L1 Long Short Fund Limited (LSF) Earnings Call Transcript & Summary

Good morning, everyone, and thank you for joining us for the L1 Long Short Fund Investor Webinar. My name is Mark Landau, I'm the Joint Managing Director and Chief Investment Officer of L1 Capital. I'm delighted to be able to give you an update on LSF today. Over the past year, it's been obviously a very eventful year for everyone around the world, and our thoughts go out to everyone who's been through quite a lot, particularly those fellow Victorians. But I guess from our perspective, the share market has provided a lot of opportunities. Over the past year, the portfolio has returned 78% and the LSF share price has increased by 93%. So it's been a truly exceptional period for the portfolio. One of the things we've been really happy about is the quality and breadth of the returns. We've generated strong positive returns from both longs and shorts, small caps and large caps and domestic and international. So it's been a great contribution from everyone across our team to deliver such really broad-based returns. We've had 28 different stocks that have delivered more than 2% to portfolio returns, highlighting that it hasn't been one stock or one theme. It's been really broad. And we've also had portfolio construction that's been a positive driver as well as we positioned very early on for vaccine success and also for higher inflation, and both of those trends have started to play out throughout the past 12 months. So turning to performance. As I mentioned at the outset, our performance has been very strong over the last 1 year and 3 years and now since inception as well. We've seen a positive return over the past year of 78% compared to roughly 30% for the market. On a 2-year view, roughly 35% versus 8% and on a 3-year view, roughly 24% versus close to 10% for the ASX 200. So it's been really pleasing that the performance has been very strong and consistent in each of the last 3 years, and we've now posted double-digit returns over all time periods. Since inception, the strategy going back to 2014 has delivered close to 24% net return per annum, which is the best return of any Australian hedge fund over that 7-year period and that compares to about 8% per annum for the Australian Index. Since inception of the Long Short strategy back in 2014, what we've seen is a variety of market conditions over that time. On this page, you can see the performance of the portfolio in both rising and falling markets. In rising markets, the average stock market rise during an up month has been 2.9%, and the portfolio has been able to keep pace with that, essentially delivering what they call 100% upside capture. On the other hand, when the market has a sell-off and there's been 30 individual months when the market has fallen, and average market fall has been down 3.2%. And in those same months, the portfolio has actually been up modestly, up by 0.2%. This is one of the really unique features of the Long Short strategy that has been able to not only keep up with markets when they're rallying but to protect investors' capital when markets fall. This is not a guarantee that we will always outperform the market in a sell-off, but it is a good sign that over a long time period, over 7 years, we've demonstrated resilience in falling markets due to the way that we go about our research and our investment process. We find companies that are very undervalued, they have strong balance sheets, attractive industry structures and favorable operating trends, and they tend to be the factors that ensure that the portfolio performs better than market in a sell-off. The way we've been seeing markets for 2021 hasn't changed throughout the year. At the start of the year, we talked about 4 key themes that we thought would be really the drivers of market returns and the market focus over the course of the 12 months. And for those of you who have been reading our presentations and reading our quarterly reports over the course of the year, you'll notice that these 4 things haven't changed. The first one is the market rotation. For the past 12 months, we've been very clear in our communications, saying that we felt that the market was very undervalued and that we'd see a rotation out of cash and bonds into equities out of growth stocks, which have dramatically outperformed during COVID into value stocks that were very oversold because of COVID and from defensive into cyclicals as global growth started to accelerate. The reopening trade is the second thing. We believe that we're only about 2/3 of the way through that trade, and many of the stocks that we still like have really got nowhere over the last 6 to 9 months, despite the fact that the operating environment has dramatically improved for these companies and we think we're very close to an inflection point that we'll start to see come through in February results and particularly, in August, as these companies report their half year and full year results. Thirdly, the M&A wave. It's been quite extraordinary, just how much M&A activity has happened so far in 2021. We've already exceeded the highest level of any period on record. The highest period prior to this over the last 20 years was 2007, and 2021 has already