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

Good morning, everyone, and thank you so much for joining us for the L1 Long Short Investor Webinar. My name is Mark Landau, I'm the Joint Managing Director and Chief Investment Officer of L1 Capital. Today, I'd like to give you a summary of how things have been going in the portfolio, how we're seeing the macro environment and what changes we're seeing beneath the surface, how we're positioning the portfolio and also some stocks that we think are really exciting over the next few years. So turning to performance. On this page, we provide a snapshot of portfolio performance over all time periods. As many of our investors would know, our portfolio is comprised of Australian stocks, global stocks and has the ability to adjust market exposure like a hedge fund. So on this slide, we've provided a comparison with all 3 of those benchmarks the ASX 200, MSCI World and the Global Hedge Fund Index. Since our last investor webinar in November last year, the portfolio has returned just over 16% compared to 8.7% for the ASX 200 roughly 12% for the MSCI World and 0.4% for the Global Hedge Fund Index. Over the past 3 years, portfolio performance been very strong. We've returned 33.4% per annum compared to 14% per annum for the ASX 200 and 13% per annum for the MSCI world. The Global Hedge Fund Index at the same time has returned 3.5% per annum. Since inception of LSF, when we IPO-ed in 2018, the portfolio has returned just over 12% per annum and since inception of the strategy, going back to September 2014, we've returned almost 21% per annum, which is almost 3x that of the ASX 200 or MSCI World and about 20 percentage points better per annum than the Global Hedge Fund Index. Since inception, the L1 Capital Long Short strategy has been the best-performing Australian Long Short strategy and is a track record we're very proud of, considering the factor headwind that we've had from the outperformance of growth stocks versus value stocks. We're a value manager. We've had a consistent headwind for most of that period, and we feel like the market is finally starting to rotate into our types of stocks. One of the unique aspects of the Long Short strategy is how it's performed in up markets and down markets. In up markets, when the ASX 200 has been positive for the month, the portfolio has been able to keep up with market with roughly the same return for the index and also for the strategy. And that's despite the fact that the strategy has around 1/3 less market exposure. On the flip side, when the market has a sell-off and there's been 40 occasions when the market has been down in a particular month, we've been able to preserve roughly 90% of our investors' capital in those same months, demonstrating very strong and consistent capital protection over time. We believe this is one of the unique features of our strategy where our investment process focuses on the strength of balance sheets, industry structure, operating trends and management while also having a very strict focus on valuations and as these attributes of our process really come to the fore in down markets. In terms of the key stock contributors and detractors for the calendar year-to-date, Alibaba has been a key positive performer. We significantly increased our position in Alibaba around $65 a share in late October and early November last year, when concerns around the likelihood of China reopening were very prominent. Since that time, we've seen China reopen. The share price of Alibaba rallied from roughly $65 to $116 in the space of less than 2 months, and we exited our position at that time. Since then, as concerns about the China reopening and also the outlook for the Chinese economy have moderated, we've seen Alibaba shares retrace back to around $85, and we've since reentered the position at around that level. BlueScope has been a really strong performer for the portfolio. In the last few weeks, earnings guidance has been increased by more than 40% due to strong improvements in both U.S. steel prices and spreads. Capstone, which is one of our key copper positions listed in Canada has benefited from strengthening copper prices and continued strong execution of its growth projects. Flutter, which is the #1 player in U.S. sports betting has extended its leadership position. Its market share is now up to 50% from roughly 40% a year ago. Newcrest has also been a positive performer for the portfolio. They received a takeover proposal from Newmont at a 46% premium to the pre-offer share price. QBE has been a really strong performer for the portfolio, not just this year, but over the last 2 years. We're seeing cash NPAT at their recent result was 15% to 20% ahead of consensus estimates and premium growth in their sector continues to remain strong. Qantas has also been a really strong performer for the portfolio. In February, they announced an extremely strong profit result, announced a further $500 million share buyback. And for the FY '23, consensus earnings expectations have increased by more than 100%. Teck Resources received a takeover proposal