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

Hello. My name is Chris Clayton, and I'm the Head of Distribution at L1 Capital. With markets exhibiting more volatility than normal and several stock markets now producing negative returns for the calendar year, we thought it was an opportune moment to ask Mark Landau, Co-Chief Investment Officer and Co-Founder of L1 Capital, to provide his views on the global markets and the recent reporting season. Welcome, Mark.

Thanks, Chris.

Mark, can you provide a brief overview of the recent market performance and where you needed to be invested in 2024 to be successful?

Sure. Well, in 2024, the ASX 200 Index returned just over 11%, which at face value gave the impression that the market was relatively strong. But when you actually look beneath the surface, you can see that about 95% of the market return was actually from financials and tech stocks. So it was really narrow leadership. The financials move was largely a rally in the major banks, and we believe that wasn't really driven by fundamentals. What we saw was large global funds wanting to avoid any China exposure because, obviously, China had been weak. They wanted to get out of resources. So you really saw a move within Asia Pacific into safe havens like Australia's domestic banks. What we've seen since is that the sector has become -- the bank sector has become incredibly overvalued. So as an example, CBA reached the highest earnings multiple that's ever traded at in the last -- basically since inception since it listed in 1991, and that was about 4 standard deviations above its normal trading range. On the other hand, tech stocks and growth stocks more broadly rallied strongly. And largely, that was a result of a lot of the excitement around AI, which is really coming from the U.S., where very few tech stocks in Australia actually have any clear benefit from AI, at least that we can decipher at this stage. So in general, this strong performance was largely underserved.

As you touched on, we've seen a really strong performance of growth stocks. Can you see any catalysts coming about we might see a change to this and a rotation back to value?

Well, firstly, I think investors have underestimated just how big this outperformance of high P/E stocks have been. If you look back over the last 45 years, we've only seen a comparable period of outperformance twice in 45 years. So once was during the dot-com boom, which everyone knows was a period of basically craziness. And then there was a period during COVID, where tech stocks were clearly the COVID winners, and they dramatically outperformed. But in both cases, we saw an equally rapid reversal over the following 1 to 2 years. So they were largely anomalies in the context of markets. In the last couple of months, we've started to see the early stages of this rotation back away from expensive and crowded growth stocks back towards relatively undervalued and under-owned value stocks. So that's been a positive for us. The second factor is that investors are starting to question the durability and the general narrative around AI. So it's been a sector that's obviously been incredibly hot. There's been lots of excitement. But in the last few weeks, we've seen a possible peak in optimism regarding anything to do with AI. So we've seen NVIDIA shares actually fall 8% post their results despite delivering really strong revenue, really strong earnings growth, and those shares are now down more than 25% from their recent highs. Microsoft has also started to struggle from a share price point of view as investors start to question whether they're spending $80 billion a year on investments in data centers and NVIDIA chips is going to pay off. We've seen DeepSeek, which is the Chinese AI technology start to come to the fore. So we've seen concerns about the assumed dominance of U.S. AI. And we've also started to see these Chinese AI names start to perform really strongly and outperform their equivalent names in the U.S. And lastly, valuations and positioning have become really stretched within the growth stock space. So we're now starting to see a pullback even on minor negative news flow. So the combination of all those things is giving us the sense that we're seeing an inflection point in markets.

You've been very vocal on Australian banks and the price and the valuation. Do the recent wobbles indicate some sort of turning point there? Is there anything on the horizon that you can see?

