L1's Long Short Fund

The L1 Long Short Fund (ASX:LSF) burst onto the scene in dramatic fashion, just over a year ago.

The Listed Investment Company (LIC) was going to follow the same strategy, that had returned 36.9 per cent per annum after fees, since inception.

The LIC raised over $1.3 billion. Fast forward a year, and the share price now sits 60 cents below the listing price, and at a discount to Net Tangible Assets (NTA) of approximately 20 per cent.

I spoke with Mark Landau, the Joint Managing Director and Chief Investment Officer of L1 Capital, to learn more about this deeply discounted, long term, high performing fund manager.

Mark, can you tell me about the fund's investment strategy first up?

Sure.  The L1 Long Short Fund's strategy is to generate strong positive returns with less market exposure for the market or less volatility in the market, essentially what we're trying to do is to find out as much as we can about companies and industries.  We are what they call fundamental bottom up investors, and we're trying to identify companies that are both undervalued and of above average quality.  What we essentially try to do is not necessarily to find the absolute best business and also not to find just the cheapest business, but to look for the best combination of both and I guess the best analogy I could give you is you don't necessarily just go to buy the best house in the best suburb because if the asking price is a billion dollars you're probably getting a great asset, but you're getting a very poor investment.  And equally there are plenty of examples of companies that are notionally cheap but the fundamentals of the company are weak so that the value of that opportunity is never realised.

I guess in the old days, department stores or newspapers always screened as cheap but that upside proved to be illusory.  Essentially what we're doing is looking for companies where when we do our detailed fundamental research, we meet with senior management, competitors, suppliers, customers, basically anyone who'd give us some genuine ideally objective long-term insight into the prospects of the company.  That's what we're trying to do, and we then do a pretty forensic analysis of the accounts to try and understand the cash flow profile, because often that doesn't necessarily transfer from the P&L into the cash flows.  We're much more focussed on the cash flows because as your listeners will know, accounting has a lot of assumptions included in it and obviously what we care about as investors is how much cash we're going to get back versus how much we put in.  I guess at a high level, that's really what we're about.

Now before we get into the long approach and the short selling approach, I did want to just tackle head-on, it's been in, especially when you guys listed you raised about $1.3 billion or thereabouts during the initial offer period, you listed at $2.  I'm talking to you now, we're sitting here for a share price of around $1.40.  The fund, the underlying strategy of the fund up until the listing had outperformed the market from 2014 by about 30 per cent per annum, then it just seems to, I don't know, things just didn't pan out the way a lot of people had expected after the listing.

Can you tell me what drove that initial under performance in the fund compared to the market?  And maybe some lessons as well that have come out of that for you guys?

Yeah, the unlisted version of the Long Short strategy started in September, 2014, so we're coming up close to five years now, and that strategy, up until the time of the IPO, had delivered roughly 35 per cent per annum on after fees, which put it in the top few Long Short strategies globally.  We're really proud of that track record.  One of the unfortunate coincidences of the IPO was that the performance of the strategy suffered its worst year pretty much from the time that the portfolio got set in around May 2018, and it was nothing to do with the higher FUM.  I think that's one of the common misconceptions about the strategy, is that the higher FUM caused the bad performance.  That's definitely not the case, and if you look through the stocks that cost us most of the negative performance in 2018, the vast majority of those stocks were long-standing, long positions that just happened to have a sell off around that May/June period.

Whether it’s stocks like Boral or CK Hutchison or HeidelbergCement, there were two factors that really dominated that impact on the portfolio.  The first one was that a lot of the long exposure we had offshore was primarily in Europe and Hong Kong, and those two stock markets went into bear markets around May last year.  The second factor is that at a stock level, we had a number of stocks where they got hit by left field events.  In the case of say, Nufarm, which has been a long-standing position in the Fund, the court cases against Bayer to do with their Round Up or glyphosate product, which is what Nufarm also sells.  That happened around the middle of last year.

