L1 Capital - an interesting investment methodology

Mark Landau is one of the two founders and Chief Investment Officer of L1 Capital, which started 10 years ago, with a long only large cap fund which has done pretty well and more recently launched a long short fund which has about three quarters of its positions in a wide variety of long positions, that is to say long term investments and about a quarter of the returns come from shorts. That’s also done fantastically well, 36% over four years. 

More recently, it launched a UK residential fund which sounds like amazing returns being generated there in towns or cities like Manchester, Birmingham and Liverpool in the UK. Well worth listening to – he’s a bit bearish on the market overall, but really interesting methods for investing and well worth investors listening to and picking up some tips about how to go about it. 

Here is Mark Landau, joint Managing Director and Chief Investment Officer of L1 Capital.

L1 Capital, you appear to have started with an Australian large cap equities fund in 2007, is that correct?

Yeah, that’s right.

And just tell us about what you tried to do with that?  It was you and your main partner, Raphael Lamm?

‘Raphy’ Lamm.

Where were you guys before that?

I was at Invesco, which some people might know better as County Net Worth.  I was there for five years mainly in the large cap long only Aussie equities team and Raphy was a portfolio manager at Cooper Investors, which in those days was called Paradise Cooper, one of the better regarded boutique managers in Australia.  Raph and I became friends through the industry and then five years down the track started L1 in 2007.  Initially we started out just with our long only large cap Aussie equities fund which has been going since ’07. 

We started out with a focus on institutional clients, so we manage money for large superannuation funds like Hostplus and Sun Super.  We’ve got endowment funds, insurance companies, global private banks… Then, over that time we’ve sort of broadened the business and we now run a long short fund which we started a few years ago and also a fund out of New York and also London.   

That long only fund you started has done pretty well.  I think you’ve had 4.8% outperformance over the ASX200 accumulation since inception.  What was the approach that you brought to long only large cap investing that made you think you would be able to do something better than everyone else, which you seem to have done, actually?

Yeah, the fund has done really well, we’ve got one of the best track records over the last 10 years.  I think what we’ve done well is we’re not afraid to take on the market, we’re not afraid to be contrarian and we’re very independent in the way we think.  A lot of the best stocks we’ve had over that period have tended to be fundamentally really good companies that have either been mismanaged historically or have had some short term issue and we’ve been prepared to do the work and get confidence in the story and then build a position and then as the momentum in terms of earnings and catalysts have come through, the shares have recovered strongly and we tend to exit those positions once they’re well liked and well understood.

Do you call yourselves index-unaware?  I mean, are you kind of just overweight and underweight or do you take big positions and go all out of something and all into something or what?

In our long only fund we’re definitely benchmark aware.  It’s a relative return fund.  If the banks are a quarter of the index or 30% of the index, we’ll still hold a position in the banks even if we’re not positive on the banks.  Whereas, in the long short fund it’s much more index unaware, absolute return fund. 

I’ll get onto the long short fund in a moment, I was just interested in how you’re approaching the large cap investments.  What do you mean by large cap?  Anything in the ASX200 or smaller or larger than that?

Yeah, we tend to have about 85% of the long only fund in ASX100 and we hold the balance in ex 100 stocks but it really is a top 100 product.

Tell us some of the more successful bets you’ve made over the 10 years?

Obviously, in that sort of GFC period, back towards the end of 2008, we sort of took the view that a lot of the selling that was coming through the market was just irrational and a lot of stocks were getting dramatically oversold.  We were buying Seek and Flight Centre and Rio Tinto at the time when they were really bombed out.  We were buying Seek at $3-4 dollars a share and when you look at the share price today it’s about $20.  Flight Centre at that time, I think we were buying it at $4-5 dollars a share and it’s now well over $50. 

I think it was those stocks where the market had just capitulated, had basically given up on them, that they were big successes for us and I guess more recently it’s been quite a few of either construction companies like Leightons or some of the more cyclical stocks that we’ve bought at the right times being quite contrarian, things like Bluescope and Qantas and some of the yield stocks like Macquarie Atlas and Chorus which are probably not as well known to most investors but they’re fantastic quality businesses that were just misunderstood because their accounts are quite complex compared to most companies.