Yes. We think there is a major turning point happening at the moment. So you can see over the last couple of months, there's been a clear negative change for share prices in the bank sector. We've had a short position in CBA and NAB. Both of them have delivered positive returns for our portfolio because the share prices have been falling, and we've got a short NAB shares were trading at about $41 in early February. But since then, they've fallen to around $33 after quite a weak trading update and some unexpected management changes. We saw that NAB announced their net interest margins, which is a key barometer of their profitability, had actually peaked and it started to fall, which was below market expectations. We saw an increase in their arrears, which is typically a precursor to rising bad debts. And we've also seen some unexpected senior management changes where the well-respected CFO, Nathan Goonan, has left to go to Westpac. We've also seen the departure of the Head of their business bank, Rachel Slade. So given that the share price had such a quick fall from roughly $41 to $33, so roughly a 20% fall in share price, we've decided to close out our NAB short. On the other hand, CBA, we've retained our short. We think that CBA continues to be extremely expensive. So up until recently, CBA was trading on a P/E of 27x, which compares to its long-term average of around 16x. We think it's incredibly hard to justify a higher P/E versus history on fundamental grounds. If you look at CBA's result, they just delivered a 1% increase in profits over the past 12 months. And if anything, the outlook is getting harder. So to put those earnings multiples in context, if CBA was to trade anywhere near its long-term average of 16x, the share price will be closer to $100 rather than today's share price of close to $150. So from here, we believe it's unlikely that CBA will deliver strong earnings growth. It's not giving you a high dividend yield anymore. So it's pretty hard to mount a compelling buy case. We much prefer the U.K. banks. So if you look at our portfolio, we're short some domestic banks, we're long the U.K. banks. U.K. banks such as Lloyds and NatWest, which are really high-quality businesses, they're trading on a P/E of 7x, not mid-20s. They offer 6% dividend yields. They've got large-scale buybacks. They're growing their earnings at 10% to 20% per annum for the next few years, and they've got really conservative balance sheets. So to us, they're a much more compelling investment proposition than buying shares in CBA.

Mark, in light of this recent volatility, what's been happening in the portfolio? How has performance been over the last couple of months?

We've seen a really pleasing performance from the portfolio in February and March. Since the market's peak in mid-Feb, we've seen the ASX 200 Accumulation Index and the S&P 500 each fall by around 7%, while the NASDAQ is down almost 12%. Despite the significant fall in the market, we've been able to deliver positive absolute returns in the Long Short fund. So we're really happy with that. This was driven by a strong reporting season where we picked several stocks that performed well, and we only had a handful of stocks that performed poorly. We also have been benefiting from this recent tailwind from this market rotation, which we think we're in the early stages of. This once again demonstrates the role that LSF can play in investors' portfolio as we tend to have low or even negative correlation with many other long-only and Long Short fund managers.

Mark, you touched on the reporting season. Were there any surprises, whether that be economic or from companies through that period?

Overall, reporting season was pretty much in line with market expectations. But if you look at the next layer down, you can see that roughly half of companies reported in line and then roughly 1/4 beat by at least 5% and roughly 1/4 missed by more than 5%. So it was a very balanced reporting season. What we did see there was that many companies that beat expectations tended to do so through margins where cost management was basically the driver. What we've seen is a much more bigger focus on tougher operating conditions and companies looking to adjust costs to maintain earnings growth. But that's a lower quality way of delivering earnings growth and probably less sustainable over time. We've also seen that the share price performance post results shows that the strongest performers leading into results were often the worst performers post as elevated expectations and positioning made it really hard for companies to beat expectations. So you can see that momentum has actually been the worst performing factor in reporting season. And that's obviously to our benefit. We tend to be contrarian and not driving momentum. So during February and early March, we had one-on-one meetings with more than 100 company CEOs, gave us a really good insight into the Australian economy and opportunities and stress areas within that. And what's clear from our catch-ups is that the cost of living pressures are really starting to build, and it's going to be a big focus coming into the election, obviously. We're starting to see a more pronounced difference in spending patterns between those lower income consumers, who are allocating more of their income to paying their mortgage or rents, while older consumers and wealthier cohorts are continuing to spend as they have been previously. Another factor that we suspected and it was clearly confirmed during reporting season was that Victoria is really entering a tough time. They're entering a recession. So when we caught up with Seven management, they own Coates, which is the largest equipment hire company in Australia, they called out Victoria being down 20%, whereas the rest of their divisions, the rest of the states of Australia are actually performing very well. Most retailers we spoke to said that Victoria was clearly their weakest state. Property developers are finding Victoria a much more difficult state to operate than other markets. So across the board, we're seeing weakness for those companies exposed to Victoria, and that, again, was highlighted by NAB in terms of their higher exposure to Victoria. In some cases, there's also been a bit of a pullback as some companies start to grapple with Trump's tariff policy and obviously, the erratic nature of those announcements. We've seen a lot of companies pull back their investment decisions until they get more clarity on where things are likely to settle.

