HMC Capital Comeback Tour and AFG Fights Housing Slump: With Star Fund Manager Luke Laretive

0:00I'm Adam Schwab. I'm Adir Shiffman. And this is The Contrarians with Adam and Adir.

0:09And we are back, episode 241. And we have a very special guest with us today, Adir. Not that special. The king of financial podcasting was with us, Luke Laretive, who I think has done more podcasts than us, potentially. So it's amazing to have you in the studio. Yeah, I've done them back, not as well as you guys. Adam is very big on counting the podcast number, as you might have caught on to. Do you count your podcasts? How many have you done? I definitely do not count them and I've got no idea. But it's been a pretty, as I was saying to Adam before, pretty significant driver of business for us.

0:38And it's a good opportunity to sort of talk long form about stuff that we're interested in and kind of explain how we do stuff at Seneca. First things first, happy birthday. Oh, thanks. Happy birthday. I was on Monday last week, yeah. There's a couple of millennials in the room. Before I. So we're obviously very close in age. I can only respond to one out of every 15 insights. So I just got to let most of them slide. This is what happens to me at work every day. I get bullied by my colleagues. That's what happens. She's alone 40 years. So tell us a bit about what Seneca is. And it's a pretty incredible business you've built in not that long, really.

1:12You've sort of come from nowhere. You obviously worked your whole lifetime in financial services, but really built this incredible brand in a pretty short time that I find Seneca is everywhere. That's really sweet. and yeah, appreciate the compliment. I suppose we've done nine years of Seneca now. I kind of started out as an advisor, I suppose, in the industry and then I got jack of paying somebody half my money and so I got my own licence and we started doing advice and then I kind of got sick of smiling and dialing and trying to convince people to do stuff that I know they should do and then them taking credit for how it works and blaming me when it didn't.

1:51so we made products and that's kind of just been the rabbit hole we've continued to go down sort of productizing my advice business for lack of a better word Seneca's a fund manager sort of more and more selectively investment advice specialist and we have the good research subscription research product as well we kind of help typically business owners entrepreneurs high net worth individuals and families or anyone who will pay me. That is my definition of a customer. Anyone that's willing to pay, that's a customer. Look, yeah, I'm not fussy or fancy as you quickly learn. So I'm just here to make a quid for myself at the end of the day.

2:35So, yeah, I mean, that's what we do. It's a small business. There's kind of four and a half people who work with me. We have a tight team. We've been together a long time. and I suppose we're increasingly focused on sort of our small cap fund, our Aussie shares fund and the good research product. So you've got two funds. Two funds. You've built and you've had a pretty good run with these funds. Tell us a bit about performance and how you've got. There is obviously been a big push really in the last 20 years to index funds which imperversely in a way gives you guys a really good opportunity to outperform because a lot of the weaker performing funds have gone by the wayside and we're left with just the great funds and we obviously, our friends at L1 have done really well.

3:18You guys have done really well. There's only a handful of funds that have really outperformed and you guys are ones. Can you talk about your performance in the last couple of years, how you've gone? Yeah, sure. Yeah, look, if I can end up with$537 million like the boys at L1, I'll be real happy. One year dividends. Yeah, not too bad for a year's work. No, yeah, look, we look up to those guys. You can't compete with their performance fees. Well, in fairness, I think they've got$70 billion under management. Yeah, I mean, we're definitely not trying to compete with anybody. We just kind of run our own race.

3:46I sort of look up to those guys. I think that they're probably the best example of a legitimate kind of boutique two-man operation going massive. We're kind of an illegitimate two-man boutique. But the – look, so, yeah, I mean, we've done – our small cap fund's kind of been – that's where we chase the alpha. That's where we really kind of try and do our best. That's sort of done 23 % per annum for the last 2.11 years, about three years coming up next month. This is better than Buffett, who was about, what, famously 19.9%, I think, over his journey. Yeah, look, I wouldn't want to compare myself to Warren Buffett for lots of reasons, but look, we're really pleased with that.

4:22That's sort of 11 % or 12 % ahead of the index, and I'd probably say it's the second or one of the top handful of ranked products in our peer group. So, you know, we're really pleased with that. How do you, like, juggle active? Because obviously it's active management for small cap fund, and so active management has headed very much towards momentum trading or front-running index changes. I mean, that is the truth, right? It's hard to say I'm an active manager who buys businesses that I think will outperform over the next five years because especially if you're listed, you have to report in net tangible assets every month, every day sometimes, right?

