Artemis Income Fund update

Source for all information: Artemis as at 31 March 2025, unless otherwise stated. 

Market review

Global equity markets had a challenging first quarter. The S&P 500 posted its worst quarter of returns since mid 2022, with DeepSeek, concerns around AI demand and talk of and the imposition of tariffs onto some of the US’s largest trading partners significantly denting investor confidence.

Performance was better outside the US, with the FTSE All Share returning +4.5% in the first quarter. The chancellor’s spring statement – despite highlighting the UK’s fiscal challenges – did contain some bright spots, in the form of continued efforts by the government to cut red tape and deregulate as well as the announcement of plans to boost defence spending to 2.5% by 2027, with an ambition to reach 3% in the next parliament - a potential boost to the UK’s manufacturing sector over the long term.

Despite some mis-steps thus far, the government’s recognition of the importance of economic growth remains in place, we believe, with several of our company management teams citing positive engagement with government officials. Execution will not be straightforward, but we have seen enough to believe on balance that the intent is at least there, which is a significant change versus recent history.

Performance

The fund returned 2.7% over the quarter, underperforming the FTSE All-Share index, which returned 4.5%.

Negative contributors

Tesco's shares (as well as those of other UK supermarkets) sold off as a result of Asda announcing a programme of significant price cuts in an attempt to stem market share losses. We believe this is something of a ‘hail Mary’ from Asda, who have been losing share for 10 years and are clearly doing this from a position of weakness. These price reductions will be facilitated by cutting all technology investment, and Asda's balance sheet remains highly levered. We were not surprised to see the shares of UK supermarket peers fall. The supermarket price wars of a decade ago looked very different to the rational competitive environment we see today. However, Tesco’s market position, scale and balance sheet strength – as well as significant optionality from its Clubcard data, which is the best UK consumer data set bar none in our view – suggest it is well placed to remain dominant in the UK. We do concede that there could be some shorter-term pressures on gaining further market share. All in all, we believe a 4% yield that should grow at mid-single digits thanks to share buybacks alone remains compelling, but we are conducting some channel checks and examining whether Asda’s actions could damage our investment thesis and assessment of Tesco's risk/reward payoff.

SSP's shares sold off with the broader travel and leisure sector on concerns about economic growth. A first- quarter trading update (released at the end of January) re-iterated the company's full-year guidance however and pointed to positive trading momentum in the first three months, with North American sales growing +17% year on year. The long-term prize for SSP – taking share in the structurally growing travel concessions industry at a relatively high return on capital – remains significant. However, execution has been poor in a number of areas in recent years, and this, along with SSP’s investment into growth, has depressed both cash flow and the share price. Shorter term, we believe the market to be significantly undervaluing SSP’s stake in its Indian joint venture which is likely to float on the stock market in the coming months. As a result, we think SSP's market capitalisation of £1.3bn looks anomalous despite these execution issues.

Pearson's investors took profits after a very strong run of performance. The shares have returned +142% since we invested in August 2020, versus +55% for the NASDAQ (in sterling). The company's US higher education division returning to growth in the third quarter challenged some of the naysayers on the stock. Since then, more investors have woken up to the significant market opportunity facing Pearson in digital learning, assessments and accreditation. As a whole, we believe Pearson is one of a relatively unusual group of stocks where AI is a clear and demonstrable opportunity to enhance the user experience and create significantly expanded revenue streams. Previous CEO Andy Bird repositioned the business, and new CEO Omar Abbosh brings deep understanding of digital transformation, AI, and experience in executing it from his time at Accenture and Microsoft. We believe Credly, Pearson’s digital credential platform, is a particularly underappreciated part of the business. Credly issued its 100 millionth unique 'badge' in early 2025. In a digitised world, trusted accreditation looks set to become increasingly important. With all of this in mind, a market capitalisation of £7.6bn, a net cash balance sheet and a 6% free cash flow yield that has ample room to compound at mid to high single digits over the long term, suggest to us that there is material upside for Pearson's investors from this point.

Positive contributors

Lloyds announced strong full-year results across the board. Profits and return on tangible equity continue to accelerate thanks to the benefits of higher interest rates. The structural hedge (a means by which banks invest a portion of their profits in fixed income instruments to smooth earnings volatility) should continue to drive further earnings upgrades for several more years. Lloyds' managers have suggested that the earnings benefit from the hedge will be c.£1.2bn higher in 2025 than in 2024. Dividends per share grew 15% year on year, and Lloyds looks well set to continue – like the other UK banks – buying back significant amounts of their own equity going forward. Some analysts' estimates suggest as much as half of its current market capitalisation could be returned to investors by 2027. With respect to the ongoing newsflow around motor finance, a more balanced view around the worst-case scenario here for Lloyds has eased investor concerns, and, importantly, these potential penalties have not (yet) affected distribution policy.