Did any individual stocks really stand out?

A large number of our stocks actually gave really strong updates, and they displayed a lot of confidence about their outlook over the next 1 to 2 years. In Australia, we saw really positive results and a confident outlook from stocks like Light & Wonder, Worley, Ventia and Imdex, while offshore, we were really impressed with the updates from NatWest, Flutter and Rightmove. One of the key negative updates came from Mineral Resources. So Mineral Resources obviously been quite topical of late. I guess the first thing to say about it is just to remind our investors that we hold about 80 positions in the portfolio. They're all relatively small in size. So none of our investors should get too excited or too concerned about any individual share price move. But Mineral Resources shares sold off in February due to a 3-month delay to their Onslow iron ore project and the prospect of having to spend an extra $300 million in CapEx to repave the road. That was obviously a disappointing update. But in the context of a very large business, we believe it was a relatively modest negative. But on the back of that announcement, the shares fell 40% in the space of only 5 weeks, which we viewed as an excessive reaction and not reflective of the valuation impact that the company is likely to endure. As a result, we used the sell-off as an opportunity to significantly increase our position in the company. We thought it was a fantastic buying opportunity. And if you look at it from a valuation point of view, the Mineral Resources market cap today is less than $5 billion, which we believe is incredibly undervalued. And to put that in context, for less than $5 billion, you get one of the best mining services business in the world. It's growing earnings at over 20% per annum over the last 5 years. Its outlook continues to be very strong, and we think it's going to deliver close to $1 billion of earnings per annum by 2027. The company typically signs 20- to 50-year contracts with miners, which gives them fantastic reliability and certainty of earnings. And we believe that this division alone is worth the entire enterprise value of Mineral Resources, which in layman's terms means you're getting the entire market cap and the entire net debt of the company covered just by this division. In addition to that division, they've got 2 other very large businesses. They've got the Onslow iron ore project, which we think will deliver around $750 million of earnings post ramp-up later this year. And in that assumption, we've assumed an iron ore price of around $90 a tonne, which is well below current spot price. We also assume they only hit their near-term target of 35 million tonnes of production. So we and the market are not valuing any potential upside from higher production despite the fact that there's ample resource and ample capacity to enable further increases over time. And lastly, they've got an enormous lithium division. It includes a 50% stake in Wodgina, which is one of the largest hard rock lithium mines in the world. This division is currently being valued at 0 by the market because the lithium price is obviously very depressed and a large part of the lithium industry is losing money at current prices. But if you look at the stock market, you can see a comparable business that's listed in Australia called Pilbara Minerals. It currently has an enterprise value of about $5 billion. Yet over the long term, we believe Wodgina is actually a superior asset. So on that basis, Mineral Resources 50% stake in Wodgina, in addition to their ownership of Mount Marion and another lithium mine implies that their lithium division should be worth at least $2.5 billion. So in terms of Mineral Resources balance sheet, which is obviously another focus, the consensus view is that they're likely to do a capital raising in the next few months. Now our view and that of the company has been that the capital raising is not really necessary as there are no debt rollovers until 2027. There's no debt covenants on their U.S. bonds. The bonds are trading close to par, which basically means that there's no signs of stress from bondholders. And the company also has several asset sale options if it's required, which would be obviously a much better option than raising equity at a very depressed share price. The current headline gearing is about 7x, but it quickly falls to 3x once Onslow hits its $35 million production rate, which we expect will happen around Q4 of this calendar year. Further degearing is also likely the following year as earnings grow and net debt starts to fall. So in summary, we think there's large share price upside over the next couple of years, and we expect that the market will wait to see progress on the Onslow ramp-up and the Board renewal process. We think that the progress on these 2 issues is likely to happen, which will enable the share price to recover and return the share price closer to fundamental value, which we think is way above today's share price. So in many ways, the Mineral Resources situation reminds us of the hysteria and negativity that we saw with Qantas 12 months ago, which was one of our biggest positions in the portfolio when they were trading around $5. Since then, Qantas has returned more than 90%. It's been one of our best performers in the portfolio. And in hindsight, the point of to buy was actually the time of maximum panic and negativity a year ago. Now we think it's a very similar situation with Mineral Resources where you see a lot of parallels with the sentiment and the valuation upside.