from Glencore at an implied value of CAD 58 per share. On the negative side, we've had 3 key detractors, a short position in Apple, which obviously benefited from this rally in mega-gap technology stocks with investors crowding into defensives. Apple shares have rallied around 20% over the last 2 months. Cenovus, which suffered from lower oil prices and a refinery outage, which impacted production. And lastly, Downer, which had a weak first half in FY '23 and announced its second downgrade for the full year. It's been a really interesting start to this calendar year. The bond market has been unbelievably volatile, the likes of which we haven't seen since the '87 crash. In terms of what we're seeing in the yield curve, it's been fascinating. In the first 2 months of this year, we saw the yield curve steepen, interest rate expectations increased with people expecting interest rates to peak in the U.S. at 5.5%. Furthermore, there was no expectation of rate cuts throughout 2023. Then obviously, in March, we saw some issues with the U.S. regional banks, the collapse of Silicon Valley Bank, issues with Credit Suisse. And then we've seen the yield curve retrace all the way back to less than 5% for terminal interest rates and 3 rate cuts now factored in for 2023. On this page, we can see the change in 2-year bond yields. It was the largest move in 2-year bond yields that we've seen in more than 35 years, bigger than the GFC, bigger than the dot com crash, you have to go all the way back to 1987 to see a larger move in 2-year bond yields. In terms of the stock market, it's also been a very interesting start to the year. Mega-cap technology stocks have really led the market higher and high multiple growth stocks have started to outperform after a year of struggling in 2022. You can see the relative performance of growth versus value stocks over history. And what we saw is that from 2007 all the way through to 2021, we saw an extraordinary period of outperformance of growth stocks, the likes of which we've never seen before. Value stocks began to outperform in 2021 until the end of 2022. And then we've seen a reversal of this trend in the first few months of 2023. You can see a comparison between the index return for the S&P 500 compared to the equal weight of the S&P 500. If you were to strip out the 7 best performing stocks in the S&P 500, you would remove 75% of the index return for 2023. The other 493 stocks have only increased a couple of percent but the index is up almost 9% for the calendar year. What that shows you is that the market leadership has been incredibly narrow. And this is typically a sign of a rally that doesn't have much conviction. If we were to see this rally broaden, that would be a bullish signal for the market. But equally, if we were to see that narrow leadership persist, that would be a concerning sign. In terms of investor positioning, we're at a really extreme point. Cyclicals are very underowned and defensives are incredibly crowded. And this setup that really interests us. If you look at long-only funds and hedge funds, they're both sitting at the most depressed levels in terms of their exposure to cyclicals that we've had in many years. And at the same time, JPMorgan recently did a survey of hundreds of fund managers and asked them what is the best way to position in equities in the current environment. The feedback from that survey was fascinating. Only 2% of fund managers believe that cyclicals were the best place to invest in the current market, suggesting a very unliked and extremely underowned part of the market. On the flip side, defensives were the most popular response with 56% of fund managers replying that they felt defensive were the best place to invest. Typically, periods of extreme positioning, good or bad, tends to be an excellent contrarian indicator. So we believe this survey and the positioning that we can see from long only and hedge funds suggest that cyclicals are the opportunity in the market and defensives are crowded and expensive. As you can see on this page, the disparity and valuation between different sectors and different factors is now also very stretched. Low P/E stocks resources look very undervalued versus history, while defensive and growth stocks look very overvalued, and as we saw on the previous slide, very crowded as well. This chart shows the ASX 200 valuation premium for different sectors and factors versus its decade average. And as you can see, the multiples for defensives and low-risk stocks are at extreme highs. Offshore earners, which are a very popular place for investors to invest are now in the 96 percentile versus their history. In addition, for those offshore owners, the Aussie dollar is also trading at very depressed levels versus its 20-year range. So you have an inflated multiple plus inflated earnings because of the currency. And lastly, Low P/E and energy stocks are one of the few parts of the market that truly looked undervalued from an earnings perspective. Our portfolio is well represented in those undervalued parts of the market and is either short or not exposed