Aviva delivered double-digit organic revenue growth in 2024 and increased dividends per share by 7% year on year. We think the market is rightly optimistic about the Direct Line deal. The combined entity amasses more than 20 million customers and skews the group more towards 'capital-light', higher returning business lines. Additionally, there is likely to be a large capital release after the acquisition that is surplus to the solvency requirements of the combined entity. This is likely to be larger than the market is expecting in our view. Aviva’s investment in its technology stack in recent years is beginning to show itself in more customers using the Aviva app to insure and invest. There are signs that this means that Aviva can service customers more effectively, offer them more products and do all of this at a lower cost. The fact that many customers have at least two products with Aviva lends credence to this. A 7% dividend yield that should be able to grow at mid-single digits over the long term (and be supplemented by share buybacks that will resume in 2026) therefore looks attractive from a risk-reward perspective.

Next’s most recent results (year to January 2025) showed another strong year of progress across the business. Group profit before tax grew 10%, with earnings per share – thanks to share buybacks – growing by more than 11%. The current year's trading has also been tracking ahead of expectations which was seen as a further positive, with sales and profit guidance also upgraded. Execution has been consistently strong at Next in recent years, with the company investing sensibly in technology and innovation in order to "break free of historic constraints" (to quote the latest results commentary) to growth. For a company with a long runway of growth – both in the UK and internationally – we believe a 6% free cash flow yield that should be able to compound at mid-single digits looks compelling. The strength of our investment thesis is reflected in Next being one of our largest positions.

Activity

In recent months we have been building a position in UK housebuilder Berkeley Group, which specialises in large, brownfield regeneration projects in London and the South East. We have always held the business and its management team in high regard. Given the cost and complexity of these projects, there are relatively few competitors and strong execution (which has been high quality from Berkeley in the past) can result in attractive returns. We have been investors before (we sold the stock in 2018) and, with the share price having fallen by a third since August 2024, we believe now to be another attractive entry point. The significant structural undersupply of housing in London and the South East should underpin the value of Berkeley’s land bank and the planning outlook looks to be improving. As a result, the risk/reward for a high-quality business with a proven track record that we know well, looks attractive. We have been able to acquire shares at a valuation of between 1.1x and 1.2x price to book, which is close to historic lows.

Outlook

In the wake of President Trump's announcement of a much harsher tariff regime, only to put it on hold several days later, equity markets have been very volatile. There has been little in the form of reassurance from the US administration, with Trump himself reaffirming the necessity of tariffs to ‘fix’ the US economy and reconfigure trade deficits with many international trading partners.

We do not profess to be macro specialists, and as has been the case since the fund’s inception in June 2000, we would never position the fund in accordance with any short-term, ‘heads or tails’ macroeconomic views. We remain focused on controlling what we control – which is whether our investment theses and assessment of a company cash flows are correct – and ensuring that the portfolio is diversified and not overly exposed to any one sector, industry or investment style.

We continue to believe that the fundamentals of the portfolio look robust. The competitive position of the portfolio, in aggregate, is as strong as has been the case for a number of years, and this is supporting healthy free cash flow generation and dividend cover. A c.4% dividend yield is supported by a >2% buyback yield at present, with >70% of the portfolio currently buying back shares. The scale of these share buybacks point to the strength of the portfolio’s free cash flow generation, and while these buybacks could decelerate in any significant downturn, they provide healthy insulation for the portfolio’s dividend.

The UK looks compelling at this juncture we believe. Valuations remain depressed, with net selling of UK equities having continued in recent months. On the other hand, the US remains expensive and popular. Even if tariffs are rolled back to some degree, confidence in the US has been (materially) dented, and given US equities account for almost three quarters of developed market equities globally there is the potential for significant amounts of capital to come out of US equities and into other markets. We would expect the UK to benefit from this phenomenon.

With respect to portfolio activity, we are not looking for short-term trades as a result of recent volatility. However, if opportunities to improve the portfolio’s long-term quality present themselves – whether this be changes in capital allocation within the portfolio or adding new positions – we will, as usual, examine each case on its merits and the prospective risk-reward on offer and act where we see fit.