eclipsed that level. Deal activity is being driven by business confidence. Boards are feeling much more positive about the outlook for their business. Earnings have been very strong. Debt and equity are very cheap to access, and private equity is very cashed up and looking to do deals. And lastly, higher inflation, which is obviously front of mind for a lot of our investors. There's been upward pressure on inflation due to rising input prices and very extreme monetary and fiscal policy. And one of the things that's been very notable has been that rising energy prices and also a tight labor market is accelerating that inflationary pressure, and we expect that to persist into 2022. So in terms of the market rotation, as you can see on the chart at the top right, the outperformance of growth over value has been quite extraordinary. It's been the largest period of outperformance we've ever seen in the history of financial markets. Since 2008 until 2021, it's been almost one-way traffic, and we saw an acceleration in that trend because of COVID as investors look to hire in companies that would not be hardly affected by COVID, so sectors like tech, health care and other defensives. On the other hand, cyclicals and value stocks are very hard hit by the pandemic. So we saw an acceleration in that trend, and you can see that on the chart on the top right, the area that circled is really the COVID impact and what happened to accelerate that trend. We don't take issue with outperformance of growth stocks over value stocks over the prior decade. There's been lower falling interest rates. There's been disruption in many sectors. We agree that growth stocks in many ways deserve to outperform some value stocks due to those industry effects and due to that interest rate effect. What we do take issue with and we do think we'll reverse is that last part of the chart where you can see that the COVID impact caused about a 30% relative change in performance between growth and value stocks, and we think that's going to start to unwind over the next 12 to 18 months. One other thing that's been interesting, it just hasn't been the price performance, it's also been the P/E rating that these growth stocks trade on. And as you can see on the chart on the bottom right, the premium that growth stocks trade at versus value stocks or versus the broader market, I should say, is absolutely off the charts. If you look at the average over the last 35 years, we've only seen a similar level of premium once before during that time and that was during a very brief period during the dotcom boom, and I think everyone knows how extreme that period was. What's been really pleasing for me personally is that the portfolio has performed very well in 2019, 2020 and again, in 2021, despite the fact that we're a value manager and a contrarian -- we have a contrarian mindset. To be able to deliver that performance means we've been doing some really good stock picking to be able to offset that massive headwind from growth stocks outperforming value stocks. And if we were to see a period where that headwind stabilizes or indeed starts to reverse, we feel that would be a huge tailwind to the portfolio performance. In terms of the reopening trade, it's a topic that we've talked a lot to our investors about over the past 1.5 years. We feel that we're getting into quite an exciting period. Essentially, over the last 6 months, this reopening trade is stalled. Investors have become concerned about rising case numbers in Israel, which had a very high vaccination rate. They became concerned about the rise of delta, and we feel both of those concerns are about to become much more -- I guess people are going to become much more relaxed about the outlook for those 2 issues over the next 6 months. One thing we've seen in Israel is that hospitalizations were doubling every 10 days, despite the fact that you had a very high vaccination rate in Israel. One of the things that we've observed is that once Israel put in place their booster program, hospitalization stabilized and began to plateau. And that's been very encouraging because obviously, there was a real concern when case numbers in Israel started to accelerate after having declined 99% as of April this year. On the bottom right-hand side, you can see that in Australia, the vaccination rate is now well and truly through 70%. We expect that Australia is going to surpass its target of 80% and that essentially, you'll see a gradual opening up of the Australian economy, starting with New South Wales, closely followed by Victoria and subsequently, other states will follow in due course. One of the other really encouraging things that's got a lot less press coverage is the improvement in treatments. There's been 2 new drugs. One is an antiviral and one is what they call an SSRI drug. Both of those are well and truly on the way to being used in the field, both of them are proving to be dramatic benefits in terms of reducing the chance of being hospitalized and reducing the chance of dying as a result of COVID. So we think it's a combination of the progress on the vaccination front as well as some new really exciting treatment options, we think the outlook for reopening trade is totally on track, and