And then secondly, another one of the stocks in the portfolio called Venator had a fire at one of their main plants and again, the company was underinsured, there was a lot of issues in terms of them being able to rebuild their main plant, and at the same time there was a lot of remediation cost that far exceeded the insurance coverage of the business.  We had a combination of markets that were very skewed towards growth stocks over value stocks, which is a difficult backdrop for us, combined with the Europe and Hong Kong selloff, and at the same time a few things that we either got wrong or were unlucky with, like the case of Nufarm and Venator. 

Unfortunately, it was just the timing which was incredibly frustrating for us and I'm sure it was for a lot of the new investors who hadn't had the benefit of those really strong returns in the prior years.  I guess the positive I can give you is that if you look at the Fund this year where we're up 10 per cent for this calendar year to date, that's with a very modest net-long exposure so we haven't benefited from being long the market so much, and the parts of the market that have been rallying, so whether it's yield stocks or iron ore stocks or bank stocks, are sectors that we are either not exposed to or actually net short. 

The fact that we've done 10 per cent this year has been from stock picking, and hopefully that's a sign that we're back on track to get people back their money and then hopefully start delivering some strong positive returns going forward.

Let's talk about that stock picking and let's start with perhaps the long side to your portfolio.  You talked about cash flows being incredibly important and doing some detailed forensic analysis on that.  Can you explain that a little bit for us?

Yeah, so the way we think about the value of a company is pay for the future cash flows that that company will generate, discounted back to today's values.  So a discounted cash flow is what most of our valuations use.  The reason we do that is because we find that accounting is becoming more and more, I guess susceptible to adjustments.  There's a lot more use of provisions and capitalising of expenses, which essentially means you spread those expenses over many years even though the cash might be incurred in the given year.  You see situations where companies are doing all of things to adjust their P&L and the cash flow's not reflecting the same trend. 

What we want to do as people that have a very strong background in accounting and finance is to really isolate those cash flows, understand what's going on in the balance sheet, and to ensure that we're not buying I guess the appearance of strong earnings growth without the cash flows to support that.  When we do our valuations, it's very much cash flow-focused.  In terms of quality we look at three factors, the management team, not just the CEO and CFO, but the board, the rest of the senior management team, the culture, the incentives.

Secondly, the industry structure.  Over time companies that are in a strong industry structure, monopolies, duopolies, tend to hold up far better in down turns, and thirdly operating trends.  Does the company have tailwinds that are going to see improving return on capital over time, improving margins?  Or are there competitive threats or regulatory threats that are going to deteriorate the outlook for the business? 

And then lastly, we do a very detailed check of the balance sheet.  We started our funds, our original fund, back in 2007, our Long Only fund.  Obviously, that was a year before the GFC.  The lessons of the GFC we still remember vividly and the balance sheet was the answer, not the P&L, so we still spend a lot of time trying to understand the strength of the balance sheet and I guess the appropriate gearing levels, because we still think that that’s a part of the analysis that tends to get less focus than it deserves.

Would that part of the analysis come at the end when you've gone out there, you've met with management, you've observed the industry trends, and then the last thing is right, it ticks all these boxes.  Now let's actually do a deep dive on this balance sheet just to make sure that there's nothing there that's going to surprise us?

Yeah, that's right.  For us, the balance sheet is a pass or fail.  It doesn't determine whether we invest.  Companies get screened out based on their balance sheet if we believe that either the gearing is too high or the business model is too vulnerable to worsening financial conditions where their access to debt or their access to a line of credit could be in jeopardy.

Now, I just want to go back a bit as well, and I think this is always a really interesting topic to discuss, you mentioned that you go out there and you meet with management, you determine the quality of management, and also the incentives.  Can you give us an example of where the incentives you believe were right and in favour of the business or an incentive scheme that was maybe in place that put you off a potential investment?