And Mark, given what you've just said then about the reporting season and your previous comments about the macro environment, the market setup, is there anything you're thinking differently about portfolio positioning or the key opportunities for the period coming ahead?

Yes. I mean we're seeing lots of opportunities at the moment. There's stacks of market mispricings in our view. I think investors should expect to see this recent period of elevated market volatility is likely to persist. I think it's a structural change that people need to get used to given Trump's policy announcements, the tariff uncertainty, you've got heightened geopolitical tensions, and it's also less clear what central banks are likely to do going forward. So I think the combination of all those things means we will be in a structurally higher period of market volatility. But our job is to do the best thing for our investors, and that means looking to take advantage of any irrational share price moves that come up as they have been doing over the last couple of months, and we think will continue to happen as we look forward. I think there'll be further factor rotation. And what I mean by that is that there will be this continued shift out of crowded high momentum, high P/E stocks towards those stocks with more valuation support that have temporarily been out of favor. And we're increasingly positive about the outlook for gold and copper stocks in particular. In the case of gold, we've seen a big rally in the gold price, reflecting central bank buying and safe haven status at a time of elevated uncertainty, but we haven't seen a commensurate move in the price of many mid-cap gold stocks. In the case of copper, we actually traded out of most of our copper exposure in mid-2024, but then we've seen a pullback in share prices, and we think the fundamentals for the copper market are now becoming much, much more positive. And we think you're going to enter a period of tightness over the next few years as strong demand is starting to come through, and it's going to be really difficult for that to be met by higher production. We're seeing the best opportunities in the copper space at the moment in Canada rather than Australia. And we've got the benefit of being able to navigate our portfolio to where we think the best opportunities are globally. And then from a geographic perspective, we're much more optimistic about the prospect of a resolution in the conflict in Ukraine than I think what the market is. But on the flip side, we're much more pessimistic about the situation in the Middle East. So I believe there's likely to be a flare up in the Middle East again later this year. We've seen Iran come out with commentary to suggest they want to go full steam ahead in their development of nuclear weapons and Qatar and Turkey continuing to ally themselves with extremist groups that fund terrorism and civil unrest in Western societies. So a bit of a mixed bag on the geopolitical front.

From an economic point of view or from an opportunity point of view, are there any countries or geographies that are exciting?

Absolutely. I think one of the things that's interesting about our portfolio today is that we've been running a very low net long to Australia. It's been running at around 15% or so for the last at least 6 months, and we've considered the Australian market fully priced for some time. We've also maintained a low net long to the U.S. market for similar reasons on valuation grounds. On the other hand, we've increased our exposure to the Canadian market, where we see lots of high-quality copper, gold and energy stocks that are trading far below fair value. And lastly, we've actually had our largest geographic exposure to the U.K. and Europe where we found lots of compelling opportunities, stocks like Flutter, Lloyds, Rightmove. There's some really high-quality businesses over there that we're excited about. Flutter, as hopefully, our investors know, is the clear #1 player in sports betting in the U.S., U.K. and Australia. It's got a fantastic management team, market-leading products. It's likely to grow its earnings at more than 25% per annum for the next few years. And despite being such a great quality business, the stocks retraced almost 20%, and we've used this recent sell-off to add to our position. At today's share price, the stock is trading on only around 18x FY '26 P/E, which is less than the average Aussie industrial despite the fact it has a far superior business outlook. Rightmove, a lot of people obviously know REA in Australia. Well, this is like the REA of the U.K. It's got 80% market share, which makes it even more dominant than REAs in Australia. Rightmove is a less mature business than REA. So we think it's got a lot more years of double-digit earnings growth ahead of it, and yet it trades on a P/E of only 21x. To give us a bit of validation on our logic for the investment, we saw that REA actually made 4 takeover bids for Rightmove in 2024. Each of them was rejected by the Rightmove Board, but it gave us extra confidence in that position that they see what we see, which is a great quality business trading at a very undervalued share price.

