Where L1 sees opportunities ahead, after clawing its way back

L1 Capital is perhaps best-known for its listed investment company, which made headlines for all the wrong reasons when it launched almost exactly three years ago.

The Value-focused portfolio misfired spectacularly in the weeks and months after its IPO on 1 May 2018. This followed a dream run of more than three years when the stellar performance of its unlisted Long-Short Fund and other strategies ranked L1 among the world’s top-performing fund managers.

What happened? The fund was caught on the wrong side of the spike in momentum trading, along with a few events that were freakishly aligned. These included the US-China trade war, which saw bond yields plummet and thumped stocks with low price-to-earnings ratios, which typically comprise most of the fund’s long positions. And some of L1’s larger holdings were also knocked by unpredictable events:

• UK paint and chemicals company Venator saw its share price more than halve after a massive fire at one of its European plants
• Australian agricultural firm Nufarm’s (ASX: NUF) shares dived in response to legal action around its large glyphosate weed-killer product line Roundup, along with the ongoing drought.

But having pulled the LIC back into the black, the fund manager’s co-founders and Co-CIOs, Mark Landau and Raphael Lamm, are confident it will continue to outperform in the years ahead, as they recently told my colleague Patrick Poke during a recent podcast interview.

How have they responded?

“With the benefit of hindsight, there were a few stocks where our judgement wasn’t as good as it usually is,” says Lamm

“If we had our time again we’d just have that little bit of extra focus and make a few of those calls a bit more on the money.”

Helping balance out some of their earlier misfortune, US homewares company Bed, Bath and Beyond (NASDAQ: BBBY) is one call they got spectacularly right. 

L1 bought the stock last May when shares in the out-of-favour company were hovering around US$9, having fallen as low as US$5 last March, from a peak of around US$75. “It was a retailer well on the way to bankruptcy,” explained Landau.

L1’s interest in BBBY was sparked when an Australian executive with an impressive track-record, Mark Tritton, took over as CEO.

The high degree of short-seller interest the company had attracted was another drawcard for L1. If they were right about the turnaround prospects under new leadership, “that 60% of the register was going to want to close its position,” says Landau.

At the time, BBBY was the second-highest short interest stock in the US – behind only GameStop. When the company’s fortunes shifted and BBBY’s share price began to climb, L1 rode it up to $45 before selling the stock, which touched just over $50 before dipping again.

Obviously, it’s no longer a stock L1 holds, but Landau says he would like to get back on the register at some point. “We do think there’s an exciting turnaround story, we just want to do it when the odds are stacked more in our favour.”

How much upside is left in valuations?

Zooming out, Landau and Lamm also discuss the current market environment and what they see ahead. Their level of net equity exposure – the difference between their long positions and short positions – remains elevated at around 100% net long, beyond their average of around 65% net long.

But this sat between 130% and 140% during the worst of the COVID sell-off last year. This is the only time they’ve gone beyond 100%, such was the opportunity they saw in the rock-bottom valuations between last January and March.

“In many cases they were becoming disconnected from what we thought were the long-term opportunities of the businesses,” says Landau. “We saw an extreme opportunity for upside at that time.”

While he sees a lot less upside now than 12 months ago, Landau believes equities remain compelling. He points primarily to the greater certainty markets now have around:

• Vaccine efficacy and timelines
• The actions of governments and central banks on monetary and fiscal policy.

“You’ve got massive stimulus … and you’ve got rising business, investors and consumer expectations about how the world looks, so we think you’re going to have accelerating operating momentum and global growth of more than 6%,” says Landau. 

“That’s a really conducive backdrop to equities continuing to rally."

Where are the biggest opportunities?

While emphasising that he and the team build the portfolio on a company-centric basis, “looking at it top-down, you see a big skew toward value and cyclical stocks.”

“Relative valuations of growth versus value have never been more extreme, currently even more dramatic than the dot-com boom,” Landau says.

He believes we’re nearing an inflection point that will see the outperformance of value and cyclical stocks continue longer-term, pointing to three specific catalysts:

1. The “vaccine trade” – which will see many of the “COVID losers” boost their operating momentum over the next 12 months
2. An enormous M&A cycle – “Probably the biggest since 2007 … think we’ll see a very similar year in 2021,” says Landau. “You’ve got very cashed-up private equity firms, corporate confidence that’s now through the roof, and everyone we speak to is saying how busy they are.”
3. Rising inflation – Landau holds the increasingly popular view that inflation will start ticking up over the coming year.

Emphasising the final point, he notes that higher inflation would also push bond yields higher. “If we saw an inflection point (in bond yields) play out over the coming 12 months, we think investors would look to take their profits out of some of those tech and growth sector names and rotate into those cyclical parts of the market that are going to enjoy the benefits of this economic recovery”

In terms of the vaccine trade – also often known as the recovery or reopening trade – Landau believes we’re currently only about halfway through. And he emphasises the nuances in the recovery story between different markets, specifically Australia’s slower rollout of vaccines versus the US.

“Obviously Australia has been a bit behind the eight-ball in terms of the vaccine rollout…the Astra Zeneca and the University of Queensland vaccines also have some issues in that they’re not as flexible as the mRNA vaccines,” says Landau.

In this regard, he sees the ability of his fund to hold both locally-listed and offshore listed companies as an advantage. L1 has rotated some of the potential “vaccine trade” winners it holds, reducing its exposure to ASX travel plays Webjet (ASX: WEB) and Qantas (ASX: QAN) and retail name Scentre Group (ASX: SCG). On the flipside, the fund has increased its allocation to some offshore names, including French aerospace manufacturers Safran S.A. and Airbus.

Aussie small cap with a big future

A locally listed cyclical name Landau likes is the mining services and exploration drilling firm Imdex (ASX: IMD). Having invested more than 30% of its profits into R&D for many years, with very little debt on its balance sheet, the company currently has a market cap of $753 million.

“We think it can easily grow at more than 20% per annum for many years to come,” Landau says.

“Even at $2 (stock was trading at $1.93 at 4pm Monday 3 May) it’s a really compelling risk-reward.”

Local large cap with plenty of upside

From the ASX 100 cohort, Lamm names oilfield services company Worley Limited (ASX: WOR) as a favourite stock. “We’ve owned on and off over last few years, but we’ve recently increased our weighting because it has good medium-term prospects”

Despite the challenging oil price environment last year, when prices dipped below zero as demand plummeted during the pandemic, he’s confident companies will expand.

“We see earnings growth well above the broader market over the next couple of years,” says Lamm. He also expects Worley will shift its business focus to cater to the transition toward renewables from hydrocarbons in the years and decades ahead, further expanding its addressable market. 

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