Can you describe your investment style?
We are fundamental, bottom-up stock pickers. This means that we look very closely at the financials of companies to assess their valuation – and try to find stocks that the market is mispricing. We spend a lot of time thinking about the quality of individual businesses, looking at the management, industry structure and operating trends. But, ultimately, it’s a combination of value and quality that determines a great investment, not just one or the other.
From a style point of view, most people would label us as being value and contrarian. We’ve got a modest value bias. Our longs (positions that we buy) tend to be stocks that aren’t the flavour of the month. They may have some sort of short-term issue, or they might be at a weak point in their cycle, but our longer term outlook for them is positive. We tend to short stocks that are in the opposite position. They’re often well loved and are expensive and we think some sort of negative catalyst is likely to emerge.
When we spoke to you at our Future Generation webinar in April, you were pretty pessimistic about the market. Has your outlook changed? What do you see happening in equity markets over the next 1, 3 and 5 years?
In a very short-term sense – say, over the next few months – we’re still cautious. We think that the market will remain weak and erratic, given there are numerous fears that won’t be resolved quickly. These are things like Central Bank policy tightening, a potential US recession and the impact of the Russia-Ukraine situation.
On a one-year view, we’re a little bit more positive because we think that some of the excessive fear and pessimism that has been driving markets will start to reduce. Central Banks should be able to stop tightening because we think inflation is peaking at the moment; the concerns about a US recession will lessen; and China will reopen, which will be positive for equity markets.
But that’s not to suggest that the market will return to a bull market. We don’t think markets will go dramatically higher – or lower – on a one-year, three-year or five-year view.
Equity returns have been very strong over the past 30 years. We’ve typically seen a 10% return per annum – and it’s been the same for property and bonds. A big driver of that has been falling interest rates, where rates have gone from roughly 18% to 0% as of a year ago. Now that that period has come to an end, it’s going to be much harder to generate attractive real returns. A lot of the return that you’ll need to find won’t be available as the rising tide stops lifting all the boats. It will have to come through alpha, rather than beta, which is finance lingo for excess returns versus market returns. Unfortunately, I think the best years for investors are probably behind us. It will, however, still be possible to find attractive returns via active management – whether you do that yourself or whether you do it through a vehicle, like Future Generation.
What sort of returns do you think are reasonable to expect going forward?
For equities, on a five-year view, I would say around a 5% to 7% p.a. nominal return is probably more realistic than the historical 10% p.a. And if we believe that inflation is likely to be above the 2% per annum (p.a.) that the Central Banks have been targeting, that means that real returns are only a few percent positive. You might be up 5% to 7% p.a. on paper, but you’re only going up slightly in terms of your standard of living.
You spoke earlier about your focus on business fundamentals. Obviously at times markets are driven by fundamentals, and at times they’re driven by sentiment. We seem to be in a period where fundamentals barely matter. How does that impact your investment style?
We’re always focused on fundamentals; it helps us to sleep better at night! Markets do have these temporary periods where they ignore fundamentals, and you feel like you’re losing your mind. We’ve seen that recently with profitless tech stocks, the “buy now, pay later” sector, NFTs and lots of other fads that surged and then collapsed. But, in the long run, fundamentals (like cash flow, industry structure, operating trends and balance sheets) are the only things that have been proven over 100 years to drive the value of businesses and ultimately deliver value for investors. That is why we’re consistently focused on fundamentals. And as a long short manager, when markets go through these periods where they are detached from the fundamentals, that becomes an opportunity for us on the long or short side.
So you weren’t at any stage tempted to join the tech party over the past few years?
It was frustrating watching many of these shares surge because we didn’t participate in it at all. I can’t think of any of our holdings that were real beneficiaries of that profitless tech hype. On the flip side, over the last six months or so, we’ve been big beneficiaries because we were short a number of stocks in the profitless tech space, where we felt that the fundamentals were far worse than the share price was implying. When the reality check arrived, these share prices fell by around 70% in the space of 6 months.
Looking at your investment portfolio, what would you say the key themes are?
We have a very disparate set of positions – typically around 80 to 90 holdings across different sectors, geographies and themes.
But if I had to summarise the main themes by looking at our portfolio top down, then energy and commodities is an area that we continue to think is under-appreciated. The recent sell-off that you’ve seen in oil and copper shares, in particular, is not consistent with what we’re seeing in the physical commodity markets.
If you look at the oil market, supply remains tight and demand continues to grow. The oil majors are simply not investing enough in new supply and OPEC+ is struggling to even meet its existing quotas, let alone increase beyond that, so we believe the oil market will stay tight for some time.
In the case of copper, we’re buying stocks on 2-3x earnings, which is incredibly depressed compared to the market. The outlook for copper is very positive as the world transitions to electric vehicles and the developing world expands its electricity grid. These applications are extremely copper-intensive and it’s very difficult to bring on new copper supply. A new mine takes about 10 years to get up and running and demand will be growing a lot in the meantime.
Another theme that we really like is US online sports betting; it’s one of the most exciting sectors globally. We think the industry is going to grow by more than 500% over the next few years. In our portfolio, we own the number one and the number two players: Flutter (which owns FanDuel) and Entain (which owns 50% of BetMGM). Both of them are incredibly dominant players and, combined, they control about two thirds of the market. Despite the growth that they’re about to enjoy, we think they trade on very attractive multiples.
