Artemis Funds (Lux) – US Smaller Companies update

During Q2 of 2023 the fund returned 3.9% (in US dollar terms) underperforming the Russell 2000 Index's return of 5.2%.

April marked the start of the first quarter earnings season which gave us an update on how our companies are navigating the unpredictable economic environment. Earnings were somewhat better than expected, but the fallout from the collapse of Silicon Valley Bank did lead to tighter capital controls for smaller regional banks, causing slower loan growth. As we moved through the quarter, the economic outlook shifted from expecting a potential interest rate cut by year end to acknowledging that there would be further rate increases still to come.

Covid and the response to it had an extremely dislocating impact on almost every business. As we built a portfolio during last year, acknowledging higher inflation and interest rates than we had originally expected, we focused very much on bottom-up drivers for the individual stocks we bought. Recovery from the severe Covid disruption formed a significant part of the investment case for a number of stocks we invested in. While we were early (or in other words wrong) in some of these investments it was reassuring to see that some of those recoveries starting to show through during companies' most recent earnings reports.

Building stocks boosted by housing recovery

Our exposure to the recovery in the housing market is one example of this. Eagle Materials, Builders FirstSource and TopBuild all performed well. Housing data, especially new home starts, continues to surprise to the upside despite stubbornly high mortgage rates. We think that high rates have led to a major slowdown in existing home sales. Home owners are unwilling to move and swap a low mortgage rate for a meaningfully higher mortgage rate, and as a result demand for new homes has increased. At Eagle Materials, this should correspond to higher demand for wallboard. Builders FirstSource should see the benefit from higher housing starts quickly – it sells products that are used early in the construction phase (such as trusses and sidings). TopBuild should see a benefit late this year or early next year, as its insulation is installed in houses that are close to completion. While our thesis on these names has played out a little faster than we were anticipating, we still think they are attractive long-term holdings.

Trucking companies benefiting from market share gains

We continue to look for opportunities for recovery in companies and industries that have seen more extreme dislocation in their typical cycles than we would have seen without the impact of the pandemic. The less-than-truckload companies are a good example of this. We own two of these: SAIA and TFI. We saw strong performance from SAIA in June, after news broke in industry trade publications that a larger competitor, Yellow Corp, was potentially heading towards bankruptcy. In terms of scale, Yellow had a little less than twice the revenue of SAIA in 2022. Yellow has been losing market share for years, following a series of bad acquisitions, and the recent freight downturn has hit it particularly hard. The company claims it needs more flexibility from its employees, who are unionized. The union points out that it has made significant concessions over the years and so is unwilling to change the current terms of the contract. Yellow filed a lawsuit against the union, noting that the company could run out of money as soon as mid-July. While we are not sure if Yellow will file for bankruptcy, its financial position is precarious, and we would not be surprised to see its loss in market share accelerate. SAIA should be a beneficiary. TFI, another trucking company, performed well but lagged SAIA. We think it will stand to benefit from the ongoing situation at Yellow. We added to both positions in June. Another stock in a similar situation is Avantor (healthcare) where we are yet to see an inflection in the recovery, but we remain confident in the opportunity here, and see a lot of embedded value in the idea.

We reduced our holding in Envista although we continue to like the long-term outlook for the business. Envista is a dental company that makes instruments, implants and equipment. It continues to innovate and take share, but more recently there have been some concerns about the slower-than-expected recovery in China, as well as some softness of demand in some European markets.

Okta's share price sold off after the company reported that it anticipates reduced IT spending will curtail growth for the remainder of the year. We still hold the shares at a valuation that does not reflect what we believe to be a very good future of profitable growth.

Outlook

As we look ahead, it is still not clear whether the US will fall into recession or not. We continue to see a breadth of opportunities across the market.