Why this fundie believes you can outperform the market with 10 stocks or less

It was Nobel prize laureate Harry Markowitz who famously posited that the "only free lunch in investing is diversification". By this, he meant that diversification can help investors generate acceptable returns while lowering their risk. 

Sounds great, right? Well, maybe not. We only need to call on perhaps the world's most famous investing great, Warren Buffett, for a rebuttal. The Oracle of Omaha once said that diversification is but "protection against ignorance - it makes little sense if you know what you're doing."

It seems L1 Capital's James Hawkins would agree. As the man behind the firm's 10 stock “best ideas” Catalyst Fund, he believes that if investors are to generate better returns than an index, they need to be completely different from it. 

In Hawkins’s case, that means tapping into the activist opportunities available in the Australian market – seeking “catalysts” that could unlock value for a company's shareholders and see a stock's share price soar as a result.

For those not in the know, much-loved long short equities house L1 Capital launched the new fund in July 2021, leveraging L1 co-founders Mark Landau and Raphael Lamm’s stock picking capabilities from their flagship L1 Capital Long Short Fund. From its launch to the end of August 2022, the Catalyst Fund has delivered its investors a return of 18.1%. in a time when its benchmark, the S&P/ASX 200, returned 0.1%.

This is an impressive feat, particularly given some of the losses sustained by some of the country's finest stockpickers.

So in this Expert Insights video, Hawkins shares how his skillset works alongside the minds of Mark Landau and Raphael Lamm, sets out the case for concentration, explains how a stock makes its way into this "best ideas" portfolio, and shares one stock that passed L1’s filters. 

Note: This interview took place Monday 1st August 2022. You can watch the video or read an edited transcript below.

Managed Fund

L1 Capital Catalyst Fund

Australian Shares

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Edited Transcript 

Can you tell us a little about yourself?

James Hawkins: I started my professional journey as a solicitor and worked at Clayton Utz for three years in M&A and Project Finance before joining Macquarie's Investment Banking Group in early 2004. I spent nearly a decade with Macquarie in Melbourne and New York, working across a range of industry groups. I then joined Flagstaff Partners, which is a leading Australian corporate finance advisor, in 2011, and I was an equity partner and managing director there.

My professional journey has been a short period as a solicitor, and the last two decades as an investment banker. And I think the key attribute to the Catalyst Fund is not my skillset in isolation, it's a combination of my skills with Mark Landau and Rafi Lamm's skillset.

They have both had two decades of stock picking experience and we combine our skillsets as the three members of the Investment Committee for the Catalyst Fund.

What generated the idea for the L1 Capital Catalyst Fund and why do you only hold 10 stocks (or less)? 

The idea for the Catalyst Fund came about through Rafi, Mark and me knowing each other for a couple of decades. And we thought there was a unique proposition in combining their stock picking skills with my investment banking skills, and bringing those skill sets together on an investment committee and a decision-making committee for the Catalyst Fund. So, we formed the Catalyst Fund on the 1st of July 2021. 

We are seeking to achieve genuine alpha to the ASX 200 index. That is why we have got a hard cap of 10 stocks in the Catalyst Fund. 

Now, the fund is a "best ideas" fund of the L1 Capital Long Short Fund, but with an activist overlay. We think once you get greater than 10 stocks, you start to not satisfy the definition of a "best ideas" fund. Again, because activism is so time-consuming and labour-intensive, we've capped our stocks at 10. 

And finally, we aren't suggesting to our investor universe that they invest 100% of their portfolio in the Catalyst Fund. It's a sleeve or a part of their overall portfolio, which is going to seek to generate genuine alpha to the market. 

How does a stock make its way into your portfolio? 

There are three, what I'll describe as "gates", in order for a stock to get into the Catalyst Fund:

1. Value: The stock needs to meet the value expectations of the L1 Capital Long Short Fund's investment approach. 
2. Quality: The stock needs to meet the quality gate for the L1 Capital Long Short Fund. 
3. Catalyst: These might be operational-related or governance-related, but these are things that we can influence, enact or accelerate to bring forward equity returns for investors. 

It's that third gate, which is going to be different to the L1 Capital Long Short Fund's investment approach. Rafi, Mark and I sit on the investment committee for the Catalyst Fund. And for any stock to go into the portfolio, all three of us need to unanimously agree.

The thought process there is that we've got a "best ideas" fund. So if one of the three of us does not agree for any particular reason, we think that it doesn't satisfy the definition of a "best ideas" fund, and then that stock does not go into the portfolio. 

How has the portfolio positioning changed over the past 12 months? 

What's changed in the last 12 months is the macro backdrop. We're not a macro fund, but of course, the macro backdrop influences markets materially. 

The opportunity set has changed in the last 12 months, because of the significant increase in the risk-free rate, as well as having some regard to some of the geopolitical tensions around the world, and the flow-on effects these are having on markets.

As we are so stock specific in our selection, we have regard to the macro backdrop, but it's dependent on the situation, the opportunities relating to that stock and the value, the quality and the catalyst, which could be enacted and accelerated in relation to that particular stock. 

We've exited out of three or four positions that were in the portfolio when we initiated it on the 1st of July last year. 

Can you provide an example of a recent portfolio addition? 

Once stock I'll refer to that we brought into the portfolio in the first year of the Catalyst Fund is Ramsay Health Care (ASX: RHC). We liked Ramsay because it had a high-quality, irreplaceable set of hospital assets up and down the Eastern Seaboard in Australia, and also in the Northern Hemisphere. 

Ramsay was trading at a discount to the ASX industrials Index from a P/E perspective. Historically it had it traded at a premium because of the high quality, irreplaceable set of hospitals. Importantly though, it had a number of potential catalysts. 

It had a joint venture in Malaysia, which was not being valued at all by the market, but primarily the real value unlock was the property assets that it owned in Australia that were largely freehold. They were an irreplaceable set of hospital assets and we thought there was a value unlock opportunity to the tune of valuing these property assets at circa $9-10 billion, at a time when the market capitalization of Ramsay was only $15 billion. We thought Ramsay could enter into a sale and leaseback type of transaction and utilise some of those proceeds to buy back shares at a time when the Ramsay share price was, in our view, undervalued.

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