There's been a lot of volatility in interest rates and long-term bond yields. Could you give us a few comments as to where you see that going and where that could potentially impact the portfolio?

Sure. Most central banks have been raising interest rates aggressively over the last few years. But we've now seen a clear change where Australia, New Zealand, the U.S., U.K. and Europe are all either already lowering interest rates or they're actively considering rate cuts. This has been enabled by generally falling inflation rates since their post-COVID peaks and the early stages of weaker labor markets, which had previously been putting pressure on central banks to keep financial conditions tight. One of the best opportunities we see in the market at the moment are infrastructure stocks. We hold several high-quality monopoly infrastructure names in Europe. And they're all well placed to grow earnings and cash flows and dividends very strongly over the next few years. We believe that they can reliably deliver us around a 10% to 15% total return per annum with further upside if we happen to get it right, then interest rates are going to start to fall over the next 12 months. Infrastructure is actually the largest sector exposure in the portfolio at the moment, reflecting its strong return outlook and relatively low risk. One of our key positions in the sector is Fraport, which owns Frankfurt Airport, along with more than a dozen airports in the Greek Islands. We believe that dividends for Fraport are likely to surge over the next 3 years as they've now completed an enormous period of investment and shareholders will soon get the return from that investment. Our lead analyst on the sector, Andrew Levy, just came back from a one-on-one management site tour of the new Frankfurt terminal, and he came away really confident that the CapEx is almost completed, and we're about to see that inflection point hit in terms of cash flows and dividends over the next few years.

During 2019 and 2022 market had a very strong period of performance in the Long Short Fund, driven by the difference between large caps and mid-caps and also the setup between value growth momentum. What are you seeing now in terms of the setup? And is there any particular macro factors that stand out?

If you look at market performance in 2024, it was totally dominated by the MAG 7 in the U.S. and the ASX 20 names in Australia. And I think a lot of people don't realize that the median performing stock, both in Australia and the U.S., it basically returned nothing in 2024. Because if you look at the indices, it actually looks like the market return was strong. So the S&P 500 returned around 18%, the ASX 200 returned 11%. So at face value was a really strong performance from the market. But the leadership was so narrow, and what we're seeing now is the start of a rotation where effectively that narrow leadership is starting to broaden. We're starting to see in recent weeks, the early stage of a pullback into Aussie banks, which are obviously a big component of the ASX 20 and the index in general. And we're also seeing notable underperformance from some of those MAG 7 names like Tesla and NVIDIA in particular. If you look at LSF returns historically, you can see that we've been able to generate positive returns in both market environments. Given our investment style, our returns tend to be stronger in periods where value stocks are outperforming growth stocks. In both 2023 and 2024, growth stocks massively outperformed value stocks. It was like a [indiscernible] headwind for our portfolio. But what we're now starting to see is the early stages of a normalization of that trend, which sees our performance in the last 2 months start to inflect positively, and it's been really pleasing to see the benefits coming through.

How are you thinking about downside risk? What have you got in place to protect the portfolio in case of reversal or increased volatility?

