Artemis UK Smaller Companies Fund update

Source for all information: Artemis as at 31 March 2024, unless otherwise stated. 

The Artemis UK Smaller Companies Fund made 0.3% over the quarter, narrowly outperforming its Deutsche Numis Smaller Companies (-InvTrust) benchmark. However, we were still frustrated in March when it felt like our holdings were stuck in treacle while other small caps were flying – the index rallied 4.2%, compared with gains of 0.9% from our fund.

We struggled to square this underperformance – even if only for a short period – with the fundamentals of the underlying businesses in our portfolio. Admittedly, banking stock Vanquis had a shocker and the halving of its share price in March was responsible for a fifth of our underperformance, but even here there are reasons to believe it is oversold. More about that below.

Positives

Of all our company meetings in March, we came away feeling most excited about the prospects for Alpha Group, a B2B provider of foreign exchange and banking services. It is sitting on £2bn of cash which it is waiting for its alternate banking clients to deploy. As this cash is transactional, Alpha benefits from the interest income – this amounted to £73m last year, which was not included in its adjusted profit before tax of £43m.

While rates are likely to fall, we expect client cash balances to grow (new accounts were up by 54% last year). We don’t know of another company that has grown earnings eightfold over the past five years, yet is valued on a 15% prospective free cashflow yield and is expected to have one-third of its market cap in cash by the end of 2024. We increased our position in the company in March and, following a rise in its share price, it became our biggest holding at one point. As it moves from AIM to the main market in May, we expect it to attract more investor interest.

We have spoken at length recently about the growing number of our holdings buying back shares, which can be taken as evidence of strong balance sheets (the median net debt/EBITDA of the fund is expected to be just 0.1x by 2025), confidence in their outlook and attractive valuations (the median free cashflow yield of the fund is expected to be 9% by 2025). Gamma Communications was the latest holding to start a buyback – up to £35m (3% of the outstanding shares). This was less than one-third of the net cash position at the end of last year.

The fund also benefitted from avoiding Watches of Switzerland, financial services firm Close Brothers and engineer Dowlais.

Negatives

Vanquis slashed profit forecasts after a huge increase in complaints from claims management companies about its credit card business. Most came from one company and the vast majority are being rejected by the ombudsman. However, under current regulations, Vanquis must pay the ombudsman to investigate each claim, causing a huge step-up in admin costs. The shares are now on a 70% discount to assets, with management targeting a 16% return on equity in 2026. Vanquis's Tier 1 capital ratio of 20% also looks reasonably solid. It’s hard to judge how long the burden of elevated claims will last, which is why we haven’t added to our holding. A recent proposal that would force the claims companies to pay for the cost of making a claim could make us change our minds.

Pawnbroker H&T saw earnings rise 30%, but this was 10% below expectations due to weaker retail sales. It is frustrating when good results are undermined by poor expectations management. However, the company remains on a compelling valuation.

Consumer goods company PZ Cussons generated 40% of its operating profit in Nigeria last year, so its earnings have been hit by the 71% depreciation in the Naira against the pound. This issue has been compounded by a £200m cash position held in Nigeria at the end of last year which the company had been unable to repatriate (and which is now worth substantially less). Falling cost-price inflation should help profitability in the European and American parts of the business, however.

A number of stocks fell towards the end of the quarter despite a lack of newsflow. These included online price comparison website MoneySupermarket, translation services provider RWS, drinks maker Britvic and identity verification company GB Group.

Activity

We initiated a new holding in IG Group (derivatives trading), which we have tracked for many years and which is held in the Artemis Income and UK Special Situations funds.

In our view, the P/E ratio of 8x more than discounts the potential risks surrounding interest income (now forecast to be 30% of profits) and does not reflect the excellent long-term growth record or the scope for trading revenues to recover when volatility picks up. A strong balance sheet gives ample headroom for further shareholder returns once the current £250m buyback is completed.

We added to positions in TT Electronics, consultant Next 15, property developer Harworth and drinks maker Britvic, and took profits from Computacenter, outsourcing contractor Serco and defence company Babcock.

UK macro – still not as bad as people think

Domestic equity valuations only make sense on a relative basis if the UK is an outlier from an economic perspective, a narrative that we see as difficult to sustain. Inflation is likely to fall below the 2% target following April's reduction in the energy price-cap, government debt levels are low relative to other G7 countries and for all the caution surrounding the UK economy, its PMI (purchasing managers’ index) is currently top of the table in the developed world.

UK inflation is coming down 

There is no longer much scope for domestic pension funds to reduce their equity weighting to the UK, but even if there is never a re-rating, cheaper stocks are likely to deliver a better return.

Take two theoretical companies: both grow at 7% a year and both pay out 50% of their income. Company A trades on a P/E of 15x and Company B trades on 10x. Over a 10-year period, without a re-rating of Company B, it will make 17 percentage points more than Company A. Why? Because the benefit of reinvesting dividends at a lower valuation compounds up over time. If Company B gradually re-rates so that it ends the period trading on the same multiple as Company A, the returns will be higher still. Remember, valuation matters.