4:59Everyone has to report them every single day. And so what's been a bit of your investment thesis that has played out so well for the last three years? We do lots of types of investing, I suppose. You know, you talk to a lot of managers and they say, I'm a growth investor, I'm a value investor, I'm a momentum investor or some other sort of, you know, fandangled strategy they run. We're just like a make money investor. So, you know, we keep it pretty simple. I think about business in the same way that I think about investing and I actually don't think they're, you know, that different. And I suppose what we try and do is just find an advantage.

5:35Sometimes that's like an asset play. sum of parts sort of opportunity other time it's a cyclical turnaround other times it's a takeover thesis other times it's a good quality compounding earnings growth story that we do hold for five or six years so yeah there's no real rhyme or reason to it i think why people have such poor periods of performance is they're too dogmatic in the way they try and think about investing kind of like i think about my business i'm not worried about who wants to pay me i just want people to pay me same with investing we just want to make money for our investors we want to have really good alignment and i suppose make sure our incentives are matching our clients and then i think when you get all those things in a row and you work hard every day you make money i think you're talking about alignment it's really on point i think one of the criticisms of active funds is the way they charge fees and there's often a base fee so you pay the fee regardless of whether the success or not and often there hasn't been success you guys don't do that you only charge performance fee right so it's a really different structure to a lot of what people have turned away from yeah look i think there's good active management i mean our large cap strategy we do charge a management fee and no performance fee yeah i think it depends in what part of the market you're in so you know my personal views and our views at seneca are you know you're in the smaller part of the market you're trying to generate you know high returns right and you're trying to beat that you've got the opportunity to beat the market by a lot because all the capital is getting allocated as you said to index funds which naturally allocates to larger companies which naturally makes those larger companies overvalued and leaves smaller companies significantly undervalued.

7:06So if we can be good at creating arbitrage there, then we should be happy just to take 20 % of returns. That's how we get the most money for ourselves. So that's the small cap end. It's a zero and 20, essentially. Zero and 20, yeah. Which is almost unheard of, to be honest with you. Someone's got to pay the bills, right, at the end of the day. You've still got overheads. Like, you know, my rent doesn't change. How do you pay the bills with zero management? Well, because I've got a pretty profitable advice business that I've been running for a long time. We've got a management fee on the other product.

7:33We've got the good research product as well. So if I was just running a single fund, single product business, you'd probably have to charge a management fee. But, you know, our view is that, you know, we think we can do well. We think we can generate good returns. And you only charge the fee above a watermark, right? So you're not even charging off everything. So you've got to hit a certain level of performance and then you charge the fees. That's a really great way to invest it. If you do, and clearly you're doing well, also hasn't been an issue thus far. But if you did have a bad year, like you're not getting paid.

8:03Yeah, so we didn't get a performance fee from the 1st of Feb till we still haven't got one now. I'd say we'll get one in September. So we haven't been paid for six or seven months. So that's quite normal. And, you know, the market has been down as low as neg 15 in smalls. So, you know, our returns at the moment, as much as they seem sort of a little bit gaudy and great, probably the hardest period of investing we've done. so look I think yeah look I like the structure that we run it suits the clients that I speak to you know that we're going to have to beat the RBA cash rate and make you increment more money before we take a fee off you no one is more enthusiastic or opposed to rate rises than you given your watermark as the RBA cash rate all Adam lobbies for is endless rate rises are you happy now or you want more rate rises still?

8:56I think there's a few more coming you want some more? not good news for Luke Yeah, and so your low, like your watermark, basically, your benchmark, I mean, every time the RBA increases rates, your hurdle rises. It does. I mean, that's terrible. And the valuation drop. I mean, this is the most, I've never heard of a more aligned, more honest, more difficult way to make money in funds management than saying we take no management fee, we take a performance fee that's on par with everyone else's performance fee and even checking the performance fee there was a I mean just a slight digression but when Quadrant the private equity business was absolutely nailing it I think they might have increased their performance fee to 30 % right Sequoia you don't even increase the performance fee and then you say I might you never know well you should and then you say I'm going to make a like I'm going to have this hurdle rate and instead of the hurdle rate being the same as everyone else's I'm going to make it the RBA cash rate.

9:57So every time it goes up, I'm just going to make it harder for myself. It's the most honest fee structure I've ever heard of in my life. I need you to start making a few client calls for me. It's actually unbelievable. We think it is. I mean, I'm an investor in our own products, right? I don't buy and sell individual shares. Like I just buy our own products. And, you know, everyone else at Seneca, you know, pretty much the same. So I pay the fees. You know, I pay my own fees. I mean, yes, they come back to me eventually. but in a weird and wonderful way. But, no, look, I think being a good bloke, for lack of a better, or a good person, doing things honestly and fairly is the best way to make money.