we're very excited about the shares that we have in the portfolio that will benefit from this trend. So turning to M&A. It's been quite an extraordinary period for anyone involved in mergers and acquisitions in Australia. Investment banks, private equity, lawyers, anyone who's working in this field has never worked harder in their life. What we're seeing at the moment is that business confidence is at really high levels. Companies are enjoying strong earnings growth, balance sheets are undergeared, debt and equity is cheap and easy to access, and what we're seeing is deal after deal. And these are not small transactions. We're seeing lots of companies in the ASX 100 receiving or taking part in takeover bids. Sometimes, it's due to COVID disrupting their sector. Sometimes, it's due to ESG priorities. And other times, it's just due to a really exciting opportunity that COVID has presented. And you can see on the chart on the right, deal activity has never been higher. We are way above the highest level ever recorded in the last 20 years, and we think that this trend is likely to persist due to [ easy ] money, lots of untapped spending from private equity firms and specs, and we think that the portfolio is really well placed to benefit from that given that we have a lot of stocks that are undervalued, many of them have strategic appeal and lots of them also have undergeared balance sheets, which makes them even more attractive as a corporate takeover target. The last thing that I'd like to talk about is higher inflation. It's something that we've been talking about since the start of the year, and that's definitely become much more front of mind for a lot of our investors. We think that the risk of higher inflation is very real and are likely to persist for much longer than what the central banks and many investment experts would have you believe. Essentially, once we concluded our vaccine research, which was a major focus for our investment team over the last 12 months, we turned our focus to inflation, which we felt would have a really pervasive impact across all asset classes and all stocks. From our analysis, essentially, when you go back through 100 years of history, you observed that there are only 3 reasons why you tend to get a significant increase in inflation: the first is wages pressure, and we're already seeing very tight labor markets in Australia and to some extent in the U.S. as well. Often, it's sector-specific, but essentially, companies are often telling us they're finding it hard to attract and retain staff, and the balance of power is quickly shifting to the employee and away from the employer. Secondly, on energy prices, we've already seen oil prices increase by more than 100% over the past 12 months. And what we believe is that the energy market is likely to stay tight and get even tighter over the next 6 to 12 months, and that raises the prospect that oil prices might go through $100 a barrel for the first time in many years. And lastly, capacity utilization. Essentially, all of the spare capacity in the global economy has been tapped out. Supply chains are incredibly tight. We've seen freight rates and other indicators of supply chains stay very, very stretched. Order backlogs are at very extreme levels. Inventory levels are at very low levels. And this sets a very dangerous situation in terms of companies needing to pass through these higher costs in the form of high prices. One of the things that we think is very interesting is that essentially, the world hasn't had to deal with high inflation for more than 30 years. The result of lower interest rates and lower inflation has been a real boom for high P/E stocks, growth stocks and long-duration assets in general. And we think that what you might find is, this period of higher inflation sees a rotation out of long duration to short duration assets. If you look back through history, the best performers in these higher inflation periods tend to be sectors like energy, gold, commodities and low P/E stocks, and this would be a dramatic change from those sectors and stocks that have performed well over the last 30 years. Most of those sectors, such as gold, resources, low P/E stocks are still trading very cheap compared to their history and compared to the broader market. They're very underowned, and we think they're a really attractive place to look to find really exciting opportunities. As you would know, our investment team does very detailed bottom-up stock research, and we really are stock [ makers ] because we're trying to build our portfolio based on company and industry insights. But if you stood back and looked at our portfolio top down, where you'd observe our 4 obvious portfolio themes. We think that each of them offer a compelling asymmetric risk reward. Firstly, U.S. sports betting. We think this is one of the most exciting sectors of any sector in the world. The U.S. sports betting market is about to open up, and it's opening up state by state. So it's a very gradual process, but it's something that's likely to occur over the next 5 to 7 years. And what we can see is that you're getting exponential growth rates for those companies that are well placed to win market share in those emerging markets. The end