Livewire | L1 Capital loves a turbulent market. Here's how they make money from it.

James HawkinsPartner and Head of the L1 Capital Catalyst Fund
23 mins
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This article was first published by Chris Conway in Livewire Markets on 23 May, 2023.

They say that success is where preparation and opportunity meet, and that has been the case with the L1 Capital Catalyst Fund.

In terms of preparation, James Hawkins, who heads the L1 Capital Catalyst Fund, spent two decades in investment banking and acquired a specific skillset and knowledge that could be combined with the stock-picking skills of L1 founders Mark Landau and Raphael Lamm.

In terms of opportunity, Hawkins describes the Catalyst Fund as a “best ideas fund with an activist overlay”. He further adds that:

“Activist investing has been one of the most successful strategies globally over the last decade or so but, for Australian retail investors, there was a lack of opportunity to invest in these types of strategies”.

And so, the L1 Capital Catalyst Fund was born. A hard-capped, 10-stock portfolio holding only companies that the L1 team believes offer the best quality and value, and that have realisable catalysts to unlock shareholder returns. No shorting, no leverage, with a focus on the ASX 200. Since launch on 1 July 2021, the Fund has returned 15.2% p.a. (net), outperforming the S&P ASX200AI by 10.8% p.a. (ASX200AI 4.4% p.a.).

In the following interview, I explore with Hawkins exactly what activist investing is, how it adds value, what trends he is seeing in this space currently, and a couple of stocks L1 have taken sizable stakes in.

Livewire Markets | This interview was recorded on 11 May, 2023

What is activism and how does it add value?

Don’t let the word “activism” conjure up images of the 1980s, slick-haired corporate raider Gordon Gekko played by Michael Douglas in the movie Wall Street. Corporate raiders then (and now) focus on short-term profits by gaining control of a company and then restructuring it and/or selling off the parts.

Shareholder activists are the complete opposite. Activist investors seek to influence a company’s management and strategy by taking a meaningful but minority stake, and providing Boards and management with expertise and support aimed at enhancing long term shareholder value.

Put simply, activists want to help make the companies they invest in be better-run, more efficient businesses that will be around for the long term, not to smash them up to fill their pockets.

Activism is a powerful investment philosophy and, as Hawkins points out, there is plenty of supporting evidence to prove its effectiveness.

“Offshore there's a lot of data for how activism has performed across various market cycles.

What we have found analysing that data, is during periods of high stock dispersion as well as challenging markets where value is a focus, which is a similar market we find ourselves in now, that's when activism has typically outperformed other strategies”.

What’s happening in the activist space?

When asked about the shape of the activist space currently, Hawkins points to four main trends he is observing.

Firstly, the vast majority of activism takes place privately, away from the public spotlight.

“Investors will never see or hear about the activist initiatives that are being undertaken because they’re being undertaken behind closed doors, either through discussions with chairmen and chairwomen or through discussions with CEO and management teams”.

The second trend involves what Hawkins calls “swarming” where multiple shareholders all focus on a common outcome for the same company. Hawkins points to the example of Tabcorp “where a number of shareholders advocated the benefits of separating the lotteries division from the wagering division and of creating two separately listed entities, which ended up happening and was a value-creating exercise for shareholders of Tabcorp”.

Hawkins also points to ESG being a significant theme. “We see a real focus in Australia on the ‘E’ and the ‘S’. There’s less of a focus on the ‘G’ and that’s something that we are going to focus on going forward”.

And finally, and perhaps most importantly in terms of the stock-specific opportunities Hawkins talks to below, the market’s emphasis has shifted significantly.

“12 months ago there was a focus on M&A and on financing-related initiatives like sale and leasebacks. Now with the cost of debt increasing materially because of the risk-free rate going from close to zero to above 5%, there’s more of a focus on operational efficiencies and cost-out because we find ourselves in an environment whereby financing and M&A is challenging”.

“There's bloated costs in a lot of companies post Covid and we think that now is an appropriate environment to have a look at companies' cost bases and determine whether or not cost-outs are appropriate going forward”.

How the L1 Capital Catalyst Fund invests

For any stock to make it into the Catalyst Fund, it must pass through three gates, according to Hawkins. With only 10 stocks in the portfolio at any one time, anything that makes it in has been put through its paces.