10:36So it's not necessarily I'm doing it because I want to make money. And I think I understand that to get a product to scale, we're at$35 million,$40 million at the moment in that small cap fund. We can probably get that to$400 million or$500 million before we've got to change a single thing. so the game is really just getting it to scale right and getting inflows and unless you're going to get um you know a big backer someone who's got a shitload of money who's going to be able to help you which unfortunately for me i don't have yeah um you know we i know that the main hurdle to doing well in funds management for us as a business it's getting money in the scale so i just want to encourage people to invest with us as best i can and then i know once they're in they don't leave so yeah what is your churn like on on investors zero like so low right so i think we've had of course because you never take a cent off people unless they're making money and sometimes even when they're making money you don't take a cent off yeah i think we've had um three redemptions in three years that's why you don't want i mean by the way just maybe like 400 grand over 35 40 million bucks well just to refute your um dream you don't you You don't want an enormous investor involved.

11:48Like, I think it will make your life worse, not better. One is they won't want to pay fees. That's where it always starts. And then, like, they're going to be calling you, like, every three days, asking about why this stock went up and that stock went up. Like, I know that enormous fund managers get regular calls on a daily basis from some institutional investors asking about the movements of individual shares that they're invested in. Like, that's not the life that you want. Can I ask you this? Is this Seneca thing, is this, like, the Roman Stoic guy that you named this after? It is, right? Yeah.

12:17Okay. It wasn't as popular nine years ago when I did that name. Why did you choose that name? Because I saw a quote that I liked and I thought I needed a name for my business and I wanted like – I think if you think back 10, 11 years ago when I was thinking about doing this with my co-founders, like it was a – I wanted like a Google word. I didn't want like, you know, someone partners or private or whatever. I just wanted like a word that I could make word marks out of, that I could get a cool logo with that would like look good on printed stuff. And so I was trying to find a word that I didn't want to use my name or like my surname's not really that sort of good for that kind of, not Smith or something boring that's easy to print on stuff.

12:57I think it's a great name for a fund. Yeah, you know, I saw the quote about, you know, if you don't know which way the wind's blowing or whatever, you don't know where you're going or whatever the quote is. I can't remember now, but I'm not too deep on it to be honest. Very memorable quote. Yeah, exactly right. I'm not very good on quotes unless they're out of like Moneyball or the big short. But, yeah, I thought it was a cool – it looked cool when I wrote it. I thought there was some good, like, meaning we could draw out of it that kind of mapped to how we like to invest and think about the world.

13:25So, yeah, that's where it came from. I'll give you a quote, but it's by – I'm quoting myself. It's not unusual. He's worse than me. He's getting worse than me. Trying to just spit out the coffee. But, no, I think you – I've got a one-line philosophy about how to run a business. I think we are completely like-minded, like Adam and I are like-minded on this, which is trust the product and love the customer. That is my view on how to run a really great business. And you basically trust your product to deliver, and the way you treat your customer is to love the customer and try to not have a kind of reallocation of their cash into your pocket undeservingly.

14:05It's a classic agency cost, which is what so many, which is why people have turned away from active fund managers because the fees are so high, and you guys just completely flip that on its head, saying pay us if we do well for you and don't pay us if we don't or in the other fund just give us a tiny little carry and we'll and if you get all the upside so it really is a a removal of all those all agency costs yeah i don't have i i don't think that uh active manner and active managers have struggled because of fees i actually don't think it's i think it's they struggle because of returns yeah they're struggling i mean 35 yeah if you're not doing if you're not doing well and you're charging people fees to not do well yeah like they're gonna get pissed off like that's pretty normal um by the same token the idea when you know the average lay person trying to invest their money every day they got sick of being wrong all the time they pick one manager it wouldn't work out they go to another manager it wouldn't work out i'd buy this share it wouldn't work out this one was going great but then it still fell why i don't know the profit was up and so i think people just have sort of like outsourced it and said well i can buy these index funds and i'm never wrong you're never right either but you're you're never wrong so um it's opened up a kind of perverse allocation of capital, I think, in the Australian economy.

