Decade of excellence: 10 years of outstanding performance for L1 Capital’s Long Short Fund

And while those numbers tell a story, there is so much more to the journey than just the raw figures.

Humble beginnings and hard work

L1 Capital founders and Co-Chief Investment officers, Mark Landau and Raphael Lamm, only ever wanted to be focused on markets. They only ever wanted to be picking stocks and driving great returns for investors.

When building a funds management business however, particularly in the early days, you have to be so much more than a fund manager – IT manager, HR manager, marketing manager, and so on… but more on that later.

The LSF was born out of the desire to pursue a wider range of opportunities than allowed by the benchmark-aware, long-only Australian Equities Fund launched in 2007, when they founded L1 Capital.

“We realised that there are a lot of great opportunities that we were missing out on due to our investment mandate being so narrow”.

“So, we created the Long Short Fund to take advantage of the strengths of our existing long only Australian equities capabilities, and added in the ability to short, exposure to international stocks up to 30%, and the ability to vary the net long to reflect market opportunities,” says Landau.

While that evolution sounds simple enough, setting up a fund takes an immense amount of work, with Landau adding that it required “a lot of experience and mistakes to work out how to get the parameters right for a fund. You’ve got to make sure you get the right balance between being able to deliver performance and diversification, handling correlations across the portfolio, and isolating your insights to remove the unwanted risk”.

“The Long Short Fund has huge advantages over long only because it’s much better able to isolate the insights into an industry and remove risks that we don't necessarily want to take,” says Landau.

Lamm adds, “Since inception, our offshore stocks have performed even more strongly than our domestic ones, highlighting the appeal of literally having a world of opportunities available to us”.

Downside protection and incredible growth

After 10 years, the LSF Strategy now has north of $4.6 billion of funds under management. While Landau and Lamm had no concept of how big it would become, they knew how they wanted to invest their own money. They thought that would likely resonate with investors, particularly those not overly enamoured with the relative return concept.

“If the market is down 20% and you're down 15%, investors are not going to thank you,” Landau points out.

“We could see that if you could deliver strong positive returns and have a genuine ability to preserve capital in down markets, there would be virtually unlimited demand from high net worth and family offices.

“I guess what we didn't appreciate was just how broadly it would resonate beyond that client base,” says Landau.

Resonate it has, with the focus on capital preservation manifesting as significantly less underperformance in down markets for the strategy.

In the 122 months since the LSF Strategy’s inception, the ASX200 has fallen in 46 months, with an average decline of 3.1% per month. During those same months, the LSF Strategy declined only 0.4% per month (on average).

“One of the things that we've been able to achieve is to protect 85% of capital in down markets, which I think is a huge point of difference versus other funds and also versus passive”.

“Passive has become the dominant investment choice for most people. It's a way of getting access to the market and paying virtually nothing in fees, but you get a hundred percent on the downside if the market falls. I think downside protection is an underappreciated aspect of the Fund,” says Landau.

Current views on markets

At a macro level, Lamm cites the ability of global central banks to prove they have inflation under control as the biggest risk factor facing markets.

“The markets are working under the assumption that they’re going to be largely successful.

“To the extent that's not the case, you can see higher bond yields and that's going to put pressure on global economies, but also on equity valuations,” says Lamm, adding that while we’re probably past the worst of it, “getting to target and staying at target is going to be exceptionally hard”.

Regarding valuations, Landau and Lamm see markets as expensive compared to history, both in Australia and globally.

“Prospective index returns for the next few years look like they'll be lower than what investors have become accustomed to over the last decade,” says Lamm.

He notes that Australian banks look particularly expensive, while high-growth and high-PE stocks are also very expensive compared to the past.

“The good news is it's an opportunity-rich environment when you go outside of those areas, particularly in the traditional value space with low multiple names". 

“We've seen lots of really good companies, with good management teams, good balance sheets, good medium-term prospects,” adds Lamm.

He cites UK supermarket chain Tesco (LON: TSCO) as a standout, adding that it is enjoying better trends than Australian peers, but is trading on a PE ratio of 13x, versus PE’s in the 20’s for the Aussie equivalents.

JD Sports (LON: JD) is another UK retailer on the radar. Lamm labels it a “global category killer opportunity” and Landau adds that it is “likely to grow earnings at least 10% per annum for the foreseeable future, and trades on a PE of 8x.”

“A typical Aussie discretionary retailer, that's not growing as fast, would be on two or three times that multiple”.

"The management of JD are really impressive and have a great track record of winning market share, expanding margins and moving into new geographies successfully,” adds Landau.

Staying in the UK, the team likes NatWest Group (LON: NWG), which is “trading around 7x earnings, with double-digit earnings growth, solid dividends, and a very focused strategy,” says Lamm.

“They're likely to return about a third of their market cap in dividends and buybacks over the next three years. You compare that to Commonwealth Bank (ASX: CBA), where you'll probably get around a 3% dividend yield and minimal buybacks".

"Commonwealth Bank, on consensus numbers, has low single-digit earnings growth and NatWest is growing at more than 10% per annum,” adds Landau.

Another area of opportunity is gold, with Lamm seeing “lots of companies with really strong medium-term earnings growth on very low multiples” both in Australia and offshore.

“The gold sector has been a bad actor for shareholders over the past decade, and that's really taken away a lot of interest”.