“The first gate is the Value gate. The second gate is the Quality gate. And the third gate is the Catalyst gate”, says Hawkins.

The first two gates are the same two gates any stock must get through to become a long position in the L1 Long Short Fund, but it’s the Catalyst element that is an additional gate for the Catalyst Fund.

In explaining each gate further Hawkins adds that the team is looking for stocks where the intrinsic value and quality are well above where the company’s share price is currently trading.

“We are looking for companies that have high-quality management teams and good industry tailwinds.

“We want strong balance sheets. We want strong business trends in terms of catalysts. They can be strategic, financial, operational or governance related, or quite often we'll have multiple catalysts – all of which will contribute to share price appreciation over time”.

Recent investments

When asked for a couple of opportunities that he likes right now, Hawkins points to Downer EDI (ASX: DOW) and QBE Insurance (ASX: QBE).

L1 Capital is currently the largest shareholder in Downer, with over 10% of the register – a significant investment in anyone’s book. There are multiple reasons why Hawkins likes it so much.

Firstly, the cost-out story.

“They’ve stated publicly that they’re seeking to take over $100 million dollars per annum of cost-out of their cost base. We think that is readily achievable. We’ve done a lot of diligence on that. That’s an example of our shift from the benefits of the financing transaction to making the company a bit leaner, a bit more efficient, and taking some costs out given the more challenging macroeconomic headwinds we find ourselves dealing with at the moment”.

Digging a little deeper, Hawkins points out that they added Downer fairly recently, after the company’s last profit result, and that the Downer share price “is at a similar level to where it was 20 years ago”.

“That's part of the opportunity because we see a company that has been facing some challenges, be it weather-related, or attaining reasonably priced labour. It's also had some challenging contracts and operational inefficiencies”.

In terms of the three gates, from a Quality perspective, Hawkins likes Downer’s inflation-protected contracts. “That’s an attribute which we like in the current high inflation environment”.

In terms of the Value gate, Hawkins sees a company that is cheap. “If it can achieve its management objectives in terms of a 4.5% plus EBITA margin in FY 25, which we believe is achievable, we do believe it’s good value”.

And finally, the Catalysts. As well as the cost-out story mentioned above, Hawkins adds that there is a cultural reset underway with a new chair, new CEO, and new CFO. Furthermore, Downer is also seeking to sell some non-core assets, which he believes will “be able to be achieved for attractive prices and will shine a light on the inherent value within the Downer portfolio”.

As for QBE, Hawkins believes that after a tough period, there are appropriate winds in the company’s sails.

“We, like a lot of investors, had been hesitant to invest in QBE for some time. There's a lot of scar tissue. But we think there's tailwinds behind the business now that it hasn't had for some time”.

Those tailwinds include, according to Hawkins, their premium growth rates, which are far above their 10-year average, and a new management team spearheaded by CEO Andrew Horton.

“He’s a high-quality CEO. He ran Beazley, which is a UK-listed insurer, and did a very good job there”.

Turning risk into opportunity

I couldn’t help but quiz Hawkins on the factors that he recognises as catalysts, given that they are often a double-edged sword i.e. they present as both opportunities as well as risks.

Board shakeups, cost-outs, and restructures don’t always go smoothly or prove to unlock value for investors. I was curious to know what gives him confidence in the process, aside from his years of experience.

“There's a lot of hard work that goes into it when we assess the cost-out. We don't just take management's word for it. My team does a real deep dive in terms of looking at peers, looking at what comprises the cost base”.

Hawkins adds that with the Downer cost-out, specifically, his team looked at the composition of the cost base between Australia, the transport division, the utilities division, and the facilities management division.

“We look at the duplication of costs across both Australia and New Zealand where about 25% of the revenue comes from. So it’s a deeper dive to make sure we’ve really done the work. Then we assess it and we take a step back and consider the asymmetric risk-return proposition”.

Ultimately, Hawkins is hyper-selective when it comes to opportunities, always asking the question:

“Is that really worth it?’ because we've got a hard cap of 10 stocks and it needs to be one of our best ideas to get into that 10 stock portfolio”.

The L1 Capital Catalyst Fund has a recommended rating from both Zenith and Lonsec.

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