15:14I think it's actually a significant kind of issue at the moment sort of for the broader economy that we're just allocating all of our surplus capital to the biggest, lowest growing, arguably least efficient businesses going around. But, you know, that's a story for another day. I'm probably not even qualified to be speaking publicly about that sort of thing, but you get my gist. I'd love to talk about some actual companies now because this is why we got you here. Our listeners love our deep dives. who've got an expert in, not just us, talking about it. Just before we go, everything discussed here today is obviously general advice only and may not be appropriate for you.

15:46Seek personal advice for acting. And you or us may have interest in these shares as well. Yeah, we do. Okay, well, you definitely do. We definitely do. We may. So, a couple of companies you want to talk about, which I actually find both super interesting. Let's go with AFG first, Australian Finance Group. So, why don't you tell us a bit about the business? What's your narrative? Why you love it? And we'll get into some financials. Yep. So AFG is Australia's largest mortgage aggregator. So if you're a mortgage broker in Australia or you've used a mortgage broker in Australia, chances are they actually don't just go talk to all the banks.

16:18They use a platform to go and sort of sort those mortgages and compare them and make a recommendation to you. And they're probably using AFG's platform to do that. So AFG make a small amount of money on the upfront, same way your mortgage broker does. They make a small amount of money off that broker for access to the platform. They make another a small amount of money on the trailing of the life of that loan. And increasingly over the last few years, they've started actually lending their own money. And I suppose that lending your own money part of their business is what I'm really interested in because it's 20, 30, maybe 40 times the margins of the broking business.

16:53So that's sort of taken them from a, you know. So they're not a broker themselves. It's purely a platform for brokers. They're a platform for brokers. They also license brokers. Like a net wealth for brokers in a way? More like a licensee if you wanted to compare it to the financial advice business. Basically, I mean, I know this world quite well because I was involved in Finsure and 1.300 home loans, right? Which I think Finsure ended up getting sold to Mollus actually in the end. You sold to Mortgage Choice as well? What was that business? I sold my Help Me Choose business to Mortgage Choice.

17:23I was like the biggest generator of home loan leads in Australia at one point. One of my CROs used to work for you. He used to work for, oh no, maybe it was after you sold it. He worked for Help Me Choose. Yeah, well, they bombed that business into the ground post-sale. But I will say, the way to think about it is like this. Every mortgage broker needs to sell home loans. No bank will talk to an individual mortgage broker to do a contract. So they have to go somewhere where someone has spoken to all the banks and is kind of acting as a middle man with some technology as well that the brokers can use.

17:56That's what these aggregated businesses are. And then sort of AML stuff, you know, make sure you're doing it all properly. You know, there's a bunch of other sort of regulatory things as well. And there's been a lot of consolidation in this space. REA bought one of them. I forgot who REA bought, but they bought one. So there's a lot of, I suppose, there's the consumer-facing side of it. And I suppose AFG's part is more the B2B side. Their clients are the mortgage brokers. They're not you guys getting a loan. Like a mortgage choice or... Yeah, so they're there. Well, mortgage choice is a... Yeah, I think that's who REA bought.

18:28I think REA... They bought mortgage choice. Mortgage choice. is an AFG competitor that's owned by REA. The Mortgage Choice is consumer. B to C, right? No, but their Mortgage Choice is customer. Yeah, maybe in the old school way of saying it, you'd say B to B to C, where the customer is the mortgage broker who then services the retail consumer. So AFG is like Mortgage Choice and they're a franchise. No franchises. But the long story short here is broker makes some money. Some of that money comes back to AFG. That business, though, is growing last year EBITDA like 2%. Just a tics along. And that was last year.

19:05We can talk about what's happening now and how much that impacts your thesis. Correct. But the manufacturing, the lending of your own money, that's growing 25 % per annum last year. And that's them acting as a bank, essentially. As a bank, right? As a non-bank lender. So they're sort of picking the eyes out of, I suppose, the loans they want to make. Like a Liberty Financial competitor. Yeah, competitive. With all those other non-bank financials that you would sort of talk to. And they probably get a warehouse facility. They have a warehouse facility, that's correct. They're not an authorised deposit taking institution.

19:30That's correct. And just want to really explain what a warehouse facility is. So there's two ways you can get access to money. I mean, you can steal it. That's a third way. It's not a long-term sustainable business model in Australia, outside politics. And so basically you can get retailers to give you deposits and you can pay them interest, but you need a banking licence for that. It's problematic for most companies. Yeah, hard to get and hard to maintain and you need lots of capital to maintain it. or you can go to someone that has lots of money and you can say, how about you give me your money to lend out and I'll give you an interest rate on your money and I'll effectively go and lend that downstream and make a margin on the difference.

