Artemis Income Fund update

Source for all information: Artemis as at 30 September 2024, unless otherwise stated.

Despite concerns that US (and global) economic growth could be slowing, a 'flash crash' in Japan, rising geopolitical tensions and a slew of political news including several elections and some extraordinary events in the US presidential race, equities were generally strong in the third quarter.

After the steepest path of hikes in recent memory, interest rates have begun to fall, with the Bank of England cutting by 25 basis points in August and the Federal Reserve delivering a 50 basis point cut a month later. Rates were cut 26 times around the world in September, the fourth largest month of monetary stimulus since 2000. China also announced a significant stimulus package towards the end of the quarter, to try to awaken demand and restore confidence. Chinese equities responded positively, posting their strongest week of returns since 2008.

In the UK, Labour won the third largest parliamentary majority since 1900. For what at first sight appears to be an increasingly pro-business and fiscally sensible Labour party, this significant majority can hopefully usher in a period of stability for the UK after several years of political volatility. Many of our portfolio companies have commented on constructive engagement with the new government thus far

Performance

The Artemis Income fund returned +2.9% net of fees in the third quarter, outperforming the FTSE All Share which returned +2.3%.

Contributors

Tesco’s strong value proposition continues to appeal to all customers, from the most affluent to least well-off. This has helped the company to drive market share gains from an already dominant position. The latest industry data suggests Tesco’s market share of UK grocery is almost 28%, nearly double the share of second place Sainsbury's. Aside from its own efforts, Tesco is benefitting from the travails of Asda and Morrisons, which are privately owned and highly indebted, leaving them with less leeway to invest and respond to competition. Both have ceded market share over the last 12 months, helping to further consolidate Tesco’s competitive position. All the aforementioned gives us confidence in the long-term free cash flow potential of Tesco and makes a 7% free cash flow yield look attractive. Moreover, Tesco is one of many examples of the power of share buybacks in the portfolio: a c.4% dividend yield could grow at 5% per annum through the effects of buybacks alone – this is before we consider the supplementary effects of cash flow growth.

Online trading platform IG’s first half results saw earnings per share beat estimates by 4%, with commitments made to buy back another £150m of shares (IG’s share count has already fallen by 14% since the end of 2022). Most importantly, however, this was new CEO Breon Corcoran’s first set of results at the helm of the company. His results presentation – as well as a meeting shortly afterwards – helped us to garner some interesting perspectives on how he operates and what he believes the ‘prize’ to be at IG. Corcoran is well known to Artemis, having formerly been CEO of Paddy Power Betfair (now Flutter) which has been held by a number of our investment teams in the past. There are many similarities between IG currently and Paddy Power Betfair when he took over several years ago. For example there is a feeling that the market opportunity has not been fully taken advantage of, that costs are too high and that a cultural reset is required. We would largely agree with his diagnosis, and in our view the prize could be better cash flow growth and a re-rating of the shares. This transition is likely to take time, but from a current valuation of a double-digit free cash flow yield and net cash on the balance sheet, we see the potential for outsized returns taking a long-term view.

Corbion's shares traded higher given US rate cuts and Chinese stimulus. The speciality chemicals and ingredients company has had a challenging couple of years due to stubborn supply chain issues, weakness in China and plenty of profit warnings from its peers. However, so far this year the shares have returned over 30%. The sale of its emulsifiers business for $350m in January reduced leverage and allayed any balance sheet concerns, and Corbion’s H1 results also indicated strong growth in its algae ingredients division. The potential market opportunity here is significant, we think, given the lower emissions intensity of producing a range of ingredients and feeds with algae in comparison to traditional methods. A significant program of capital expenditure which is coming to an end should feed through into improved earnings and cash flow, and with a market capitalisation of less than EUR1.5bn, Corbion remains vulnerable to M&A activity in our view.