Do you approach those ideas top-down or only bottom-up?  Do you come at it and say there’s an interesting thought around construction, for example, and then look for businesses within that?  Or do you just keep and eye on all of the businesses and look for oversold situations?

Our exclusive focus is bottom-up.  We’re really trying to find a specific company that has some really positive attributes that the market hasn’t reflected in the share price.  What we use top-down for is really from a risk point of view, so that if we were to build up a number of bottom-up positions that have similar exposures and were quite correlated, we’d want to de-risk that from a top-down point of view.  Effectively, all of the stocks we buy tend to be bottom-up ideas and then that risk overweight from top-down.

Explain what you mean by de-risk from a top-down point of view, what does that mean?

Effectively, let’s say we found a lot of infrastructure companies that we liked and we bought all of the different stocks that were effectively yield stocks, embedded in those positions is a bet on interest rates, because if interest rates go up their yield stocks tend to get priced off the risk free rate and therefore in a rising interest rate environment, those share prices would get hit.  It wouldn’t necessarily be an issue with the company and its earnings, it’d be an issue that they’re getting repriced based on interest rate moves. 

What we don’t want to have is a situation where macro indicators like interest rates or currencies or Chinese GDP tends to be the dominant impact on the portfolio.  We want the bottom-up stock research to be the dominant impact and to try and reduce as much as possible those macro bets.

You approach it first from bottom-up?

Definitely.

Okay, I’m just wondering what’s the sort of themes – you’re saying construction and infrastructure but isn’t it possible that part of the reason they’re under-priced is that interest rates are going to rise and you’re not picking that up?  I suppose that’s what you mean by de-risking it for a top down situation?

Yes, in our long only fund, we’re underweight sectors like property trusts.  We’re underweight telcos, we’re underweight utilities and that enables us to have an overweight to other yield sensitive sectors that we do like where there are some great really under-priced stocks and that’s effectively what we’re trying to do.  We’ve got an offset to that yield exposure by having the underweights in property trust, telcos utilities which de-risk the interest rate bet we’ve got implicit in those infrastructure stocks.

Is it inevitable in a large cap fund like this that most of the investments are income/yield stocks?

Not necessarily.  I mean, a lot of the Aussie index is income yield stocks when you think about the banks and Telstra and property trusts, there is a large part of the market that, by its nature tends to be lower growth and more of a dividend stream.  We don’t tend to buy stocks that are in that sort of boring camp, not because they’re not fundamentally good companies.  It’s more, there needs to be some sort of insight that we’ve got that differs dramatically from the market to give us an edge in investing. 

When we bought Macquarie Atlas, which is probably the best quality toll road network in France, we bought that because the underlying cash flows were more than doubled what the dividend pay out was and we knew that over time the dividends were going to more than double because there was a very complex debt instrument that they had in place that was going to unwind and when that unwound their available cash flow would roughly go from 20 cents a share to 40 cents a share and that was the insight we had, it wasn’t that it’s on a 5 or 6 per cent dividend yield and that was it in and of itself.  It was that there was some insight we had about the accounts that made it interesting.

What are you overweight at the moment?

We’ve got a bunch of stocks we’re very excited about.  Boral is one of our bigger positions.  Boral has two main sources of upside we think the market hasn’t factored in.  The first one is that, because there’s so much spending on the east coast of Australia on infrastructure construction, road spending is going to more than double from 2017 to 2019.  It goes from roughly $6 billion on road and rail projects to $16 billion over that period and we believe that Boral is really well positioned through their quarries on the east coast of Australia to supply most of those road projects.  We think the market hasn’t factored in the price increases that are likely to come through from having a tight market.  I think the brokers have got the volume increase in their numbers, but we think they’re under-estimating the price increases that are likely to come through.

Another position we’ve got is News Corp.  News Corp has been reinvented, it’s a new set of assets they own.  Obviously, Fox Group is the Murdoch business in the US and News Corp is largely a set of Australian and US assets they’ve got with the biggest asset they own being their 62% stake in REA and they also own the number two property portal in the US called Realtor.com or Move.  We think that those assets are fundamentally undervalued because it’s a complex structure and the earnings that these businesses generate are not being reflected in the earnings at a headline level, so effectively because not all the earnings get consolidated in the accounts. 

