L1 Long Short Fund : Quarterly Report - March 2022

•  The L1 Long Short Fund portfolio returned 11.3% (net)1 for the March quarter (ASX200AI 2.2%).

•  The portfolio performed very strongly due to a number of positive company updates during reporting season, together with long exposures to resources and short positions in overvalued high P/E stocks.

•  The L1 Capital Long Short Strategy has been the best performing Australian long short strategy over 1, 3, 5 and 7 year periods and since inception in 2014.2

•  We invite you to join Mark Landau for a LSF investor webinar where he will discuss portfolio positioning and the outlook for equity markets at 11am AEST on Thursday 19 May. Please registerhere.

Global equity markets suffered their worst quarterly drop in two years since the start of the COVID-19 pandemic in early 2020 (NASDAQ -9.0%, MSCI World -5.2%, S&P500 -4.6%). Markets were impacted by Russia's attack on Ukraine, as well as ongoing concerns over an imminent tightening of monetary policy from central banks.

L1 Long ShortS&P ASX200

Returns (Net)1 (%)

Portfolio

AIOut-performance

3 months

11.3

2.2

+9.1

9.4

6 months

4.4 +5.0

1 year

33.5

15.0 +18.5

2 years p.a.

68.4

25.7 +42.7

The ASX200 had a small gain over the quarter (+2.2%) with the strongest sectors comprising Energy (+28.6%), Materials (+15.4%) and Utilities (+14.1%), while Information Technology (-13.7%), Healthcare (-10.1%) and Consumer Discretionary (-9.6%) lagged.

3 years p.a.

29.0

10.6

+18.4

LSF since inception p.a.

14.9

10.4

+4.5

Strategy since inception3 p.a.

23.6

8.2

+15.3

The portfolio performed exceptionally well over the quarter with 17 individual stock positions each contributing 0.5% or more to returns.

The outperformance was driven by four key aspects:

• 1. Positive reporting season/company updates: Detailed, bottom-up stock picking remains the focus of the investment team and the key driver of performance. This quarter highlighted several examples of the team identifying 'winners' over the reporting season. Some examples include: SES (positive earnings guidance and increased dividends), Challenger (solid half-year result update), Smartgroup (strong free cash flow generation with a large special dividend) and CK Hutchison (resilient earnings with significant flexibility for capital returns).

• 2. Energy and commodities exposure: In early March, global energy and commodity prices soared to the highest level since 2008 as the market reacted to potential disruptions in supply from the Russia/Ukraine conflict. We have been positive on these sectors over the past 12 months, given our favourable view of supply & demand, along with our belief that these sectors would outperform in a higher inflation environment. The portfolio's ability to invest internationally and identify the best companies globally to leverage our research insights was a significant advantage over the quarter and drove additional returns. An example of this is the outperformance of our international copper positions relative to domestic peers, where Teck Resources (+40%) and Capstone (+27%) significantly outperformed the two large cap ASX copper stocks, Sandfire (-14%) and Oz Minerals (-5%).

• 3. Shorts in COVID-19 'winners' and ultra-high P/E stocks: Our short positions have been very strong contributors to returns over the quarter and the past 12 months. Two areas we have been short are high-multiple, concept stocks that are many years away from profitability and consumer discretionary companies that have been significant COVID-19 beneficiaries. The companies we shorted had major negative catalysts, such as a large sales or earnings miss or new competitive threats that were not expected by shareholders.

1. All performance numbers are quoted net of fees. Net returns are calculated based on the movement of the underlying investment portfolio. Figures may not sum exactly due to rounding. Indices are shown on total return basis in AUD. 2. FE Investment performance database since Strategy inception in Sep 2014. 3. Strategy performance and exposure history is for the L1 Long Short Limited (LSF:ASX) since inception on 24 Apr 2018. Prior to this date, data is that of the L1 Capital Long Short Fund - Monthly Class since inception (1 Sep 2014). Past performance should not be taken as an indicator of future performance.

Ultra-high P/E stocks have de-rated significantly as interest rates have risen and the market has (finally!) focused on profitability and cash generation. Despite this correction, we continue to see ongoing downside risk in many of these names. Figure 1 shows the Goldman Sachs Non-Profitable Tech Index. While the index has corrected sharply in 2022, it remains well above pre-COVID-19 levels. For some technology businesses there has been a step change in user adoption and growth through this period, which supports a higher valuation, however, there are many other examples of lower-quality names where tailwinds have been transitory in nature and where we see expensive share prices, combined with decelerating trends presenting large downside risk. If these share prices were to return to their pre-covid peak levels, it would imply a further 30% downside to these shares (despite already falling 50% since Feb 2021).

Figure 1: Performance of the GS Non-Profitable Tech Basket (indexed to 100)

600

500

0

Source: Goldman Sachs as at 31 Mar 2022.

