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Livewire | Why L1 is playing defence right now and 3 standout stocks in a tough market

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Mark LandauJoint Managing Director and Co-Chief Investment Officer
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33 mins
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This article was first published by Chris Conway in Livewire Markets on 29 March, 2023.

L1 Capital, via the L1 Long Short Fund Limited (ASX: LSF) had been “relatively bullish” and “very optimistic” on equities since March 2020.

More recently, however, L1 has become “more cautious” according to Joint Managing Director and Co-Chief Investment Officer, Mark Landau.

Landau notes that valuations look much more stretched, particularly as central banks have hiked rates with unprecedented speed.

“We think that the valuation of the market, in general, is quite expensive. So we think now's a time to dial back market exposure.”

This is part of L1’s contrarian approach, which has made it the best-performing long-short fund in the country, delivering annual net returns north of 20% since inception (2014) (note that LSF, which replicates the unlisted fund, was launched in 2018).

In this wire, I explore with Landau the levers the fund can pull to dial down risk whilst also searching for suitable opportunities, why research and networking are key drivers of performance, and three stocks that have him excited right now.

Landau also shares the two things he and Co-Chief Investment Officer, Raphael Lamm, focus on when assessing a stock, and what ‘quality’ means to them.

Livewire Markets | This interview was recorded in March 2023.

FUND INFORMATION

  • Name L1 Long Short Fund Limited (ASX:LSF)
  • Asset Class Absolute return, alternative strategy
  • Description An absolute return portfolio that offers investors a highly diversified portfolio of long and short positions based on L1 Capital’s fundamental bottom-up research process.
  • Objective: To achieve a 10% return net of fees and expenses p.a. over the long-term.

Edited Transcript

Mark Landau: My name is Mark Landau. I’m the Joint Managing Director and Co-Chief Investment Officer of L1 Capital, and I co-manage The L1 Long Short Fund. The ticker for that is LSF.

I think the benefits of exchange-traded products are that they enable you to easily access a very diversified portfolio of shares, and also to pick out exactly what strategy or geography or investment style resonates with you.

Why did you choose to offer your strategy as a listed product?

When we first started out, the Long Short Fund was purely offered to high-net-worth investors. Our background was institutional clients. We progressed to high-net-worth investors, and then we realised that the strategy wasn’t available to retail investors, and obviously, having it as a listed company was a great way to offer that to retail investors.

What is the role of your fund in a portfolio?

Essentially, what we’re hoping to do is to deliver alpha or returns above the market, and to do that in a way that has low correlation to the market and low correlation to other funds.

What is unique about your investment strategy and process?

I think there are many things that are different in the way we go about it.

The first thing is that our approach is very contrarian.

So when people are panicking and valuations look amazing, we’re happy to take the market on and buy shares. And equally, when valuations look stretched and people are probably getting a bit ahead of themselves, we’re typically selling or shorting those stocks. So we tend to position ourselves a bit of an opposite to the herd.

The second thing is that we do an incredible amount of research on our companies.

In a typical year, we’ll do several thousand company meetings – meetings with the company, competitors, suppliers, customers, board members, industry experts – anyone that can give us insight into the trends in that industry.

What we find is that we're able to add value through that research in terms of our performance for our investors.

What’s the difference between a traditional long-only Australian equities fund and the L1 Long Short Fund?

Essentially, there are three main differences.

They all got born out of the frustrations we had of running a long-only fund originally.

Firstly, the Long Short Fund, by its nature, is able to short stocks – so it benefits from share prices falling, not just rising.

Secondly, we can invest internationally, not just in Australia. So sometimes, we do a lot of research on a company in Australia and it leads us to a better way to exploit that insight overseas.

And the last thing is that we can adjust our market exposure. When the market looks expensive or risky, we’ll dial down our market exposure. And equally, when the market tends to look attractive – lots of undervalued stocks, maybe some good tailwinds – that’s a time we dial up our market exposure. So, there’s a lot of differences from a traditional long only fund.

You have a knack for adapting to different market conditions. Can you explain that, please?

My background – my university days – apart from accounting and finance, I studied economics and economic history. It’s always been something I’ve been interested in and I think that’s a good background for understanding equity markets and also the psychology of markets.

One of the things I think we've done well is that we've been very rigorous in our research.

As I mentioned before, we do hundreds and literally thousands of company meetings every year, and that gives us a much earlier indication of when we hit inflection points or when we’re noticing a change in the market environment.

The second thing is we have a contrarian nature, so we tend to be relatively unemotional.

When the market's getting too excited or too bearish, we'll tend to take the market on and move in the opposite direction.

And then the last one is we’re very much focused on looking forwards. What is the market going to look like in 12 or 18 months time? Not to focus on the history and the baggage or things that may have looked good before or things that may have looked bad before, but to have an open mind and think about the world one year out and often, that’s the best way to make money.

Where does the portfolio currently sit on the risk spectrum? Are you more bullish or bearish?

We’re definitely more cautious at the moment.