The earnings makes the stock look like it’s on 25 times earnings, when really it’s on a PE of closer to 12 or 13 times.  We think that as the company deploys its balance sheet and as a lot of these earnings get consolidated you’re going to see a really strong earnings growth trajectory compared to market expectations which sort of price the stock like it’s a going out of business newspaper business which is definitely not the case.

Do you mean it’s better to get exposure to REA through News Corp than to buy REA directly?

Yeah, if you bought News Corp today, you’re effectively buying REA shares half price.  That’s what’s implied in the share price once you strip out all the other assets, so it’s definitely a cheaper way of buying REA.

Well, that’s good to know, that’s amazing!  Because you’re right, everyone’s pricing News Corp as if it’s a newspaper business, which it is of course, but you’re saying the newspaper businesses are not that relevant?

No, I mean the assets apart from REA and Realtor.com, there’s about a dozen assets that sit outside of that.  That’s names that everyone’s familiar with like Wall Street Journal, Dow Jones, Herald Sun, Daily Telegraph, Foxtel, Fox Sports… There’s a bunch of assets, they deliver about $1.25 billion dollars of EBITDA or earnings before interest tax depreciation amortisation.  Those businesses are being valued at about one times earnings if you use REA’s current share price or you can flip it around and say, if I value those assets fairly I’m paying roughly half price for REA.

Maybe those assets are worth one times earnings – I mean, I’m just saying.

[Laughs] You may know better than me.

Well, obviously I’m quite interested since I work for them as well as run The Constant Investor.  Let’s talk about your long short fund, when did you start it?  I’m a bit confused because it says in the thing here that it started in 2017, but actually the performance data goes back to 2014. 

The long short funds started in September 2014.  We’re about to do a listed investment company which is launched in April this year.  That might be the reason for the confusion.  The long short funds delivered more than 36% net return since inception per annum and it’s been one of the best performing funds in Australia over that time. 

Yeah, that’s a phenomenal performance, how did you do that?  How much of it is short and how much of it is long?

Since inception, we’ve generated probably just over three quarters of the return have come from longs and just under a quarter from shorts.  Given the market’s risen – I think it’s up about 26% since we started the fund, we’re really proud of the fact that the shorting has contributed a lot of return since inception.  We’ve returned roughly 185% over that period since we started and I think it’s 26 percentage points after fees has come from the shorts.

What are the fees?

The fees for the fund is 1.5% as a management fee and a 20% performance fee with a permanent high watermark. 

What’s the benchmark for the performance?

I should mention for the LIC it’s 1.4% rather than 1.5%.  The benchmark is zero, so it’s an absolute return fund that’s aiming to deliver a 10% return per annum after fees with roughly the risk of the market.  Essentially, the proposition we’ve got for investors is we believe we can deliver a 10% return per annum after fees with roughly half the risk of the market and essentially we think that’ll be a better return for investors than what the market delivers, but you’ll have much better downside protection in a market sell off.  Obviously, the fund’s done a lot better than that since inception but we generally think the 10% is reflective of what investors will hopefully get, assuming we’re doing good jobs, and the 30-40% per annum is not realistic long term. 

Just to be clear about it, are you saying you get 15% of the performance above 10%?

No.  The performance fees is above zero and for those people looking at prospectus and any of our presentations, all returns that we show are after all fees and the investment objective we have of 10% is after all fees.

Okay.  Just while I’m on fees, what’s the fee of the original fund, the long only large cap fund?

The long only charges a 0.75% management fee and a 15% performance fee for any returns after fees above the ASX200 accumulation index.

Also, on the long only large cap fund, how much money is in that now?

It’s about $1.6 billion that we have in the long only fund and it’s about just under $1.3 billion we have in the long short fund.

Okay.  What are the sort of investments you want to make and how do you choose the investments in the long short fund, in particular the long investments?  How do they differ from your long only fund?