The third theme that we like is the reopening trade. That’s well and truly underway in the Western world, but we think it’s likely to inflect over the next six months in China as well. The travel sector is a clear beneficiary of this trend, so a company like Safran, which is the biggest supplier of engines and parts for narrow-body Airbus and Boeing planes, is really well placed to benefit. The shares still have 50% upside if they return to their pre-COVID levels.
Your performance has been strong at a time when many others have floundered. What have been the most notable contributors?
One of our biggest contributors has been the Canadian energy sector. Stocks like MEG Energy (TSE: MEG), Cenovus Energy (NYSE: CVE) and Teck Resources (NYSE: TECK) have all been really strong contributors, even though they’re not stocks that are written about in the papers every day.
The other major contributor, where we’ve clearly had different positioning to most investors, has been our shorts in the U.S. profitless tech sector, along with shorts in several “COVID winner” stocks, like Peloton (NASDAQ: PENTON) and Logitech (SWX: LOGN), and on US retail stocks, like Williams-Sonoma (NYSE: WSM). All of these shares are down between 30% to 80% over the past six months.
In general, our performance tends to have low correlation with the market and peers. We hold a very different set of stocks and we are exposed to different themes, which is what you would expect from a contrarian value manager.
In the wake of the current sell off, do you see any more opportunities for shorting?
Yes, there are always great opportunities for shorting, even in bull markets. The types of stocks that we’re shorting at the moment has changed dramatically. If I look back over the last six or 12 months, we were shorting “COVID winners”, profitless tech stocks and US retailers. Today, the shorts that we’re building are in a completely different part of the market, but I might keep those specifics to myself for the time being!
What are the two main lessons you’ve learned over 20 years in the markets?
That’s a hard one to summarise. I’m a very analytical person and have spent a lot of time reflecting on what works and what doesn’t, both in our own investment decisions and those of other investors. I look at where I’ve made mistakes and how I can keep fine tuning the way I invest.
I think what I’ve realised more and more is that I need to keep sight of the two-year view and ignore the two-month view. There’s a lot of noise that you get day-to-day in the stock market – from the newspapers, the brokers – but the key to being a successful investor is just to work out, “Where is this business heading over the next couple of years?” Don’t pretend you can forecast 10 years out, but on a two-year view, you can usually get things more right than wrong. Stay focused on that.
The other lesson is to listen to everyone, process all the differing points of view and then ignore everyone and make up your own mind, based on your instincts and research. We were aggressive buyers of stocks in March 2020, when there wasn’t a single person I’d spoken to that month telling me to buy stocks. Everyone was telling me, “It’s the end of the world, sell everything!” The reason I bought is that that level of pessimism was letting me know what sentiment was like, what positioning was like, what was likely happening with margin calls and redemptions. When everyone’s expecting Armageddon, it’s probably a good time to buy.
It sounds stupid to say “Listen to everyone and then ignore them!”, but I’m not saying that in a disrespectful way. I’m just saying that at the end of the day, I have to live with the decisions I make. I have to make sure that I’m comfortable with them and that I’m not relying on someone else’s judgment or opinion. I will listen to them to make sure I’m not missing something – but I’m not just going to blindly follow.
Do you have any investor role models?
I’ve been obsessed with the stockmarket since I was a teenager and always loved reading stories of the great investors. What I’ve tried to do over the years is to pick the eyes out of each of their strategies and trading approaches to find parts that resonate with me. Take someone like Stan Druckenmiller, who I rate as the best investor of all time. He’s done 30% returns a year for 30 years and never had a negative year, so he’s clearly doing something right! I’ve learnt a huge amount from listening to him over the years, looking at his trading strategies, how he identifies an opportunity, how he builds positions, how he stays open-minded and humble. Then there is, obviously, Buffett and Munger. I also enjoyed reading letters or books from Bill Miller, Anthony Bolton and Michael Steinhardt. There are also several Australian fund managers that I greatly respect like Peter Cooper and David Paradice.
I think you have to find what works for you. I like what Raf [Raphael Lamm, Co-Founder and Joint Managing Director of L1] says: “There’s not only one way to make money.” So even though I’m a value and contrarian investor, I’m not naive enough to think it’s the only way to make money. It’s just that that style of investing works with my personality, so I think that’s what I should stick to. I shouldn’t try to be something I’m not.
L1 Capital is an independent investment manager that is 100 per cent owned by its staff. How important is this alignment of interest between the investment team and your clients?
I think it’s critical. There are lots of benefits to having 100% ownership by staff and also having our investment team heavily invested in the fund and not doing any personal share trading.
For starters, it’s beneficial for our investors because it means we’re likely to be able to attract and retain talent across the firm. People have a reason to stick around because they’re sharing in the success of the business.
From a cultural point of view, it engenders a culture of being more entrepreneurial, more collegiate and much more focused on team outcomes than individual outcomes. That’s important when you’re thinking about a portfolio with a bunch of different people contributing and sharing ideas and knowledge.
Lastly, half of our staff bonuses are invested in our funds, and they are escrowed for the long term. So for Raf and myself, almost our entire personal wealth is invested in our funds. That gives our clients comfort that we’re acting in their best interest because it’s our life savings in there alongside theirs.
Why is managing Future Generation money important to you?
I think that we are in an incredibly privileged position, where we’re able to help a large number of people through the charities that Future Generation supports. Seeing the personal stories and the changes that Future Generation Australia makes on a day-to-day basis for people who’ve been doing it really tough is the part that we get enormous satisfaction from. Obviously, we do a lot of charity ourselves on a personal level, but to be able to do it on a much larger scale, positively impacting so many more charities, is what excites us.