as good a business as online advertising was, right? I think those tech founders didn't necessarily sit down and think this is going to be a great business, but they ended up with the greatest business models that we've ever seen, right? They were CapEx, Light, The Profit. grew like crazy and you didn't have to keep reinvesting your profits. And now this is one thing that we know for sure. It is a very, very capital intensive business. Are the returns going to be great on that capital? We don't know the answer to that yet. It can be like electricity, right? Electricity is an amazing technology that is not a great business because the returns are pretty low on the amount of capital that you have to put in. So there's a lot of questions there about business models. And I think at the moment, most people are just, if it's got AI in the name, they're buying it. And one thing you can rest assured from in the broker world is that they will sell you things that will sell. And you see IPOs and you're Speaker 4 (9:28) going Speaker 2 (9:28) to see all of this stuff coming behind it. There's so much money to be made by selling this stuff to investors. And where there's money to be made, it's going to happen. Speaker 4 (9:38) Well, speaking of IPOs, do you have a view on Firmus? Speaker 2 (9:42) Look, I've been flicking through the, we got sent some of the slide decks and the materials. I mean, for me, this is the epitome of bubble-like behavior. It is at the moment nothing. Speaker 4 (9:54) That Speaker 2 (9:54) is what you are buying is a promise. And I would say the baseline probability here for CapEx overruns and late delivery and the returns here not being what they've put in those slide decks is very, very, very high. And you're probably going to see that pretty quickly, is my guess, that in 12 months' time it's... this thing's going to cost us twice what we thought it was going to cost and it's going to take longer and we've been delayed because of regulatory whatever. There's actually just not much to it when you look at what that business is here and now. It is a very small company, not doing very much. And they've got this huge pipeline that's going to, again, require an enormous amount of capex to build out. But it is the epitome, I think, of something that... can only sell with this narrative behind it. There's no way in the world you would get away with listing that stock on the stock market without the narrative that we have behind AI at the moment. Yeah. Final question on AI. Speaker 3 (10:50) How do you think it ends? What are the red flags or data points that you're looking out for? Speaker 2 (10:54) Well, I think this return on capital piece is really, really important. I think we're spending all of the money and all of those people that are providing the money want returns. And especially, I think, with the leverage that's involved in a lot of this. So within a couple of years, we're going to start seeing... whether the returns stack up in terms of profitability on this. I think that's number one from a fundamentals perspective. I'd say this interest rate environment is a problem for the capex that needs to be put in here. There's a bit of chicken and egg there. I think a lot of the capital that's going into the AI trade is sucking out of other places and therefore the returns on bonds and everything else are going up. But also I think if you start providing debt to these things where the interest rate before margin is sixes and sevens instead of threes and fours where it was a while ago. It's just more expensive. And then look, I think bubbles just end in and of themselves to a certain extent. It gets tired. Like it's sucking in an enormous amount