to those parts of the market that are very expensive. Over the past 2 years, inflation has been by far the dominant impact on equities. We've seen a surge in inflation with services and goods inflation and energy prices have driven CPI to over 8% year-on-year compared to the Fed's target of 2%. In recent months, we've seen some encouraging signs, goods inflation has really collapsed and is now barely contributing to higher CPI. It's been a beneficiary of lower freight rates, which are down more than 80% globally and also some capacity freeing up in China, which is by far the biggest determinant of manufacturing goods prices. On the other hand, we've seen persistent higher numbers coming through for services inflation. Services inflation is obviously very linked to wages and wages continue to rise at more than 4% per annum, both in the U.S. and in Australia. The ISM prices paid index is historically a very good predictor of where CPI is likely to trend and based on what we've seen in recent surveys, we expect to see further downside in U.S. headline CPI over the next few months. The question is whether CPI will fall far enough for central banks to be able to start cutting interest rates. So turning to the U.S. economic outlook. Unfortunately, several indicators are suggesting an elevated risk of a U.S. recession. The yield curve comparison between the 10-year and 3-month bonds suggest an elevated risk of an economic downturn. Historically, this has been the single most reliable indicator of the U.S. recession. It's predicted every recession since 1955. And at the moment, it's the most inverted that it's been in decades. With every period of inversion, predicting a future U.S. recession. In terms of the ISM manufacturing PMI, this has also been an excellent predictor of recession. It's predicted 11 of the last 12 recessions and any time the rating has fallen below 45, it's been a precursor to an economic downturn. What we're seeing at the moment is market expectations of recession are very elevated, and therefore, investors are crowding into defensives but we think this is already priced. So given that we're seeing a likely decline in inflation, along with a likely slowdown in economic activity, we've seen the bond market start to price in at some cuts in interest rates going forward. One of the things that's a really interesting disparity is the difference between what the bond market is telling us versus what the Fed is telling us. At a recent FOMC meeting, press conference, Jerome Powell, the Head of the Fed, said participants don't see rate cuts this year. They just don't. But if you look at the bond market, the bond market is assuming several rate cuts later this year. And it's this distinction that the market is really going to have to focus on. Our view is that the market is already priced in those interest rate cuts. And that's why we're seeing that outperformance in long-duration stocks, such as growth stocks and infrastructure stocks. And we're also seeing the market be relatively complacent about the rest of the market with both the Australian market and the U.S. market, enjoying very strong rallies, not just in the start of this year, but over the last few years. So turning to the market outlook. We think the outlook for equities is much less attractive than it has been for the last few years. On the positive side, inflation pressures are likely to moderate over the next 6 months. We think interest rates are almost at a peak. China is about to reopen, and we'll see the benefits of their reopening and their policy stimulus come through, particularly for the Australian economy. And lastly, despite the fact that per capita GDP will probably be quite weak in Australia, we're about to see a huge influx of migrants that will support the economy. On the negative side, valuations are very full. When we were positive on the market a few years ago, the ASX 200 was trading at 4,500. Today, we're at more than 7,000. The S&P 500 has also had a massive rally from 2,300 to more than 4,000. Corporate earnings are unlikely to beat expectations going forward. We see tail risk from the U.S. regional banking crisis. We don't believe that, that issue has been resolved, and there's huge flow on risks for the commercial real estate sector in the U.S. The likely economic downturn that's coming both in Australia and the U.S., rising geopolitical tensions, the Russia-Ukraine situation, risk from the China, Taiwan flare up and also the situation in the Middle East particularly with Iran has the risk of higher oil prices down the track. And lastly, we believe there's been a number of adverse government policy decisions for corporates, which are going to reduce the return on capital for many corporates and also make the business outlook cloudier. We believe the stock market now offers a much less compelling risk award. But importantly, we don't need the stock market to rally to generate positive returns. We're able to adjust our market exposure, we're able to benefit from share prices falling, not just rising and we believe we're coming into this period well