“We believe in many cases the boards and management teams have learned their lesson and we're at a point where expectations are very low, but companies are poised to finally deliver,” says Lamm.

The L1 Capital approach and lessons from the past

The current views on markets are informed by previous successes and lessons learned from a few missteps, as well as a determination not to get caught up in the latest investment fads.

Of the latter, Lamm notes it’s particularly important not to get swept up when there has been a long period of sustained strong performance – like there is now.

“There's a natural tendency towards complacency and people assume that what's worked is going to continue to work and then you can get quite sudden inflections, especially when there's so much quant money influencing markets these days,” says Lamm.

Thinking differently, willingness to take an opposing view, and not being wedded to any particular investment style have also served L1 Capital well.

Landau notes that a lot of fund managers effectively pick growth or value.

“Our view is that a great investment has to represent both, not one or the other – you're trying to optimise the best possible value and the best possible quality.”

“Whereas if you just focus on one, you risk buying a value trap if you're just focused on value. And for quality, you could buy the most exciting growth business – there's plenty of companies on 100, 200 or 300 times earnings that are great businesses, they've got great management, but I can't possibly justify why I'd pay that sort of price,” says Landau.

The combination of those factors saw the L1 Capital team take advantage of the mass market dislocation through the Covid period, which Lamm and Landau highlight as one of their greatest successes.

They highlight investments in Qantas Airways (ASX: QAN) and aerospace company Safran (EPA: SAF) at the peak of Covid negativity as examples, where “people were trading [Qantas] like they were never going to fly again,” says Lamm.

Another example, on the short side, was Peloton Interactive (NASDAQ: PTON).

“Everyone thought that they would be doing gym at home for the rest of their lives and everyone already bought their machine”.

"The stock was trading assuming much higher than normal sales and much higher than normal margins and then trading at a much higher than normal multiple".

“You put all those things together, and overvaluation was extreme”, says Lamm, with Landau adding that the share price fell from around US$120 to just $10 in the space of 12 months.

Another winner closer to home has been AGL Energy (ASX: AGL), which the team bought and sold multiple times over the journey – highlighting their willingness not to be wedded to a view and to change course when new evidence presents.

“We originally bought AGL at around $10 a share and held it all the way through to about $25 and then we went short and held it till it was around $7, and then went long again and held it until it was well into the double digits.”

“We've successfully traded it probably half a dozen times in the last 10 years,” says Lamm.

Another winner, which colleague James Hawkins spoke about at Livewire Live this year, has been BlueScope Steel (ASX: BSL).

“The company really was in trouble and there was a massive turnaround proposed by management that the market didn't buy into.

“We did a lot of work on it and we thought the turnaround was mostly cost-out driven, and share price went from roughly $3 to low $20’s over a few years,” notes Lamm.

Despite the successes, there have been challenges along the way. As fruitful as the Covid period ultimately proved to be for the L1 Capital Long Short Strategy, it required a level of effort that pushed the team to the limit.

“It was a really challenging and stressful period, and I can't tell you how many times we went to bed at two o'clock in the morning and did it all again the next day, and then again the next day,” says Landau.

As for investment challenges, Landau cites former ASX-listing Boral as a misstep, saying poor management, bad acquisitions, and accounting irregularities in the US all amounted to “one disaster after another”.

But the silver lining was that it was a great lesson “in terms of how important management is; having management that is sensible with shareholder funds and also allocates capital in a sensible way,” says Landau.

A more recent example has been not being invested in the "Magnificent Seven" stocks in the US. While Landau notes that it hasn’t “cost us any money…with the benefit of hindsight, it's pretty obvious that over the last decade, Microsoft, Meta, Google and these companies are fantastic businesses.

“They've got great outlooks, they're very dominant, they've got great balance sheets. It really ticks the boxes of our process, but we could never quite get there valuation wise… and that was a really bad error of omission,” says Landau.

“I think that if we look back, if we're going to be objective markers of ourselves, I think that was a really bad mistake”.

Honing their craft

That willingness to be objective markers really stands out when talking to Landau and Lamm. While rightfully proud of the business they have built and what they have been able to deliver for their investors, they are always hunting for how to improve their edge – it is an unending pursuit.

But they have also developed the wherewithal to know where they can move the needle and where they can’t, a skill which they have honed over the journey.

“When we do have a strong idea, I think over time we've got more confidence and as we’ve got more examples to compare to, I think the chances of thinking an idea is a strong idea and it actually being strong ideas is higher.

“We're better now at identifying what the great ideas are, where the work's been done, and then we're better at implementing those in the portfolio,” says Lamm.

Landau adds that it’s “important to be realistic about where you've got edge and trying to focus your investments purely in those areas”.

In a nod to the rest of the L1 Capital team, which has grown considerably over the years, Lamm notes it is critical to “always do the work yourself or within your own team”.

The final word

With success comes reward. For Lamm and Landau, one of the biggest rewards has been what they wanted all along.

While they had to balance running the business and running a fund in the early years, success has enabled them to focus less on the former and more on the latter.

“There was no desire for Rafi and me to be IT people or HR people,” says Landau.

“We're very happy to have lots of capable people at L1 Capital who are better at those jobs than us. The more that we can focus on stocks, the happier we get”.

Given their track record, that’s likely music to the ears of LSF investors.

Managed Fund

L1 Capital Long Short Fund – Wholesale

Australian Shares

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