Since March 2020, we’ve been relatively bullish, so we’ve had a very optimistic outlook for equities. Since then, the Aussie market’s rallied from roughly 4,500 to over 7,000.

Central banks are ratcheting up interest rates very quickly. You’re getting no more policy stimulus from governments and also, we think that the valuation of the market, in general, is quite expensive. So we think now’s a time to dial back market exposure. Let’s see how the dust settles with some of those macro risks.

We’ve also got tail risk on the geopolitical front. The Russia-Ukraine situation, China-Taiwan, we think they’re tail risks that are very difficult to forecast and we’d rather reduce a bit of market exposure on that basis.

How do you narrow down the opportunities that you want to pursue and that ultimately end up in the portfolio?

We have a team of seven in the Long Short Fund, and essentially, each person in the team is expected to be a genuine subject matter expert on those stocks and sectors. Each person typically covers only two to three sectors, but they’re expected to go very deep in terms of the network of contacts that they tap into to understand what’s happening in that industry.

We give people on our team a lot of autonomy to hunt where the opportunities are. And then they come back with their research, their valuations, their assessment of management.

 

Often, that's part of the process where we're interrogating the relative opportunity sets across different parts of the market and working out whether they are long opportunities or short opportunities and whether to go overseas to exploit that insight better. And that's the exciting part of our job that we love doing every day.

Do you use the same criteria when assessing and buying an opportunity as a selling opportunity?

When we’re looking to buy stock, we look at two things.

One is valuation, in which we focus on cash flows. The second thing we focus on is the quality of the company.

To us, quality is four things: management quality, industry structure, operating trends and balance sheet.

We think they’re all equally important and we do a lot of work to understand where they rate on that quality score. Often, you’ll find a value manager – which we are – skews too far to value and ignores quality, and they end up buying a value trap. So the company keeps destroying value over time because of one of those qualitative factors being weak.

The other area is you could be too focused on quality and not enough on valuation, and you end up overpaying for a great company, but it might just be too expensive. Essentially, we’re trying to balance the two.

The way that we go about that is we’re doing all of those meetings with different people. So not just talking to a favourite stockbroker. We’re talking to company management, which a typical fund manager would do, but those extra meetings that are harder to organise, but also much more insightful because typically, those people are less biased and they’re also giving you a bit more extra information than you would get from just reading the company presentation.

How difficult has it been to build those relationships so that you can get that access that you were just talking about?

Co-founder Raphael Lamm and I are incredibly lucky. Rafi used to work at Paradice Cooper. It’s now called Cooper Investors. Through that initiation in the industry – he was there for five years – he built up an extraordinary network of contacts across a lot of different parts of the market. I was at Invesco, which is a UK fund manager that had a business in Australia.

Through those jobs, we were able to build up that initial set of contacts and then we've expanded that over 20 years to really know pretty much everyone in corporate Australia.

We just had reporting season. In that time, we would’ve met with 150 different CEOs and CFOs of different companies.

It's an incredibly exhilarating part of our lives, February and August, when companies are doing reporting season. You're sort of getting your exam results. You find out whether you've made the right calls or not.

But what we love about it is that you’ve built up these relationships literally over decades in a lot of cases, and it’s much less about a fund manager interrogating a management team. It’s like friends catching up and discussing what you’re seeing in the industry. And it’s more of a two-way conversation than us interrogating them.

Could you please explain some of the key positions in the portfolio right now?

We’ve got a very diversified portfolio. We typically hold 55 long positions and 25 shorts, and they’re all in relatively small size. So any position I talk about, please keep that in mind that they’re all relatively minor, but hopefully, we’ll get more than 50% of things right and that’ll deliver good returns to our investors.

Three stocks that I think are really interesting at the moment are Capstone (CS:TSE), which is a Canadian copper company, QBE Insurance (ASX: QBE), which most people would know is an Australian insurance company, and the last one is Chorus (ASX: CNU), which is the monopoly owner of the fibre network in New Zealand.

Can you talk a little bit more about the Capstone idea and why that company earns a position in your portfolio?

At the moment, copper is one of the most interesting commodities globally. It’s one of the really safe ways to play the shift to sustainability and the shift to electric vehicles.

Copper, as people would know, is a metal that’s used in almost all devices that have electricity running through them, but one of the things that’s a structural shift is the shift to electric vehicles. And a typical car that uses electricity to operate uses about three times as much copper as a traditional internal combustion engine car.

What we’re also seeing is that wind farms and solar farms, and a lot of the new forms of power, are very copper intensive.

To get a new copper mine up and running takes about 10 years. So we know that there's this huge increase in demand coming, but it's very hard to meet that with supply in the short term.

The reason we like Capstone, in particular, is that that company is incredibly undervalued.

Capstone is the most undervalued copper company we've found in any safe jurisdiction globally.

Secondly, it’s got a very strong production growth pipeline. It’s likely to increase its production more than 50% over the next few years. And you’ve got a really entrepreneurial and very street-smart management team that has found really smart ways to expand production in a low-cost manner. So we think it’s a standout in that space.

Additional resources

Learn more about the L1 Capital Long Short Strategy

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