From a consumer discretionary standpoint, there are numerous COVID-19 'winners' where the share prices have more than doubled in the last two years but their business models have not structurally improved. Our view was that the market had not appropriately reflected a normalisation in demand for these companies as economies re-open, stimulus measures roll-off and inflation impacts become more pronounced. We have started to see this play out in several of our short positions such as Peloton, Logitech and Williams Sonoma which each fell more than 30% while we were short the stock.

4. Mergers and Acquisitions: We have written extensively about our optimistic expectations for the M&A cycle and how we expected this to be a tailwind for the portfolio given our skew to undervalued companies that have strategic appeal. The portfolio benefitted from two takeover offers during the quarter: CIMIC received a bid from its parent company HOCHTIEF at a 33% premium, while Turquoise Hill received a bid from its majority shareholder, Rio Tinto, at a 32% premium. We continue to remain positive on the M&A cycle with numerous industry data points indicating deal pipelines at or above 2021 levels which was a record year for M&A. Current geopolitical tensions may dampen near-term deal volume, however, we expect this to rebound quickly as markets stabilise.

For further information on individual stocks positions that contributed to performance over the quarter, please refer to page 6.

Portfolio positioning

We build our portfolio on a 'bottom-up' basis from our company and industry research (selecting stocks that represent the best combination of value and quality). However, when we step back and look at the major themes and opportunity sets we see at present, they broadly fall into four key themes:

1. U.S. Sports Betting and Gaming (e.g. Flutter and Entain)

This part of our portfolio has underperformed over the last six months, with the market concerned about two key aspects 1) impacts from the upcoming U.K. regulatory review, and 2) competitive intensity in the U.S. sports betting market.

The U.K. regulatory review has been ongoing for more than two years and has been a significant overhang on U.K. listed gaming stocks. A Government white paper is due to be published in May 2022 which will provide much needed clarity for the industry. While the market is focused on near-term uncertainty regarding the impact, what is overlooked is that U.K. revenues are only a minority of both Flutter and Entain's revenues (~29% for Flutter and ~21% for Entain). We factor in a material impact from adverse regulation in our base case, however, we still see compelling value in both stocks given their strong global growth profile.

On the U.S. sports betting and gaming side, irrational promotions by some players over the NFL season in Q4 2021 raised concerns about the long-term viability and profitability of the industry. We have seen promotion levels moderate considerably in 2022 and even with a highly competitive market, we believe Flutter and Entain are best placed to succeed versus peers. Both companies have the best technology and most efficient operations in terms of customer acquisition costs ('CAC') relative to long-term customer value ('LTV') which sets them up to be profitable in the U.S. market in the next 12-18 months, well ahead of competitors. Flutter and Entain also have the ability to fund U.S. growth from their highly cash generative European and Australian businesses without the need to raise external capital.

We are incredibly excited about the U.S. market with huge structural growth forecasted over the next few years. The market more than doubled in 2021 (growing from US$3b to US$8b between 2020 to 2021) and is expected to be larger than ~US$20b by 2025 (refer to Figure 2). We expect the market could be close to US$50b at maturity due to the growth of in-play sports betting and iGaming (which would be more than 6x the size of the U.K., the next largest regulated market). By owning Flutter (FanDuel) and Entain (BetMGM), we own the two leading players in the market, with a combined market share of over 50% across sports betting and iGaming combined (refer to Figure 3). We believe both companies are very undervalued at only ~16x FY23 P/E for Entain and 18x FY23 P/E for Flutter, despite our expectation of extremely strong earnings growth over the next decade.

Figure 2: U.S. Sports Betting and iGaming revenue forecasts (US$)

Figure 3: U.S. Sports Betting and iGaming market share estimate

Sports Betting Revenue

iGaming Revenue

Source: Morgan Stanley Research as at 31 Mar 2022.

Source: Rolling six month average estimates. Entain investor presentation.

2. Energy (e.g. Santos and Cenovus)

We have been positive on both 'new' energy, from tailwinds in electrification, sustainability and decarbonisation, as well as 'old' energy, where we believe there has been structural under-investment in oil supply that is going to exacerbate the tightness of the market over the next 1-2 years. Given the huge share price rally in 'new' energy exposed stocks (lithium/rare earths), we have trimmed and exited most of our exposure in this sector.

We continue to remain very positive on 'old' energy, with our key positions factoring in long-term prices far below what we think is likely. Over the past 18 months, we have talked about our bullish outlook and how, at sub-$40/barrel, oil prices had reached an extreme low that was unsustainable. This view was very contrarian at the time, and we have seen a shift in consensus sentiment as oil prices have now risen to around ~$100/barrel. Energy equities remain under-owned, with their weighting in the S&P 500 currently only ~3.9%, far below the ~10% level it averaged from 2007-2014.

