How an activist approach delivered 42% in under 3 years (and the next big target)

In May last year, I interviewed James Hawkins of the L1 Capital Catalyst Fund as part of Livewire’s Undiscovered Funds series. At that time, Hawkins spoke candidly about the rise of activist investing in Australia, how he practices it, and some of the investments he had been making.

I recently caught up with Hawkins again, for a Rapid Fire interview. The interview comes after the Fund delivered 18.4% in the six months to 30 April 2024 - part of the 42.1% the Fund has delivered since inception (1 July 2021).

Note: The interview took place on Thursday 23 May 2024 and his responses have been edited for brevity.

How are you seeing market conditions right now, particularly as they relate to activism in Australia?

If you look at the Australian stock market at the moment, you have a bifurcated market.

You have the Australian banks, which in my opinion are overvalued - record P/Es with dividend yields at or lower than the Australian cash rate - and then you have the rest of the market, which includes resources.

The resources sector has more companies, in my view, trading at much more reasonable valuations.

This divergence opens up good opportunities for active, bottom-up fundamental investors like us at L1 Capital, and that's where I believe there is value to be found in the market.

What has precipitated the rise of activism, other than injections of capital? 

Capital being injected into the activism space has assisted its rise, but it's also the evolution of investors' willingness to be active and express their views, as has been the case in the US and UK for some time, and is now becoming more common in Australia.

You're seeing the industry super funds are becoming more willing to be active, with a recent example being Aus Super rejecting the Brookfield/EIG bid for Origin Energy (ASX: ORG).

Also, as the corporate sector evolves to a more business-as-usual mentality post-COVID, this has enabled investors to become more active as they express their views as to what corporates should or should not do to unlock value.

I also think the investor universe is becoming more aware of activism as being a successful strategy given that, in the last calendar year, it was the best-performing strategy globally. 

Has the shape of activism changed since we last spoke - where is most of it taking place?

I think you're starting to see more activism come into the public sphere, but most activism will still take place behind closed doors. 

There have certainly been more examples of investors being publicly willing to articulate their views to gauge the support of other shareholders, particularly when we're talking about companies at the larger market cap end of the spectrum.

M&A has picked up lately. What is that a product of and do you expect activity to continue?

At the start of calendar 2023, I expected a poor calendar year for M&A simply because there wasn't a clear view of the inflation and interest rate outlook. 

It wasn't until those two things settled down, that boards and private capital could take a view on what the cost of capital was likely to be, and therefore, what the net present value of their future cash flows was likely to be. 

In an environment where you have high inflation, boards are often coming to the realisation now that it is cheaper to buy rather than build.

I think, as a consequence, we're going to see more M&A activity, particularly in the resources space.

What have been some of the big drivers of your performance since inception? 

Performance is always, ultimately, going to be driven by stock selection.

That being said, the ASX 200 presents a fertile hunting ground for activist investors. 

Since inception, we've been able to deliver 42% absolute performance and outperform the ASX 200 by circa 24%.  So it's a combination of a fertile hunting ground and critical stock selection.

Downer EDI (ASX: DOW)

Downer has been a key contributor over the last 18 months since it had a new chair, CEO, and CFO appointed.

Our investment thesis in Downer was premised on the opportunity for both a cyclical and operational improvement. We believe the core business is high quality, benefiting from structural trends, and we fundamentally view new management targets - FY25 EBITDA of 4.5%+ - as being readily achievable.

There has been substantial progress achieved to date. There's still some progress to be achieved, but we remain positive about the ability of the company to continue its momentum and deliver organisational transformation into FY25. 

Z Energy (ASX: ZEL)

Z Energy has been another key contributor to the performance of the Catalyst Fund.

It was the subject of a takeover by Ampol (ASX: ALD). It was a New Zealand fuel retailer, which was lowly geared with a strong market position, and we acquired it at a time of significant negativity during mid calendar year 2021, with New Zealand still in COVID lockdowns.

We acquired our stake on an undemanding valuation, with a strong dividend yield of 7%, which the company said was going to be payable in all circumstances - which was important since New Zealand was in COVID lockdowns at that time.

The business also had several potential catalysts, including a working capital release through converting the New Zealand oil refinery to an import terminal, and also realising the value inherent in the business' land and buildings, by separating them into a property REIT.

Ultimately, the Ampol takeover brought forward returns for equity investors. 

Have you taken any new positions recently – if so, what are they and why are you finding them attractive?

Our most recent public disclosure of an investment in the Catalyst Fund was our investment in Santos (ASX: STO), where we've advocated for it to become a more streamlined, LNG-centric business.

The LNG assets are the jewel in the crown of Santos' asset portfolio.

Shortly after when we went public with our proposal for Santos to de-merge its LNG business, it was announced that Woodside (ASX: WDS) was in the early stage of discussions to take over Santos. And whilst no transaction ultimately eventuated, Woodside has made it clear - and stated so publicly - that its future growth is in LNG.

In our view, that further supports our thesis regarding the high-quality LNG assets that Santos owns and that being the jewel in the crown of their asset portfolio.

This is an example that shows where activism investors invest often correlates with where there is M&A activity.

And whilst that didn't eventuate, what it has done is put a spotlight on Santos globally, for large oil and gas players, to say that the board is willing to engage on value unlock and value realisation proposals. 

For those investors who remain unaware or reluctant to consider activist opportunities, what advice would you give them?

Activism has been one of the best-performing strategies globally and now has well and truly established its credibility in terms of delivering good performance outcomes for investors, both internationally and importantly in Australia.

We think the current market, as I described it earlier, being a bifurcated market combined with the market cycle that we find ourselves in, presents some of the best investment opportunities we've seen for the L1 Capital Catalyst Fund.