positioned for anything that comes at us. Now I'll take you through portfolio exposure over the last 3 years. If you turn back the clock to March 2020, we came into the pandemic with roughly a 65% net long, but quickly increased our net long to around 100% as we want to take advantage of the sell-off in many share prices. In mid-2020, we built our confidence that there would be a vaccine by year-end, and we significantly increased our market exposure again to around 120%. As that trade played out and we moved into early part of 2021, we reduced our market exposure as share prices had rallied significantly, and there was a relief rally in many of those COVID losses. In the second half of 2021, we increased our market exposure, again, wanting to get exposure to the energy sector and commodities, in particular, which we felt were the best risk/reward in the market. And then as the market rallied, we've taken profits from the end of 2021 to April '22. And since April 2022, we've significantly reduced our market exposure as we saw a deteriorating macro outlook, much more full valuations and some tail risks emerging in the macro backdrop. Since that time, we've maintained a net long of between 40% and 60%, which is slightly below our long-term average of closer to 70% for our net long. In the recent months, we increased our market exposure as some share prices sold off during the banking crisis, and it's important to note that these are companies that were unrelated to the U.S. regional bank situation. So given this macro backdrop, where should we be investing? We believe that markets going forward are going to be much more difficult than markets over the last few years. And for that reason, we believe that passive and index hugging strategies will no longer be able to deliver double-digit returns for little cost. At the same time, the Fed put or the protection you get from central banks cutting interest rates is no longer in effect, which provided a safety net in the past. Active stock picking going forward will be required to generate alpha over the medium term and the backdrop for active management is dramatically improving. Passive investing continues to dominate flows. This is investing that has no reference to fundamentals or valuation, which creates opportunities for us. Secondly, many large institutions are internalizing their equities exposure and taking money off other active managers. And lastly, retail investors have been very active, and they simply don't have the resources or the experience in many cases to be able to compete with a well-resourced and rigorous amount of research that we're able to do with L1. And for that reason, we believe there's a much better backdrop for active fund managers going forward. In terms of LSF positioning, the portfolio is very heavily skewed to lower P/E stocks and those with very strong cash flow generation. As you can see on this chart, low P/E stocks are trading at very depressed levels versus their multi-decade history. There's only been 2 occasions in history when low P/E stocks have traded at such depressed levels, once during the dot-com boom and once during GFC. And in both cases, they went through periods of strong outperformance after that. On the flip side, high P/E stocks are trading at extremely elevated levels, the likes of which we've never seen before, even compared to the dot-com boom. So if you look at our portfolio today, the average long is trading on a P/E of 9, it's generating 8% free cash flow yield, and it's delivering very solid EPS growth. The median short on the other hand, is trading on over 21x earnings. It's delivering half the cash flow of our longs and they're giving you broadly similar earnings growth outlook. And on that basis, we believe the metrics of the portfolio look incredibly compelling today. So turning to some key positions in the portfolio. Flutter is one of our favorite positions globally. It's the #1 player in U.S. online sports betting, and it's been on a remarkable journey over the last couple of years. 2 years ago, Flutter controlled around 30% of the market. A year ago, it was up to 40%. And today, it's got 50% market share. And if you exclude the promotional bets, which other players are handing out to customers for free, they're actually up to 57% market share today. It's an industry that has huge growth over the coming decade. The industry 4 years ago was at around $1 billion. Today, it's at around $12 billion. And by the end of the decade, we'll be close to $40 billion for the industry, and Flutter is likely to be a disproportionate beneficiary as they're the clear #1 player. We're also approaching a major inflection point because in 2023, the underlying profitability of Flutter will finally become apparent. They're going to go from a loss-making business in the U.S. to strongly profitable, and we think we're at a real inflection point in terms of the exponential growth we're likely to see in profitability. We think the company can deliver 25% to 30% EPS growth per annum for many years to come. And with Flutter, we also have an outstanding management