LSN Capital reaches 2-year milestone | Q&A with founders
It’s been two years since Nick Sladen and Nick Leitl joined forces and launched LSN Capital and its offering to investors, the LSN Emerging Companies Fund. In the midst of COVID and the onset of a market sell-off, they steered the young portfolio through turbulent waters and after two years, both Nick’s reflect on the milestones—which include 2 year outperformance, increasing interest from wealth management groups and key platform placements.
Q1. What motivated you launch a small cap fund in December 2021?
Nick Sladen: When we launched the LSN Emerging Companies Fund in December 2021, we were motivated and guided by three principals, despite the challenges we faced in the shorter term.
Firstly, the Australian small companies’ market is rather unique in that there is a recurring cycle of need for quality fund managers. That’s because in the small cap segment in particular, successful fund managers may reach size capacity far quicker than most larger cap, or even global equity strategies. At the same time investors and financial advisers still have a persistent need for a small cap solution in portfolios. This sets the scene for a constant cycle of opportunity, and we want to be known as a trusted provider in this segment.
Secondly, we were also driven by our philosophy that in the context of the entire ASX, the small caps segment – companies outside the top 100 – are where the most exciting action is, in terms of market inefficiency a potential returns. Active fund managers like LSN have the opportunity to benefit and translate that mis-pricing into wealth creation for investors. But there’s a strong caveat - alpha requires research and judgment. By doing our own research and meeting with companies regularly we are confident that we can deliver strong returns for investors over the long term.
This provides a good segue into the third consideration in launching the fund. Nick and I both have long careers in the investment industry spanning over 30 years combined. We were motivated to leverage our skill sets and experience, by launching a small cap strategy that is the sole focus of our business and like other similar boutiques, we can be entirely aligned with our investors who are on their own wealth-building journey.
2. What type of problem is LSN seeking to solve for investors?
Nick Leitl: Australians typically invest for either income or wealth accumulation (particularly for those seeking to grow their superannuation balance).
Our fund is designed to fit in the wealth creation bucket of an investor’s portfolio, although this may depend on individual circumstances.
Australian small caps can be a wealth builder long term because it tends to have a higher return and volatility profile than other asset classes, including large cap equities.
From an investment manager’s perspective, we believe the best long term investment opportunities are in companies outside the top 100 due to several reasons: less sell-side (broker) research, a large universe of investible companies, inefficiencies in the listed price versus ‘fair’ price, new businesses as well as emerging technologies. These attributes form the backdrop for a dynamic investment environment with alpha generating opportunities – and potential returns for investors.
The investment opportunity can be demonstrated by comparing the earnings per share (EPS) for the index and the fund. Consensus forecasts have 9.2% EPS for the Small Ordinaries Index over the next 12 months, whilst the LSN Emerging Companies Fund is forecast to generate EPS growth of around 20%, as many of the portfolio holdings continue to grow revenue and expand operating margins. Furthermore, this EPS growth profile is far more attractive than consensus forecasts for the ASX top 100, where EPS is expected to decline 6% this financial year.
3. How would you describe the LSN Emerging Companies Fund investment approach?
Nick Sladen: The LSN Emerging Companies Fund offers investors a portfolio of 30-50 quality emerging companies and is available to wholesale investors.
We are sector agnostic and style neutral. Inevitably, when investing in smaller companies, growth is a focus, but not at any price. We are equally focused on valuation to avoid getting caught in investment bubbles. Examples include the lithium sector bubble in 2022 and the profitless growth bubble in 2020-2021.
There is also a strong valuation discipline embedded in the stock selection process. We simply won’t overpay for companies. Outside of that, exceptional return on capital, healthy margins, significant growth, and balance sheet strength are important, in companies with incentivised management teams.
Investment success also hinges on the ability to apply a robust stock selection process with a strong risk management framework. We understand this is a common principal among active fund managers but nonetheless it is critical to ensure consistency of approach and that our research and judgments are translated into an optimal blend of stock picks.
4. What have been some of Fund’ s success stories?
Nick Leitl: Launching a small cap fund just prior to one of the largest corrections in history of small caps presented some challenges, but equally this offered up some outstanding long term investment opportunities.
In terms of stock picks, an example is engineering and remediation company Duratec which has been one of best investments we uncovered during the small cap carnage of 2022. The fund bought in at $0.40 when there were almost no sell side analysts covering the stock and very little institutional investor awareness.
Now trading at around $1.50 the company’s growth profile is more appreciated by investors and is a good example of the reasons listed earlier as to why small caps offer an exciting opportunity for investors.
For investors in our fund, our investment process and portfolio management has delivered strong returns during the small cap turmoil over the last 2 years. This gives us confidence for the years ahead.
5. What are some of the lessons learned?
Nick Sladen: One of our biggest lessons has been holistic in nature rather than stock specific.
Given the small cap challenges in 2022 and the successive interest rate rises, we are now more cognisant of the different ways the cycle can impact stocks. While we remain essentially bottom-up stocks pickers, one of the biggest learnings in the past 2 years has the importance how the cycle plays a role on the companies that we model. This has a myriad of direct and secondary effects, across balance sheets, liquidity, and valuations. The flipside is the set of opportunities presented when markets overreact to the uncertainty.
6. What do the next two years look like for LSN Capital?
We are excited by the prospects of LSN’s growth both in terms of our portfolio and the general business.
At the fund level we’re looking to build on the strong 2-year performance, with support from an improvement in risk appetite with the interest rate hiking cycle over and fear of hyperinflation now passed. We expect to see the headwinds of the last 2 years become a tailwind for small cap investing.
For the LSN business we are looking forward to building our footprint and taking the business to the next level, particularly among distribution channels and new client segments. The private wealth space is appealing to us, as we believe there remains strong appetite for active small cap strategies among high net worth investors.
Elsewhere it’s exciting progress for the LSN Emerging Companies Fund. We are pleased to have the fund listed on three platforms, including Netwealth, HUB24 and Powerwrap, making it available to financial advisers using wholesale options on those platforms. We’re also looking to issue a PDS for the fund and broaden its availability to investors.