Yeah, I think we're very what I would call commercial when it comes to incentives.  We want incentives that you would be happy to put in place if you were a private company and this was your management team you were running.  It wasn't a public business, but you wanted to generate the right incentives to cause management to act in a way that's consistent with your objectives.  One of our frustrations is companies where they continue to switch between different incentives depending on what's going to suit management and what's going to make it easiest for them to hit their targets.

For example, you might see a company that focuses on EPS growth at a time when they've got huge capex, when they're spending huge amounts of money to invest.  Where that's going to generate a return and that's going to generate EPS growth, but it may not necessarily be generating a good return on capital.  There are plenty of examples of companies where they continually switch from one set of metrics to another and we would prefer to have consistent metrics over time where you're engendering the right behaviours because far too often, the reason for the switch is not to do with giving shareholders what they're after, it's to do with making sure that management have an easy hurdle to get over.

All right, so there's no one way that you like to see incentives in place, it's just each business on its own merits and what's right for shareholders at that particular point in time, is that correct?

Unfortunately, there's no one size fits all.  I think a lot of people hang their head on TSR, total shareholder return, or EPS or ROE, but depending on the type of company and depending on the point in the cycle that you're in, different incentives are more or less appropriate.  As an example, a company that's going through a huge growth phase is going to be spending a lot of money on new investments and huge capex bill, you want to focus on return on capital and you want that to be a multiyear assessment, not a point in time. 

EPS in that example would be a bad example.  Or you could be a company that the success or failure of the company might be very beholden to macro factors.  So an iron ore stock, to have a purely TSR focus, you might not be rewarding management when the iron ore price is falling and equally when the iron ore price is rallying and management is doing a terrible job, you're going to be paying them huge bonuses and they're going to be hitting their LTIs. 

Essentially you want to make sure that you're isolating what’s within management’s control and what they deserve to be compensated for and what's going to be in the best interest of shareholders.  And often, boards are very concerned about ticking the theoretical boxes and they're less focused on the practicalities of making sure that this is exactly what is fair both for the management team and also for the shareholders.

Let's move onto the short selling side of the portfolio.  On average, how many short positions would you hold in the portfolio and what's their general sizing?

We normally have around 30 shorts in a portfolio.  We normally have around 50 longs, 30 shorts, a typically short for us is around a 2 per cent weight.  One of the misconceptions around time of the LIC launch was that some of our shorts were massive, and they were having this disproportionate impact on the portfolio.  We don't have massive short positions, so a typical short for us is 2 per cent at the moment.  An average short for us is about 1.7, 1.8 per cent, so it's very much in line with the long term average strategy.  Essentially what we're trying to do when we construct the portfolio is to take the view that hopefully we'll get more than 50 per cent of our decisions right and that will lead to positive performance.

We're not trying to bet the house or bet the portfolio on a few key stocks or a few key shorts, because we think that's a much riskier strategy.  Over time, you should expect about 30 per cent of FUM to be invested offshore and around 70 per cent to be domestic. 

Let's talk about how you actually target the companies that you're looking to short sell.  Tesla is one company that you guys are currently short.  Well, you were as of the last monthly update.  Perhaps we can use that as a bit of an example.

Yeah, I think we are still short Tesla.  It's been one of the very successful shorts of the fund this year, and it's a good example because think last year, we were copping a lot of grief for that position.  Obviously, Tesla shares have rallied quite a lot.  Elon Musk has come out with his very famous $420 takeover Tweet, which sent the share price soaring, and it was a very high-profile position for us.

We've made a lot of money this year by staying short Tesla and the shares have fallen by roughly 50 per cent.  They've fallen from about $360 a share, and today they're close to $180.  I guess when we think about a successful short or what we hope will be a successful short, there's four things we look at.  The first one is evaluation based on cash flows.  In the case of Tesla, they lose about US$700 million per quarter, and the cash flows are even worse than the accounting profits, or losses I should say.

