How focusing on the fundamentals produced award-winning returns

• The fund’s long-term performance has received independent recognition from Lipper.
• The secret to our success has been consistent application of a repeatable process.
• We think returns from the UK market can beat inflation handsomely from this point; we expect our fund to do even better.

The Lipper Fund Awards 2023 identified the Artemis SmartGARP UK Equity Fund as the best UK equity fund over the last three, five and 10 years.

Those awards suggest we must be doing something right. A decade ago, however, the fund was behind the index and it wasn’t winning awards. So what changed? In short: nothing. Irrespective of the gyrations in the market – such as the extreme enthusiasm for growth stocks in the decade that followed the financial crisis – we continued to do what we believe are simple and sensible things, year in and year out.

We think the long-term results of that consistent approach speak for themselves: since Artemis started running this fund in 2002 it has returned 8.3% per annum whilst our benchmark index, the FTSE All-Share, was up by 7.5% per annum¹. We will continue to apply the same tried-and-tested process. Here, I’ll explain why I believe the prospective returns from UK equities look good – and why I think our fund will do even better.

Artemis SmartGARP UK Equity – ahead of the index and ahead of index funds 

What returns might investors expect from UK equities from this point?

To begin with our conclusion… From this point, I would expect the UK equity market to produce long-term returns that are about 4-5% above inflation. In a world where bond yields are still quite low and where property prices are still elevated and in danger of sinking, this sounds pretty good to me.

If you were to invest in a cheap passive fund tracking the UK market, I suspect your returns over the next decade should be respectable. Invest in this fund, however, and I think you will do better… Past performance, of course, is no guide to future returns. And I can offer you no guarantees. But I can explain why I think returns from our fund could be nearer 6% to 8% per annum.

Two of my starting points are:

• That the stocks in this fund currently have a dividend yield that is about 1% higher than the UK market.
• That this fund has a 20-year track record of delivering growth in fundamental value per share (‘FVPS’) that is about 3% faster than the market.

This excess growth in fundamentals has not been reliant on our superior forecasting ability. Instead, it has been the product of doing simple and sensible things year in, year out. I don’t own a crystal ball. But – in SmartGARP – I do have a repeatable, objective and effective process.

What determines returns from stockmarkets?

So why do I think UK market can deliver inflation-beating returns from here? I’ll show my working.

The return on any asset is a function of its initial yield, the growth in income it delivers plus any change in its valuation multiple. In the short run, market returns tend to be dominated by changes in valuation multiples. But in the long run – over the course of decades rather than between one year and the next – it is the fundamentals that dominate.

When we began managing this fund in 2002, the UK market offered a yield of 4%. Over the subsequent two decades, the fundamental value per share of UK equities grew at a rate of about 4% per annum. Valuation multiples, meanwhile, fell slightly over this period. This shaved around 0.5% per annum off returns.

So, the return from UK equities has been 4% (initial yield) plus 4% (growth in fundamentals) minus 0.5% (lower valuations). Or, put another way:

4% + 4% – 0.5%= c.7.5% per annum.

Inflation in the UK, meanwhile, has averaged about 2.5% over this period, so ‘real’, inflation-adjusted returns from UK equities have been about 5% per annum.

Today, I look upon the UK market as being fairly valued. So I expect future real returns to be similar to the 5% witnessed over the past two decades.

Why I think our fund will continue to outperform the UK market over the long-term (if not always in the short term)

The objective of all active fund managers is to outperform their benchmark. To do this, they must own stocks that – in aggregate – outperform the market. It might not always seem so but, in the long term, a company’s share price is linked to its fundamentals. Companies that deliver superior growth and income tend to perform well; those that don’t, tend to perform poorly. So many fund managers tend to focus on owning companies whose fundamentals are improving.

So far, so rational.

But there’s a problem. In an ideal world, share prices and company fundamentals would be closely correlated. In the real world, however, markets often exaggerate short-term trends in the fundamentals as investors get overly excited – or become too pessimistic – about a company’s prospects. So share prices can meaningfully diverge from fundamentals – in effect, the invisible piece of elastic that ties income and earnings growth to share price can become stretched.