On the negative side

Informa shares underperformed, perhaps as the market continues to digest its acquisition of events peer Ascential. At first sight, it looks like Informa has paid a high multiple, but we believe its scale, global reach and (increasingly digital) expertise equips it well to create significant long-term value from what is a high-quality portfolio of brands. Informa has a strong track record of adding value from M&A, with Informa suggesting that 90% of the assets acquired in its early 2023 acquisition of Tarsus (another industry peer) performing either in line with or ahead of plan. Informa is the world leader in the events industry and is an example of a truly global company (with 96% of revenues derived overseas in 2023) that just happens to be listed here in the UK. A 7% free cash flow yield, with a high degree of recurring revenue and strong potential for structural growth, results in an attractive risk reward ratio.

Nintendo's shares fell over the summer, given weakness in Japanese equities and concerns over a delay in the release of the highly anticipated Switch 2 console. This has clouded the progress that the company is making in expanding the monetisation of its IP into new areas such as movies and theme parks. Looking to the longer term, however, we believe Nintendo has many years of structural growth ahead. The success of (and various records broken by) the Super Mario Bros movie last year could be a compelling blueprint for commercialisation across Nintendo’s large bank of well-known characters. The shares trade on a mid-single digit free cash flow yield, but we would however point to the quality and growth potential of Nintendo’s cash flows.

Dr Martens shares fell following a placing of shares by two large institutional investors. We – like many other investors – originally thought that this may have been Permira selling down its stake (the private equity firm that bought Dr Martens from the founding family and floated the business in 2021 while retaining a large shareholding). However, we discovered afterwards that Permira was not involved in the placing, and we were encouraged to see some strong demand for the stock from long only investors after the share price fell. We have been maintaining what is a small position in Dr Martens, as we believe the market to be discounting too much bad news, given a market capitalisation of £500m squared against revenue of £880m and free cash flow of £130m in this fiscal year. This is another company in the portfolio that we see as increasingly vulnerable to a bid.

Activity

A new position we have been building in recent months is in medical device manufacturer Smith & Nephew. We believe the market to be too focused on S&N’s orthopaedics business – which has, admittedly, been challenged by sub-par execution and falling market share. However, the rest of the group, which generates c.70% of profits, is made up of high-quality, high-margin businesses in sports medicine and wound management. These are areas of structural growth in which S&N is a market leader, yet the market remains fixated on an orthopaedics business that accounts for a shrinking proportion of group revenues and cash flow. However, we see ample opportunities for the performance of orthopaedics to stabilise through better management and self-help, which could facilitate investors paying closer attention to the cash flow and growth credentials of S&N’s other assets. With this in mind, a current valuation of 16x forward P/E – below both S&N’s historical average and relevant industry peers – leaves room for plenty of upside in our view.

Elsewhere, we have continued to trim some of our longer-term winners – the likes of 3i, RELX and Wolters Kluwer – and have recycled this capital into other areas (such as the UK domestic banks) where we see more asymmetric risk reward.

Outlook – Encouraging signs for UK equities

The economic outlook remains difficult to call, although certain aspects – such as the UK’s high savings ratio and the direction of inflation – look to be well founded and encouraging. Nevertheless, we are still focused on what we can control, which is stress testing the resilience of our individual investment theses and building a portfolio that is concentrated enough for our best ideas to receive ample capital but diversified enough to be balanced and style agnostic.

We continue to believe that in the main, the competitive environment for the sorts of companies we deem attractive investments is the best it has been for many years. Higher interest rates continue to present a challenge to debt- and cash- hungry disruptors, and many business models are coming unstuck in this new normal. This gives competitive advantages to many of our portfolio's holdings, and as a result the fund's dividend (between 3.5%-4%) is covered by robust cash flow.

While on the subject of uncertainty, all eyes are now on the Labour government’s first budget, which will take place towards the end of October. Our portfolio companies have spoken of constructive engagement with Labour (over several years, not just since they were elected), with the government intent on growing the economy and boosting investment. If this pro-growth agenda begins to bear fruit – we are encouraged by talk of planning and pension reforms thus far – then the outlook for the UK economy and in turn UK equities continues to look promising, especially when we consider the low valuations in much of the UK market.