Secondly on management, Elon Musk is a very erratic CEO.  He's had a long track record of losing a lot of his direct reports, almost every direct report to Elon Musk has resigned.  Over the last 12 to 18 months, he's lost CFO, the head of production, the head of sales, the head of autopilot, almost every key person that reports to Elon has resigned, and we think that's a huge negative sign in terms of the culture and in terms of the quality of the leadership more broadly.

Thirdly, we look at the industry structure, and you're going from a position where Tesla was pretty much the only premium electric vehicle producer in the world to a position where competition is going to absolutely surge over the next two to three years.  So companies like Audi, Hyundai, almost every major car producer is coming out with a range of high quality electric vehicles.  They're going to be a direct threat to Tesla, which we think is going to cause them to struggle to hit their sales targets.

The fourth one is the operating trends.  Tesla was given a target for this year of making 360,000 to 400,000 car sales.  We think it's very unlikely that they'll hit that number.  They did 60,000 car sales in the first quarter.  There's no signs of a dramatic improvement in those trends.  At the same time, they're dramatically lowering prices in order to trigger some improvement in sales, but all they're getting is a much lower gross margin with no improvement in sales. 

And then the last one is a balance sheet.  Balance sheet is under a huge amount of stress.  They've got close to $10 billion of debt.  That debt is now trading as junk, so when you look at where that debt trades in terms of credit markets, the way that that's trading would give you some serious doubts about the long-term viability of the business and also the ability for them to raise more debt going forward.  Tesla will most probably run out of cash in the next 12 months, and then once again they'll have to come back to equity markets and try and do a capital raise.  But given that the share price has collapsed 50 per cent in the last six months, we think it's getting more and more difficult to keep raising more money.

Speaking of that balance sheet again, it's very important in your long approach and just as important by the sounds of things in your short selling approach as well.  Has there been an instance where you've gone out looking at a stock for a long position in your portfolio but upon viewing the balance sheet and whatnot, you've actually turned around, reversed that decision, and actually gone short in it?

Yes, we have.  We have had a position in the fund where we've been long stock and then because the balance sheet has deteriorated so quickly in the working capital, so whether it's the inventory or the accounts receivable, has flipped, and effectively you get this stress on the balance sheet where they're likely to breach covenants or they're likely to have a huge profit downgrade.  We have had situations where we've flipped from being long to short, but I prefer not to say the name of the company.

Fair enough, okay.  Let's move on now and just get your market outlook.  I did read through the presentation for your quarterly investor call, and to be fair your market outlook there didn't paint the rosiest of pictures.  You were saying that Australia looks relatively fully priced.  The US valuations looked a little stretched.  Europe was okay, but there were structural issues there.  So fair to say, outlook for the market probably isn't the rosiest right now from you guys.

Yeah, I think unfortunately we struggle to find a geography that feels cheap and attractive.  As you said, the difficulty for us is the Australian market and the US market from a fundamental point of view feel the most robust, but unfortunately, the valuations in those markets are the most stretched.  And then Europe and Hong Kong probably look far more attractive from a valuation point of view, but they've both got some pretty serious structural challenges that are very difficult to forecast.  In the case of Europe, you've obviously got the situation with Italy, you've got the situation with Deutsche Bank, the whole Brexit risk is obviously a factor.  While in Hong Kong, you've got the trade war that continues to dominate the way those markets trade and also the risk that the Chinese economy starts to deteriorate and some of the high levels of debt in China could become issue.

From our point of view, we believe it's most appropriate to have a relatively modest net long to all of our geographies.  The two positives that we find particularly related to Australia is firstly the bond yields have fallen from roughly 2.8 per cent to about one and a half, and that means that there's a distinct lack of alternatives apart from equities of where people are prepared to invest their money.  If you think about an Aussie asset allocator, bonds are now giving you less than inflation.  Cash gives you next to nothing.  The property market looks a bit vulnerable, so people get forced into equities.  Not because the outlook is so amazing, but because they have no serious alternative to generate a decent return.