market size, we believe is underestimated due to in-play betting, which means that betting does not just occur before the game, but it also happens during the game. And lastly, iGaming, which is a lot of the games you would typically play in the old days at a casino that you're now playing on your phone or on your iPad. The energy market is really exciting as well, both new energy and old energy. New energy, as everyone would know, has huge industry tailwinds from sustainability, renewables, decarbonization. It's one of the megatrends that we think will persist for decades, not just years. Secondly, old energy, which has been really under a lot of pressure given the oil price crash 18 months ago, we think is now reemerging and looks incredibly exciting over the next few years. One of the things that's really exciting is that we think that there's been a massive underinvestment in old energy due to ESG considerations and also because those large oil companies have been very reticent to invest in new capacity given the backdrop of what's just happened over the last 18 months. So we think the oil market is going to get very tight over the next 1 to 2 years. Thirdly, the vaccine recovery, which we've spoken about at length previously, we think a lot of the operating trends for these companies that are about to become the recovery stories are really going to start to accelerate over the next 12 months. Some of those reopening stocks that we really like have basically gone nowhere over the last 6 months, even though the backdrop is dramatically improving because of high vaccination rates; and secondly, because the inflection point is getting much closer. So obviously, we think the share prices should start to perform as we look out into 2022. And lastly, corporate restructures. We think there are lots of high-quality businesses that have a desperate set of assets that are about to do asset sales, maybe demergers, could be capital management. Each of these events will prove to be a major positive catalysts for many of the stocks that we hold, and they're happening across a wide range of sectors. So we think that there's lots of opportunity that's left in the market, given huge undervaluation in some of these companies. The first theme is U.S. sports betting. The 2 stocks that we think of the best way to play it is the #1 player in the U.S. market, which is called Flutter. They are the #1 player in U.S. sports betting, and they're the #2 player in iGaming. The industry is incredibly attractive. It's got very high and sustainable growth rates. It's a capital-light sector, and they generate very high ROEs. You've got an outstanding management team and a track record of executing really well, and they've now got roughly 40% market share in the U.S. sports betting market. The stock trades on a P/E of only 25 on FY '23 numbers, and we believe that can sustain growth rates of around 30% per annum for many, many years to come. That compares to the ASX 200, where many industrials trade on a low 20s P/E, but their earnings are growing at low or mid-single digits. Entain is a U.K.-listed company that's the #1 player in iGaming, and it's almost the #2 player in U.S. sports betting. Entain is a global business that has operations around the world, but its U.S. sports betting presence is incredibly valuable and underappreciated. Its peers, MGM and DraftKings have recognized that value and have both made takeover bids for the company over the past 12 months. Both of those deals fail to conclude, but we believe it highlights what we see as huge strategic value and a very promising outlook given their position in both iGaming and U.S. sports betting. Again, the company trades on very reasonable multiples, roughly 17x earnings on FY '23, delivering 25% EPS growth with many, many years of growth to come. The second theme is energy. We believe that both old energy and new energy are really exciting places to be over the coming 1, 2 years. And one of the examples of an old energy stock that we think is really exciting is Cenovus. Cenovus is Canadian and U.S. listed. It's a company that has an extremely long production life. It has some unique assets that are very low in terms of their operating costs. They have an ability to be positive cash flows at just over $40 a barrel compared to roughly $80 a barrel [ today ]. We think they're going to rapidly degear and be able to do capital management later in 2021. We also think that people are underestimating the resilience of the oil price. We think that the combination of ESG pressure plus the crash in the oil market last year means that the supply response that we would typically see to higher oil prices is simply not coming and the market is going to become very, very tight on energy as we look 12 months forward. In terms of new energy, we think Mineral Resources is one of the best ways to play it. The company has lithium assets, iron ore assets and a huge mining services business. The part that is really exciting from a new energy perspective is that they own Wodgina, which is one of the largest hard-rock lithium mines in the world. The operation is about to be restarted given that lithium markets have tightened significantly, and we think that the lithium market