The long short fund is much more diversified than the long only.  The long only tends to hold around 30 positions, the long short fund tends to hold around 80.  Essentially, what we’re trying to do in the long short fund is to have a very diversified portfolio of lots of small positions that we think in aggregate will deliver a good return but don’t get the portfolio on any one particular stock or any one particular theme.  The long short fund tends to have around 55 long positions and around 25 short positions.  Those positions are based on our assessment of value and quality.  For us, a great investment has to represent both, not just one or the other.  I think a typical value manager, we think, runs the risk of buying a value trap because they’ll buy a stock that looks cheap but it may have some fundamental issues that mean that the outlook is going to keep deteriorating and the earnings and dividend profile is going to keep deteriorating and ends up being a bad investment.  Equally, we think a growth manager runs the risk of just overpaying for what is fundamentally a good company but it’s not a good investment because you’re paying too much for it.  Essentially, we’re trying to blend the two and the stocks we tend to be long are undervalued and above average quality and the stocks we short tend to be expensive and lower than average quality.

Tell us what some of your bigger positions are at the moment, both long and short? 

Some of the biggest positions today – one of our largest longs is Chorus.  Chorus is the monopoly broadband infrastructure of New Zealand.  It owns 100% of the copper network and more than 80% of the newly built fibre network.  The asset base is extremely strong.  If you think about the NBN and all the issues that we’re having in Australia, the UFB, which is the Ultra Fast Broadband network in New Zealand, their fibre network is absolutely world class. 

It’s got internet speeds that are more than 20 times faster than the NBN because they’ve done fibre to the premise rather than fibre to the node and essentially that enables them to have really predictable cash flow stream and a really long life asset.  The build of that network is going to finish around 2020, the communal build which is the fibre that runs down the street and then the connection to the home is going to conclude around 2023-2024.  Essentially, once that fibre build finishes, the amount of cash flow that’s available to shareholders is going to increase dramatically.  

Even though the stock’s on a 6% yield today, we think that yield is going to dramatically increase over the next 5 years and that’s why we’re really excited about it.  Because most yield stocks we look at, we can’t see much growth in that dividend profile over time.  If you look at Telstra or the banks or the shopping centres, we think those businesses are going to struggle to grow dividends dramatically over the next 5 years, whereas we think it’s a vastly different situation for Chorus.

Is Chorus fully privately owned?

Chorus is a private company, it’s listed on the Australian and New Zealand stock exchanges and we think that it’s a pretty unique company.  There aren’t many monopoly fibre networks that are listed globally and we think they’re great assets. 

What else?

We spoke about News Corp before, that’s a deeper size position on the long side in both portfolios.  Boral is another example.  I think the upside they’ll have both from the east coast infrastructure spending and also from the headwaters acquisition in the US is going to deliver double digit earnings growth each year for the next few years and if you buy that stock today it’s on a discount to market in terms of its PE based on FY19 earnings.  One of the other positions we have in the fund is Qantas.  I know a lot of people are quite sort of jaded about airlines but I think Qantas has fundamentally changed its business so that it’s a much higher quality business than it’s ever been before. 

They generate huge free cash flow.  They’ve bought back almost a quarter of their shares on issue over the last 3 years which is the most of any ASX100 company and what’s interesting about Qantas is that when Virgin floated they had a huge cost advantage over Qantas.  It was 40% cheaper for them to operate the same flight versus Qantas.  If you look at what Alan Joyce and his team have achieved over the last three or four years, they’ve vastly reduced that cost disadvantage to the point where there’s almost no difference in the operating cost between Qantas and Virgin.  It’s a 3% difference today instead of 40%, and what that means is because the Qantas brand and the Qantas offer is considered better by consumers and business owners than Virgin, they can charge a premium for their flights because of the loyalty program, because of the frequency of flights.  Because of some of the perks you get on Qantas that you don’t get on Virgin and essentially that margin differential we think is a structural difference, it’s not a cyclical difference.  We’re buying Qantas today on a PE of 9 and free cash flow yield of more than 10%, an under-geared balance sheet and a really dominant position in Australia. 

What are your short positions at the moment?