We believe prices could remain elevated for much longer than expected. Oil inventories are currently at historical lows, following 20 consecutive months of oil demand being larger than production (refer Figure 4 over the page). However, the ability to increase supply remains constrained, with market spare capacity declining significantly, following a decade of under-investment due to lower oil prices, ESG pressure, COVID-related disruptions and pressure to increase cash returns to shareholders. Figure 5 on the next page highlights this under-investment, with capital expenditure spending by the oil majors dropping by roughly ~US$40b or ~25% in 2020 and 2021 relative to 2019 levels. The Russia/Ukraine conflict adds further risk to supply. Russia is the world's third largest oil producer with the conflict leading to many countries looking to reduce their reliance on Russian exports and prioritise energy security going forward.

Figure 4: Global oil inventory stocks (mb)

Figure 5: Oil majors - capital expenditure (US$b)

150

100

50

0

Total S.A

Equinor

Repsol

Shell

ExxonMobil

Eni

ConocoPhilips

Chevron

BP

Source: Kpler, IEA, EIA, JODI, IE Singapore, PAJ, PJK, ARA, Oilchem, Fujairah, Goldman Sachs Global Research. DoDC is the level required to normalise stocks in days of demand coverage to 2019 levels by 2023.

Source: MST Marquee, FactSet.

3. Vaccine recovery/re-opening (e.g. Qantas and Webjet)

We believe that vaccine success and the shift of COVID-19 from the pandemic to endemic phase has only been partially reflected in some share prices. As the recovery gains traction and operational momentum accelerates, we expect a valuation re-rating to follow for our reopening positions. Many of these stocks are trading at the same share price as six months ago, however the outlook is far better now and an inflection in operating metrics looks imminent.

Looking at the change in global airline capacity as a proxy for the reopening, Figures 6 and 7 below illustrate airline capacity and expected increases over the next few months based on forward bookings. Domestic capacity is currently 15% below 2019 levels, however, forward capacity estimates indicate this should trend above pre-pandemic levels over the next quarter. International airline capacity is ~35% below 2019 levels, with forward capacity estimates expected to see this narrow to roughly 20% over the next few months.

In the U.S., traveller throughput is already at 90% of pre-pandemic levels, with solid forward bookings supporting a continued recovery. This provides a strong leading indicator for the shape of the recovery in Australia over the next six months.

Figure 6: Domestic airline capacity

Figure 7: International airline capacity

Source: OAG as at 4 Apr 2022.

Source: OAG as at 4 Apr 2022.

4. Global reflation (e.g. QBE and Hudbay Minerals)

One year ago, we spoke in detail about our expectation of a large increase in inflation and that we believed inflation would be far higher and more persistent than the consensus view and would overshoot relative to central bank expectations. Figure 8 below shows how extreme this reassessment of inflation expectations has been. Consensus expectations have now quadrupled from ~2% 12 months ago (when we mentioned our expectation of much higher inflation) to close to 8% currently.

We expect the U.S. Federal Reserve (the 'Fed') to raise interest rates aggressively to counter these impacts, with the market currently forecasting 225 basis points of interest rate hikes over the remainder of the year (compared to an expectation 75-100 basis points only a few months ago).

We continue to maintain long positions in gold, commodities, financials and low P/E stocks, along with short positions in ultra-high P/E stocks, which we believe is logical from a pure valuation perspective, but also provides an effective way to hedge against persistent inflationary pressure and a central bank tightening cycle. This portfolio setting is supported by the last extended high inflationary period the market has experienced (1973-1983) where gold, commodities and value stocks dramatically outperformed (as shown in Figure 9).

From a financials perspective, we currently prefer exposure to insurance over banks. Banks will be a clear beneficiary of rising rates with net interest margins likely to benefit, however, we see some offsets from greater competition within the industry (due to the rise of mortgage brokers, non-bank lenders and 'neobanks'), increases in bad debts (from essentially a zero base today) and continued regulatory and capital scrutiny.

Figure 8: U.S. CPI Economic Forecast - Q2 2022

Figure 9: Sectors that outperformed from 1973-1983

Source: Bloomberg as at 4 Apr 2022.

Source: Datastream, STOXX, Haver Analytics, FRED, Goldman Sachs Global Investment Research.

Outlook

We expect equity markets to remain volatile due to geopolitical tensions, the ongoing fragility of global supply chains, reduction in central bank liquidity and increasing interest rates.

We see the challenge facing the Fed as particularly complex in the current environment. The Fed is one of the few central banks in the world that operates under a 'dual mandate' that targets both full employment and price stability relative to most central banks that simply target price stability. Following an unprecedented level of fiscal and monetary support, U.S. employment levels have rebounded strongly and are now back to pre-COVID-19 levels. However, in achieving this outcome, we have Fed policy settings that would be more appropriate in an economic depression, rather than for an over-heated economy facing the highest inflation levels in 40 years. The Fed now (surely) realises it is way behind the curve and had begun to lose credibility in combatting inflation.

As a result, the Fed has begun talking very tough on the measures they are planning to take to combat inflation as a means of restoring credibility and in an attempt to avoid a wages-prices spiral that would be terrible for society and markets in general. This hawkish rhetoric led to a surge in bond yields with the U.S. 10 year yield rising 80 basis points over the quarter (Figure 10 on the next page).