is likely to stay relatively tight as we move forward given the uptake of electric vehicles. The management team at Mineral Resources is one of the best that we see anywhere in the market. They're incredibly entrepreneurial and commercial, and they've got a track record of finding new value-added projects to bring online that have been a key driver of earnings over many years. We also think the company is well placed to add 2 substantial iron ore growth projects. Both of these opportunities are likely to come online within a relatively short period of time, which we believe will be a driver of earnings combined with the restart of Wodgina. The third theme is the vaccine recovery. Many of those COVID losses are now going to become reopening winners. And essentially, companies like Qantas and Ramsay Health Care are really well placed to benefit. Everyone would know the business of Qantas. Obviously, there's a lot of pent-up demand for travel, both on the leisure and business side. We see a strong outlook for loads and yields. Qantas took advantage of the crisis and enacted a $1 billion cost out program and their main competitor, Virgin, has been in the process of reducing its route network and deemphasizing its focus on the corporate market. Qantas management over the past few months have reiterated their FY '24 financial targets, and that translates to almost $1 of EPS, if they were to achieve that target, which means that the company is trading on only 5.5x those earnings, if they're able to get there. We think fair value for the company would be close to 12 to 15x, which means there's more than 100% upside in the shares, if management can achieve their targets. We think that the loyalty division is the drill in the crown. Essentially today, it comprises about 1/4 of earnings, but stand-alone, that business will trade on at least 30x P/E, given it's a high-growth, capital-light monopoly business. Ramsay Health Care is obviously a very different business. It operates the highest quality and best regarded private hospital group in Australia. The stock trades on a P/E of 24x. Once you normalize COVID impact, we think you're also going to get very strong earnings growth over the next few years, given the brownfield expansions they're doing and very long wait lists, both in the public system and the private system, which gives you a higher degree of certainty that those operating theaters will be full for many years going forward. The company also owns more than $10 billion of very attractive property assets across the East Coast of Australia, and that $10 billion translates to almost 2/3 of the market cap of the company. So there is an opportunity for Ramsay to do what they call an OpCo/PropCo deal and essentially spin out the property assets and get a huge capital inflow to enact that change. The balance sheet is already undergeared. It has around 1x debt-to-EBITDA, which for a very reliable business like a hospital group, shows they have a huge amount of capacity to either do acquisitions or to do capital management. And the last theme is corporate restructures. We think that there are many companies that are able to restructure or sell assets to highlight the hidden shareholder value embedded in the business. Tabcorp is an obvious example. Tabcorp owns an incredibly high-quality business in its Lotteries division, and it also owns a strategically attractive business in its Wagering division, which has already received 3 takeover bids in the last 12 months. The Lotteries business is a monopoly, capital-light, high-growth business that has a fantastic track record of delivering for shareholders. In the middle of next year, we expect the company to complete their demerger, which will [ see ] the Lotteries division trade as a separately listed company. The Lotteries business is incredibly high quality. We think it's really the undervalued and underappreciated part of the business, and it comprises about 3/4 of the total value of Tabcorp overall. We think that once the companies are demerged, both sets of assets become extremely strategic takeover targets, and we think that given the level of M&A activity along with the amount of money that's being allocated to infrastructure like assets, we think those are incredibly obvious takeover targets. In the case of News Corp, News Corp is a media and digital real estate conglomerate that owns companies such as a 61% stake in [ REA ], Move, which is the #2 real estate portal in the U.S. and also assets like Dow Jones, which owns with The Wall Street Journal. These assets are incredibly high-quality, high-growth, capital-light businesses that we think are underappreciated in the current conglomerate structure. Management and the Board have been very clear that they're looking to do transactions to highlight the embedded value in the business, and we think that these are likely to take place over the next 12 months, which will cause a further re-rating of the stock. We believe that the valuation for News Corp is about 50 -- the fair value of New Corp is about 50% above the current share price, which gives a lot of protection for those investors that are prepared to wait and wait for those deals to take place. In the meantime, the company has recently