We don’t tend to talk about our shorts publicly, we don’t like to annoy the companies that we short, but I can give you some high level comments.  We think that there are some yield sectors where not only because of bond yield moves but because of headwinds facing a particular sector, we’re short some of those stocks.  If you think about the shopping centres in Australia, given wage inflation is very low in Australia, Amazon’s only just arrived and is about to improve its offering dramatically and you’re starting to see a lot of retailers doing it tough, we think the opportunity for them to increase rents is getting more difficult over time, so that’s a sector that we’re quite cautious on.

I think it’s a nice offset to our longs in Chorus and Macquarie Atlas that that provides because it hedges out a lot of interest rate risk in our portfolio.

What about the banks?

We don’t have any positions in the banks at the moment, we did have sort of late last year.  In our prospectus you’ll see two of our top 10 holdings were CBA and ANZ but that’s no longer the case.  Essentially we bought CBA when we thought it was oversold on the AUSTRAC allegations.  The shares lost almost 15% of their value in a very short period of time and CBA was trading either at the same PE or a discount to a lot of other banks that we thought were lower quality than CBA.  CBA generates a better ROE, it’s got a better deposit mix, it’s got a better quality lending book than a lot of its peers and we didn’t think it was right that it was trading at such a low level. 

If you look at precedents around the world in terms of the size of fines that are typically handed down, it’s very small in the context of a $140 billion market cap company.  You might get a few billion dollar fine, but it’s unlikely to be a $30 or $40 billion dollar fine and I think that was the part that the market was getting overly concerned about.

You also launched last year a UK residential property fund, why did you do that?

It was a very unusual situation.  We had a friend of ours, [Kee Gan [26:01.4], who approached us and told us that he was personally investing in UK properties outside of London and that there was such a dramatic yield differential between the properties he was buying that were trading at around 8% yields and the cost of funds which he was getting loans at fixed rate for about 1%.  When he came to us and told us about this idea we thought it’d be a fantastic opportunity for our investors. 

Raphy and I have put in a lot of money ourselves into this strategy and essentially we think we’ll be able to deliver our clients a double digit return post fees with roughly a 6-7% yield paid out twice a year along the way.  This is a fantastic opportunity because the LVR we’re getting, the loan to value ratio, is around 60%, so it’s a very conservative review portfolio and it’s diversified by city across the top tier cities outside of London.  It’s places like Manchester, Birmingham, Leeds… These are big cities with lots of work opportunities and we think it’s a fantastic point in the cycle to be buying these apartments.

What are you buying, individual apartments or blocks or…?

It’s typically, blocks of apartments.  In the UK about 5% of their property transactions are blocks of apartments.  You might be 50 or 100 apartments in one hit, you typically get about a 15% discount to the break-up value.  The ones that we’ve bought so far we believe are around 20-25% discount to break-up value and they’re trading incredibly cheaply because the banks have made it so difficult for consumers to access loans.  When you think about a renter who’s paying an 8% yield in rent but they should be able to borrow money at 1 or 2% from the bank, you would think why would they possibly be paying rent? 

It’s because they can’t get access to a loan and because the banks in the UK all went through a lot of financial hardship in the post sort of GFC/Euro crisis period, they restricted lending so dramatically that effectively it’s so difficult to get a loan from the bank and therefore as the UK banks are now recapitalised and they’re starting to lend again, we think you’re going to see a dramatic recovery in UK house prices as the person paying 8% on their rent decides to get a loan and is able to get a loan at 1 or 2%.  Essentially, that transition is what we’re going to benefit from in the fund over the next few years.

You think you might sell on the apartments they’re renting?

We’ve already had a number of approaches for existing apartments we’ve bought at significant premiums to where we bought them for for exactly that reason.  It’s not a case that the person didn’t realise they’d be able to arbitrage effectively going from renting to buying, it’s just that they couldn’t get a loan.  If you think about the UK it’s very different to Australia.  You need a minimum 25% deposit to buy an apartment.  If you or your partner has lost their job in recent times, you can’t get a loan even if there’s no issue with you getting another job. 

