Artemis Funds (Lux) – US Smaller Companies update

Bank failures weigh on market

Shares in US smaller companies fell sharply in the final month of the quarter, erasing their gains from the previous two months. This was in the wake of the failure of SVB Bank and a deposit run on other smaller banks including First Republic and Western Alliance. The origin of the problem at SVB was unrealised losses. SVB had invested a significant amount of deposits in fixed-rate mortgages at very low interest rates.

Once the Federal Reserve raised interest rates, these holdings effectively embodied losses even though the original intention would not have been for SVB to sell the holdings and realise the losses. However, focus then shifted to uninsured deposits, that is, those that are not covered by the federal deposit guarantee.

Bank runs rarely happen in isolation and for a number of days other banks with significant amounts of uninsured deposits also saw withdrawals, greatly facilitated by the ease with which deposits can now be moved. A guarantee on uninsured deposits from the Federal Reserve and Treasury Secretary Janet Yellen was needed to calm the situation. While this guarantee was not made explicit, it is assumed that to protect the integrity of the banking system, if there were other runs on banks, the US government would step in. In any event, depositors moved significant amounts of money from smaller banks into the larger banks which are assumed (correctly in our view) to be safer.

It is too early to understand fully the implications of this blow to the financial system. What is clear is that banks which are not systemically important are far less regulated than their larger brethren and – interestingly – have grown much faster in the past few years than those larger banks. There is a possibility of increased regulation on those smaller banks which presumably will have a dampening impact on their willingness to lend. In any event the market reached the conclusion that a recession was more likely as a result of what happened. As a consequence smaller companies underperformed as investors derisked their holdings.

The fund trails the market due to holdings in financials

The fund returned 2.5% (in US dollar terms) over the quarter, marginally behind the Russell 2000, which returned 2.7%*.

While the fund was underweight banks it did hold one of those banks which experienced significant share price weakness, Western Alliance, as a large proportion of their deposits were uninsured. The stock fell markedly, but we decided to sell our holding as not many banks recover from having experienced a run on their deposits. Other financial holdings also underperformed although none of those are in a similar situation to Western Alliance.

On the positive side, it was reassuring to see that despite the turmoil in markets and increased doubts concerning the pace of economic recovery, that a number of our holdings relating to infrastructure building continued to perform well. One example was Clean Harbors, which operates waste disposal for hazardous materials. The company gave a presentation to investors which set out the opportunities to grow revenue and earnings over the next few years, and this was warmly received by the market. Other stocks which performed well included Axon Enterprise (the maker of Taser) as well as two of our holdings within healthcare services, namely Natera and Envista Holdings.

There was however, a continued trend in the market of selling the previous years’ winners, in addition to the sell off interest rate sensitive sectors, and our other holdings in the infrastructure spending theme, such as Valmont Industries, Constellation Energy and NextEra Energy Partners detracted from performance.

Activity – Adding to software, cutting real estate

We believe that companies which persist in not producing cashflows will continue to underperform the market.Within the fund we have added to software companies which we believe are ripe for either self-help like Tenable or help from the outside like Sumo. We also added Twilio.  

Looking forward, we will be paying particular attention to any lasting impacts of the SVB failure on the financial sector. While it would appear that increased regulations on smaller regional banks may happen it will be quite some time and not at all guaranteed given the divided nature of Congress. As mentioned above, we sold our holding in Western Alliance.

The most obvious part of the economy to experience weakness has been commercial real estate, both office buildings (mainly on the coasts) as a result of work from home, but also retail warehouses because of significant overexpansion during Covid. In addition smaller regional banks have been significant lenders to this part of the real estate market. Within the fund we significantly reduced our holding in WillScot Mobile which is broadly exposed to infrastructure expenditure, including commercial real estate development. We felt it prudent to cut the holding as we assess whether the company’s fundamentals are impacted by the banking uncertainty.

Outlook – Higher interest rates will continue to expose weak companies

We do not believe interest rates will return to the extreme lows of the pandemic era. As such, companies that can demonstrate growth, while also generating healthy cashflow and earnings should be able to beat the market. We expect that interest rates that are materially higher than they have been over the past five to 10 years will have a detrimental impact on ‘zombie companies’ which have been kept alive by extremely low interest rates. We believe this will benefit our portfolio’s bias to quality stocks – those with predictable, growing earnings and high free cashflows.