team that has the best track record of execution, both on customer acquisition cost and also revenue per customer. Another stock we're very positive on is Capstone. Capstone is a Canadian-listed copper producer that we think is going to be able to more than double its copper production over the next few years. It's also on track to become one of the largest and lowest-cost cobalt producers. The industry is incredibly attractive. Copper production is going to struggle to grow over the next decade. And at the same time, demand for copper is likely to increase dramatically given how intensive the usage is for electric vehicles, solar farms, wind farms and charging stations. As of today, Capstone trades on only a P/E of 8 despite the fact it has very strong production growth and very strong exposure to higher copper prices, which we think likely. If you look at global copper inventories, they've been declining consistently for the last few years, and this is before we say the real inflection point in demand for copper from electric vehicles and the sustainability initiatives. Copper inventories today are incredibly depressed and we think we're getting close to an inflection point where copper prices will move structurally higher. Cenovus is an integrated energy company listed in North America. We believe the company is on track to hit its $4 billion net debt target at the end of this year, which will enable a major step-up in shareholder returns. Management have been very clear that as soon as they achieve this net debt target, they'll be able to return 100% of cash flows back to shareholders through share buybacks or increase in dividends. The company is very well positioned. It has long life assets, a low cost of production, where breakeven oil price is around $40 a barrel and it's able to generate close to 15% of its market cap in free cash flow at current oil prices. Chorus has been a long-standing position in the LSF portfolio. We first invested in Chorus in September 2014 when we first launched the strategy when the share price was around $1.60. Today, the share price is close to $8. And despite that rally in the share price, we continue to believe the shares are undervalued. One of the things that excites us about Chorus is the fact that their dividends are likely to accelerate over the next few years. That's likely to increase this year to around $0.425 and then we can see that increasing further closer to $0.60 over the coming few years. On top of that, the company has an under-geared balance sheet and has an opportunity to significantly increase its earnings based on the 2025 regulatory reset. The company essentially benefits from higher inflation and higher interest rates. One of the other things we really like about Chorus is just how fast their Internet speeds are compared to what we're used to in Australia with nbn. A standard plan in New Zealand is around 300 megabits per second which almost 70% of the population has. On top of that, close to 1/4 of the population is enjoying speeds of more than 1 gig, and that compares to closer to 50 meg in Australia. And the last company I'd like to talk about is Imdex. Imdex is the global leader in mining exploration drilling technology. Imdex was already the clear #1 player globally. And in the last 12 months, has acquired the #2 player Devico. The combination of these 2 companies makes Imdex by far the global leader with the best portfolio of products and the best growth outlook across the sector. We believe the company is very well placed to continue growing earnings strongly over the next few years. Over the past 5 years, Imdex has grown earnings by 24% per annum compound annual growth rate compared to the market, which has grown in low single digits. Today, Imdex has an outstanding management team, the best set of products that's able to take advantage of the growth in exploration drilling, which tends to be deeper and more complicated these days. And lastly, they're also a beneficiary of the increase in exploration activity, specifically in the gold sector and the lithium sector. So in summary, the portfolio has performed very strongly over the last 3 years, returning 33.4% per annum. Given our concerns around the macro outlook, we've reduced our net market exposure as we believe the risk reward for equities is much less positive than it has been for the last few years. We believe the passive strategies will begin to underwhelm as the era of double-digit index returns ends. And defensive and growth stocks, which have both performed very strongly over the last decade, we think look very crowded and expensive. Therefore, active stock picking based on rigorous fundamental research and a strict focus on valuation will be required to generate attractive real returns. We're very excited about the outlook for the portfolio and believe that we are well placed to navigate the changing macro backdrop. Thank you, everyone, for joining us today. We look forward to catching up with many of you over the coming weeks. And please feel free to contact us if you have any follow-up questions. Thank you.