announced a buyback program, which we think is a great reflection that the Board is being shareholder friendly, and also that they see a lot of value in the shares at current prices. In terms of the key portfolio contributors and detractors over the last 6 months. On this slide, we list a number of the key performers, both on the positive and negative side. The portfolio today remains fresh, and we've rotated many of our positions to ensure that it reflects our highest conviction ideas. One of the key positive performance over the past 6 months has been Z Energy, it was a key position in the portfolio. Z Energy received a takeover offer from Ampol at a 35% premium to its unaffected share price. That is the share price prior to deal speculation in the newspaper. Wells Fargo, which is one the major 4 banks in the U.S., delivered very strong share price performance. Shares rallied from roughly $29 when we initially bought the position to around $45 in less than 6 months. Improved operational performance and falling bad debts in the U.S. market were the key driver of that share price performance. Treasury Wines, we bought into Treasury around $8 after share price had collapsed after China announced its tariffs about a year ago. Management then demonstrated an ability to reallocate their wine portfolio and also to offset some of the impact of their China tariffs. The position was exited at around a 50% gain not very long ago. In the case of Telstra, returns to their underlying earnings growth was enabled by an improving mobile segment and some cost initiatives they put in place. The monetization of their towers portfolio also was a driver of returns, and the share price has rallied from around $2.80 to $3.90. Teck Resources, which is our Canadian listed stock that we are very positive on, enjoyed strong operating performance over the past 6 months due to rising copper, coking coal and zinc prices. And despite the share price rally, we remain very positive about the prospects for the company. On the negative side, the 2 key detractors were Star Entertainment and Aurizon. Shares in Star sold off heavily after negative media coverage about their AML controls. We added to our position post the share price fall, which we viewed as an excessive reaction. And lastly, on Aurizon, the shares declined after they announced the acquisition of One Rail Australia. We viewed this transaction negatively and elected to sell down our position, despite the fact that the shares have fallen post news. In summary, performance has been driven by a very wide variety of stocks across many different sectors and both in Australia and overseas, and we're very proud of the fact that across our entire team, performance has been very broad-based, highlighting the strength of our broader investment team across many sectors. So turning to a general LSF update. Over the past year, we've seen the discount reduce significantly due to a wide range of positive drivers. Overall, since the start of 2020, we've seen a discount to post-tax NTA reduced from 23% to only 3%. Portfolio performance has been a key driver of that. Consistent strong performance in 2019, 2020, and again, so far in 2021, has been a key driver of share price performance. An aggressive on-market share buyback program, which the Board announced about 18 months ago, has been very much on the front foot. The company has bought back 28 million LSF shares, which equates to around $53 million at an average price of around $1.89 per share, which is around 6% of issued capital. Secondly, on the dividend front, the company declared its first dividend in February 2021 of $0.015 and have followed that with a second dividend of $0.03 in August 2021. The company remains well positioned to continue to deliver sustainable and growing dividends over time. And lastly, Director buying. We've seen the senior L1 team purchased a further -- just over 8 million LSF shares on market over the past 12 months, and this is in addition to the reinvestment of performance fees, which has been taking place since IPO. The portfolio has performed very strongly in 2019, 2020, and again, in 2021 so far. In each of those years, we've returned more than 25% net. We see 4 market trends that we believe will continue to dominate the market as we look into 2022: The market rotation, the reopening trade, rising M&A activity and higher inflation. From a portfolio point of view, we see 4 opportunities that we think present really exciting asymmetric upside for our investors: U.S. sports betting market, new and old energy, the vaccine recovery and corporate activity. The share price discount to post-tax NTA has been largely closed now, ensuring that shareholders enjoy the benefit of the rising NTA. And lastly, the company is very well placed to deliver consistent and rising dividends over time. We remain very excited about the opportunity set that we see at present. There are lots of stocks in the portfolio with significant upside to valuation, and we continue to be very optimistic about the long-term prospects for the company. Thank you, everyone, for your time today. We really enjoy catching up with all of our shareholders. And please, feel free to reach out if you have any questions. Have a great day.