The second thing that's positive about Australia is there's been a huge M&A cycle that we think is going to come.  We think there's going to be a wave of takeovers primarily from private equity, but also from corporates, and we've started to see that in the last six months or so.  You’ve seen bids for Healthscope, Vocus, Green Cross, Navitas, MYOB, Trade Me, there's a bunch of those companies that have typically been companies that have struggled for some either short term reason or some structural reason, but private equity is so cashed up and they're able to put so much debt into these structures that they're able to make it work.  In our recent quarterly report, we said that there's roughly US$360 billion that's been allocated by private equity specifically for Asia Pacific, and then on top of that $360 bill, there's a huge amount of debt that can be layered on top.

The firepower to support the market from M&A is very reminiscent of 2007 when we saw a similar private equity cycle, and that's I guess one of the reasons why we're not short the market.

Right.  So that just goes into your general market outlook, it doesn't actually go into say your portfolio and stock picking approach.  You're not actively out there looking for takeover targets essentially? 

No, it's an unusual one.  In fact, two of the companies who got takeover bids we were actually short the stock at the time of the bid, and the outlook for these businesses was deteriorating.  The company had been suffering a couple of earnings downgrades.  In one case, their balance sheet was at risk.  Obviously private equity have the advantage of a very low cost of debt and very easy access to debt, so their ability to improve their IRR is largely coming from the funding structure, and if you looked at say MYOB which got taken over using 11 times debt to EBITDA, for listeners' reference, a typical company has about one or two times debt to EBITDA in terms of the amount of gearing on their balance sheet to take over a company like MYOB using 11 times debt to EBITDA, is off the charts.  There's a higher level of gearing than Transurban has, and they've got monopoly toll roads. 

It's a frustrating situation for us where we're in some cases, we might be short a stock and a takeover bid arrives, but that's just par for the course and that's another reason why we think having small positions is a much more sensible strategy than betting the house on a few stocks.

Right.  Let's just quickly talk about, before we wrap up here, the structure of the LIC itself, and I do want to talk about the performance fee.  You've got a high watermark in place, and so for people listening at home, does that mean that the fund has to get back to that $2 mark before you can charge performance fees?

That's right.  There's no performance fees payable until we get people back to the $2 level where we started.  At the moment you're getting to buy shares at a discount to the value of the shares in the portfolio, and then on top of that there's no performance space payable for a period of time until we get back over that $2 mark. 

Fantastic.  Finally, as well, I think the performance fee structure that I was reading on how you guys are going to actually use any performance fees that you get is quite unique to other listed investment companies out there.  Your performance fees, management will actually reinvest them back into the LIC, either by issuing shares if the share price is above NTA or by buying on market if it is below NTA, and those shares will be held in a voluntary escrow period of about 10 years from the final listing date.  Is that correct?

That's right.  One of the things that we were really keen to do during the time when we were sorting out the prospectus was to make it as shareholder-friendly a structure as possible.  Rafi and I, so we're the two co-heads of the strategy, we both invested $5 million at the time in the IPO and escrowed that for 10 years, and then on top of that we've obviously been buying more shares over the last six months or so.  But one of the things that I think is unique is that to the extent that we generate performance fees, the after tax value of those performance fees will buy shares on market if the shares are trying to get a discount to NTA, which they are at the moment.

And that's a commitment that we've given that we won't sell any of those shares for at least the next 10 years.  So that's out to 2028, at the time of the IPO was 2018.  Hopefully that gives people a sense that we are not just here for the day one, we're definitely here for the 10 year journey.  It's by far the largest investment for both myself and Rafi.  We've got a huge amount of our personal wealth invested in strategy, and obviously the 10 year escrow should show people the confidence and the commitment we've got to the LIC over the long-term. 

Fantastic.  Well, Mark, thank you very much for your time.  It's been great talking to you, and we wish you luck.

Thanks so much.

That was Mark Landau, joint managing director and chief investment officer at L1 Capital.