You might have left because you’ve had a baby or you might have left because you wanted to move industries or something, it just prevents you from getting a loan and then there’s other features that make it difficult to get high loan to value ratios.  Whereas, in Australia, up until recently, 80-90% loan to value ratios were not that uncommon, so it’s a very different situation.

How much have you got in that fund now?

The first fund is a relatively small size, we’ve got around AU$65 million in that fund.  We primarily offered it to our existing investors in the long only and long short fund and there were a number of high net worth investors that effectively took a gamble and essentially trusted us that we’ve done the work and it was a good investment.  We’re going to be offering that more broadly for the next round of the fund and we expect that to launch around June/July this year.

What will be the minimum investment in that?

It hasn’t been finalised yet, but because we operate a wholesale licence it will most likely be $500,000 dollars or if you’re able to get a wholesale certificate signed from your accountant, you can invest a lower amount than that.

You mentioned before, something about an LIC that you’re launching, tell us about that?

Yeah, for the long short fund we’ve decided to launch a listed investment company which enables any retail investor that wants to access the long short fund strategy through a much more convenient and I guess hassle free approach of buying it through shares rather than having to buy it or invest in it by filling in a stack of paperwork.  We think it enables us to make much better long term investment decisions.  Stocks like Chorus that we think are fantastic on a five year view but we don’t really have any strong view as to where the share price is going over the next few months and LIC is great for that because we don’t have the redemption risk that we do in an open fund. 

Essentially, we think that it will most likely be the last bit of capacity that is available to investors in the long short fund.  We’ve already closed the fund to new investors, so the only way for a new investor to access the long short strategy is through LIC.

When are you going to do that?

The offer just opened today and the broker firm offer will close on the 29^th of March and it will list on the stock exchange on the ASX on the 24^th of April. 

You said before that your fee in the LIC will be 1.4% versus 1.5% in the unlisted fund, why the difference?

Essentially, while we’re covering the majority of the ongoing cost of the LIC, there are some costs that for corporate governance reasons we’re not meant to be paying on behalf of the company.  Things like independent directors fees, we shouldn’t be paying.  Essentially, that 1.4% level is likely to be around about 1.5% once you include those costs.  It should be broadly similar.  People should be ambivalent between the retail fund or the LIC.

Do you have a view about the market in general at the moment?  Obviously, you’re a bottom-up investor so you tend to not invest according to top down views, but what is your view at the moment?

We think the market’s pretty fully priced.  We think that we’re towards the later stages of bull market and now’s the time to start thinking about the correlation in your portfolio between all the different investments you have, think about the backdrop that volatility is almost certainly going to be rising over the next couple of years and that’s because central banks have been flooding the world with asset purchases. 

The Fed and the BOJ and the ECB have all been doing huge amounts of bond purchases and also equity purchases over the last eight years, so it’s about $12 trillion dollars of assets they’ve bought over that time and as they start to unwind it’s going to increase volatility and it’s also going to most likely put a bit of pressure on the bond market which will have flow on effects for other asset classes like equities.  We think now’s the time to be conservative, to take some profits and to think about what sectors you want to be exposed to and which ones you want to avoid, given that back drop.

Do you mean that it’s a good time to have a larger than normal level of cash, is that what you mean?

Not necessarily larger level of cash and it might sound counter-intuitive to say that but given that we think inflation is going to be ticking up over time, cash is a terrible investment in a higher inflation world.  If inflation’s zero, at least you’re not going backwards, but if inflation starts running at closer to 3% instead of 1-2%, in real terms you’re going backwards by sitting in cash.  One of the great things about the long short fund is that it’s an absolute return fund.  The positive return objective that we have is regardless of market conditions.  If markets are down 5 or 10%, we’re still intending to generate a positive return through that time and essentially the investment that people are making with us is a bet on us picking the right stocks to be long and the right stocks to be short, it’s less of a bet on markets.  For example, the first two years of the long short fund, the market was actually down over that period and the fund was up more than 80% after fees over that period.  It’s not a bet on markets, it’s a bet on us as managers to be able to generate alpha or outperformance.

Yes.  Well, great to talk to you, Mark, thank you.

Thanks, Alan.

That was Mark Landau, the joint Managing Director and Chief Investment Officer of L1 Capital.