I think a lot of people appreciate the fact that we've been a strong performer over time. The Long Short Fund has been the best-performing Long Short strategy in Australia over the last decade. But just as importantly, one of the real differentiators of the strategy has been its ability to preserve our investors' capital in falling markets. So if you look over the last decade, we've been able to protect around 85% of our investors' capital in down markets. And this downside protection has been a function of several unique aspects of our approach and how we construct the portfolio. Firstly, we're absolutely obsessed with only holding stocks that have very strong valuation support. And what tends to happen in times of crisis or panic, the stocks that are expensive invariably get hit the hardest, while we're holding companies with strong cash flows and resilient asset values that tend to protect them in tough times. Secondly, a key part of our process is buying companies with attractive industry structures and strong management. And as you'd expect in a downturn, those companies with strong market positions are able to weather a storm much better than others and also shareholder-friendly management teams are able to take advantage of the crisis. They tend to make attractive acquisitions at the right time. They look to buy back shares or they can adjust their cost base to sustain margins. And thirdly, our portfolio has a number of short positions that actually profit from falling share prices. So the shorts are typically very overvalued companies. They've got some sort of looming negative catalyst where their earnings outlook or their balance sheet is in much worse shape than the market realizes. So these stocks tend to fall much more than market in a sell-off. And lastly, the portfolio averages around a 70% net long, which in simple terms means that if the market was to fall by 10%, and we had no skill, good or bad, the portfolio should fall in value by 7% as we're typically carrying 30% less market exposure. So the combination of those 4 factors is what's enabled the portfolio to protect capital very consistently over time. And given the prospect of a slowing economy, elevated geopolitical risk, and a number of other factors, we think that holding a significant long position across infrastructure and gold should provide more downside protection in the event of a more severe economic downturn or some sort of left field event.

How do you think about the balance between generating income and capital growth for the strategy?

So over time, we think that the majority of investor returns should come from capital growth, but we recognize the value for our shareholders of delivering attractive fully franked dividends, and we understand the value of passing our franking credits through to shareholders over time. So for those invested in the listed investment company, we recently paid a dividend of $0.0625 fully franked, which was another solid increase compared to prior periods. The shares are currently delivering a dividend yield of around 4.6% on an annualized basis, which compares nicely to other blue-chip stocks such as CBA, Woolworths, Wesfarmers, which are paying closer to 3% to 3.5%. As our shareholders know, we have a majority independent Board at LSF. We've got an independent Chair. Rafi and I, along with our Board, are very focused on delivering attractive long-term returns to our shareholders. We've demonstrated that over the years with large-scale aggressive buybacks when the shares of our LIC were trading at a material discount to the underlying value of the portfolio. And in recent years, we've been paying out a reliable and growing stream of fully franked dividends. Hopefully, people have seen the profile of our dividends over time. We've actually increased our dividends at every half year result since we started paying dividends 4 years ago.

And finally, Mark, can you give our investors some insight into where you've been investing your money and why?

I've made 2 investments recently. I'm happy to talk about both. The first has been topping up my holding in LSF, which there has been a number of announcements about. When I look at the portfolio at the moment, I think there's a number of really compelling opportunities that we're seeing. And if you look at the P/E multiple of our portfolio, the long positions have an average P/E of 9. They're paying out more than 9% free cash flow yield. Earnings are growing at more than 15%. So the metrics we think are really compelling. For Rafi and I, LSF is by far our biggest personal investment, and we've continued increasing that investment over time, which hopefully gives people a sense of our confidence in the long-term outlook for LSF and also the alignment that we have with our shareholders. Secondly, we've recently launched a specialist gold fund, which we see as a really exciting window of opportunity at the moment in the mid-cap gold equity space globally. We've only ever launched these specialist funds 3 times in the 17-year history of L1. So it gives you a sense of how exciting we think the opportunity is. Rafi and I have both made a very large personal investment in the gold fund. Essentially, we've seen this massive rally in the gold price over the last year, where the gold price was trading at around $2,000 a year ago. It's now up to over $3,000. And we've basically found at bizarre that the share price of these mid-cap gold stocks have barely rallied over the last year despite the huge earnings leverage that these stocks have to higher gold prices. So to give you a sense of just how big the earnings move is likely to be for these companies, we think that the earnings for these stocks that we've bought are likely to increase by 200% to 300% as a result of the gold price rally that we've already seen. So given that enormous disconnect between the gold price and the gold equities and our extensive knowledge and experience and relationships in the mid-cap mining space, we decided to launch this fund. We think it's a truly exceptional opportunity where hopefully, we can demonstrate our edge in a part of the market that really requires deep industry knowledge.

Thanks very much, Mark. And thank you, everyone, for your continued support of L1 Capital. It's greatly appreciated. If you have any questions or just like some further information, please don't hesitate to reach out. Thank you.