Vodafone is a case in point. Chart 2 neatly encapsulates the rollercoaster ride its shareholders have been on over the past 35 years. The blue line shows the return a long-term Vodafone shareholder would have seen relative to the wider UK market. The beige line shows how a simple measure of the company’s fundamentals (its earnings pare share) has gone up and down. The picture illustrates Vodafone’s rise and fall as a business and as an investment.

Vodafone’s rise and fall 

For much of this period, Vodafone’s earnings per share were rising and investors looked on it as a growth company. At the start of the century, investors were in love with this kind of company and valuation multiples were extremely high (just look at how far the blue line was above the bronze line in 2000). Over time, returns on capital have fallen across the telecom industry and Vodafone’s earnings per share have done likewise. It has gone from being Britain’s biggest company in 2000 to being 24th-largest at the time of writing. So fundamentals have prevailed.

Some investors focus on valuations (the gap between the two lines); others (growth investors) on the expected direction of the bronze line. Our focus is not just on the trend in the bronze line but also on whether a company’s valuations are consistent with it. My job is to find and own companies that are likely to deliver growth in the fundamentals that is not already anticipated by the market. (As you might have guessed from the downward slope in the bronze line, Vodafone is not a stock I currently own.)

What we do: buying companies that are outgrowing the market at a reasonable price

So if we don’t own Vodafone, what sort of companies do we own? We buy companies where the bronze line (earnings per share) is heading north and where the good news is not yet discounted in its share price. To give one example, the biggest position in our portfolio (c.7% of the fund) is currently HSBC. Chart 3 illustrates its performance in fundamental and share-price terms over the past decade. You can probably see why we own it. As the bronze line shows, the growth in its earnings per share since 2021 has been exceptionally strong – but that is not reflected in the valuation multiple on which its shares trade. It currently trades on a valuation multiple just over half that of the broader UK market.

Over the past year, the market seems to have been anticipating a sharp collapse in HSBC’s earnings, but they kept growing. The share price has, belatedly, begun to recognise this – and owning HSBC has been one of the reasons why our fund has done so well over the past year. (As the old saying goes, ‘bull markets climb a wall of worry’).

HSBC climbs a wall of worry

We can also create a similar chart for our fund in aggregate. Here we illustrate the performance of our fund (we show this before charges - not to flatter our performance but simply because it is easier to calculate) and the earnings per share of the stocks that we have owned at each point in time.

Over the long term SmartGARP has successfully identified companies that provide superior growth in earnings per share (EPS)

The evidence is that SmartGARP has successfully identified companies that provide superior growth over time. The red line in chart 4 – the earnings per share of our holdings relative to the wider UK market – has been trending up by about 3% per annum over the past 20 years. In the long term, the black line – the share price performance of our holdings – should reflect their superior growth. Because share prices should reflect fundamentals, the two lines should move in unison.

Over the past decade, however, the two lines have diverged and the gap between them is now abnormally wide. This may have been because interest rates have been kept low, which encouraged speculation in financial markets. Now that interest rates have risen, it is becoming a more dangerous environment for such speculation.

Over the past decade, investors became accustomed to buying stocks whose prices were rising rather than companies whose fundamentals are improving. This is an eerily similar situation to the environment we faced when we took over the fund in 2002. At that time, investors were still captivated by the likes of Vodafone, extrapolating the recent past into the distant future.

Today, the market implicitly assumes that the earnings per share of our holdings are about to collapse. The recent weakness in earnings (the recent dip in the red line in Chart 4) might seem to confirm this. My view, however, is that our investment process continues to identify good companies in fundamental terms and that the recent wobble in the red line is just normal, short-term market ‘noise’. I believe that the relative share-price performance of our holdings will catch up with their fundamentals over the next decade – and that the next decade’s ‘winners’ will be lowly priced companies that are outgrowing the market.

Conclusion

Markets are driven by a combination of fundamentals and speculation. Our fund is very much focussed on the fundamentals. As a result, I have faith in its potential to reward patient investors - faith that rests on over two decades of evidence.