20:08And so that's called a warehouse facility. That's more expensive than deposits generally. It's generally more expensive on an interest basis but obviously you don't have all the costs of running a bank which are high. So this business is growing kind of 25, 30 % per annum now driven by this 50 % growth in EBITDA of this sort of lending business and the sort of steady state recurring revenue mortgage business. We like the business because, as you've probably been talking about before we started, you know, 90 % recurring revenue, growing, and underpinned by their own kind of steam, for lack of a better word.

20:44They don't need huge growth in mortgage volumes. They don't need huge growth in lending. The margins in lending is so much bigger than what they've been doing historically. but this is going to continue to sort of just scale their business for them over time. And mostly it's being sold through their own distribution channels or their platform, right? So basically what they said is our competitive differentiator or a key asset we have is a massive network of mortgage brokers using our platform. They're picking a loan from the platform to sell, so we should get them to sell our loan. Yeah, correct.

21:13Which is why ComBank bought Aussie Home Loans. Similar, I mean Aussie was also taking their brand direct to the customers, but then they build out a mortgage-broking network. That wasn't a successful transaction for CBA in the end, wasn't it? And they, obviously the Lendi things, I think Ozzy's now part of Lendi, our friend Dave Hyman. I think banks will just, like all of these big organisations, they'll go through periods where they buy aggregation and distribution, and then they'll go and sell them at a loss down the track, and they'll do it for wealth management, and they'll do it for home loans aggregation, that's just a cycle they'll go through, right?

21:46So I think that's what's happening. I think it happens in lots of industries, But the question is, in my mind anyway, is why is this business that's growing like this, that's recurring revenue, it's in a pretty stable sector now. We can argue about the merits of that stability. Is it a stable sector? I think it is, and I can probably have this argument with you. But anyway, my point here is this is on seven times earnings. It's on a 7.7 % fully frank dividend yield. Four times EBITDA, right? Yeah, it's cheap, cheap, cheap, cheap. I think that's interesting. Like a 7.7 % is post-franking credits or pre-franking?

22:15Pre. It's like a 10 % gross stuff year. 10 % grossed up yield. So a superannuant that has this in their super fund is effectively pulling down a 10 % yield on this stock. And so... It's dropped 50%. So why? So the question is why? Well, there's many questions. One is, you obviously think that yield is roughly sustainable. Yeah, I mean, this is a business that's grown dividends 25 % per annum, right? So it is a very steady state. The question is how depends. 90 % recurring revenue, like where's it going to go? It doesn't change. It's a platform. You know, it's not a, unless you think mortgage volumes are going to fall by half.

22:53Well, this is what you want to say in a sense. I'll just preempt and then ask your question, which is let's assume people don't abandon their existing home loans, but let's talk about potential growth in home loans in the next two years. And now you should say what you're going to talk about. I guess there's two questions. So there's two questions. One is we've seen property transactions fall off a cliff. Yep. Like 28 % down the last. since the budget from hell for property owners anyway, especially if you bought a property recently. If you've owned a property for years, probably no big deal. If you're about to buy a property, it's great.

23:25But certainly people have recently bought properties. They're in a bit of bother because there was a property in Sydney that we talked about in the pod last week that dropped 30 % in the last four years. That's obviously exceptional. It was a mortgagee sale, et cetera. But we haven't seen property drops like this since the late 90s or even the early 90s. So arguably it was due a fall, especially Sydney, which has been crazy, but also Melbourne, which actually hasn't grown that quickly. So two questions. One is how much does a completely slowed property market impact growth? And then you've got the question of delinquencies and people not paying their loans.

24:00If we see unemployment dig up. So they're clearly the two big risks. And the second one, the delinquency one, has been that risk is a much more material risk now that they've gone into lending their own money because if you sell someone else's loan and the buyer doesn't pay, there's no risk to the mortgage broker other than not getting their commissions. Correct. But if you're the lender, as we've seen, it's not pleasant, right? And so often the way the world works is you generate much better returns by taking much more risk. And so the trick is to just try and find where that curve is mismatched.

24:34And so I think that second question is especially interesting. How worried are you about delinquencies on their own loan book? Let's do the second one first because it's a really straightforward black and white one. So, you know, I agree with you. There's been, you know, Judo Bank had to do some extra provision. Stock was down 40 % on the back of that. Three lenders, basically. I think three loans, yeah. Three related loans. Three loans that they said they'd never take when they talked about their business model. Correct. Then you had, you know, this Baffler thing in Sydney now. All the private credit guys telling you that they're diversified, but in reality, it's all the same, right?