Artemis Income Exclusions Fund update

Markets

The persistence of UK inflation, which surprised to the upside for the fourth consecutive month in June, points to the unexpected resilience of the UK economy. Indeed, the IMF upgraded its forecasts for the UK and now sees GDP expanding by 0.3% this year rather than contracting by 0.4%.

Elsewhere, investors got very excited about the potential applications for artificial intelligence. US chip maker Nvidia added $220 billion of market cap overnight (an amount roughly equivalent to AstraZeneca’s entire market value) after AI-related orders saw its earnings beating expectations.

Conversely, US higher education company Chegg warned that AI poses a disruptive threat to its business model. The warning saw its share price halving in just a few hours; the jitters immediately spread to some of our holdings, including RELX, Wolters Kluwer and Pearson. To this point, our assessment is that AI presents an opportunity for further value creation as opposed to a challenge for these businesses.

Speaking of disruption, we have seen further evidence of the challenges faced by cash-hungry, disruptive business models as financial markets transition to a ‘normal’ (higher) cost of capital. Fashion platform ASOS was forced to issue shares to plug a hole in its balance sheet. Its shares have fallen in value by over 90% since March 2021.

Performance

The fund returned -1.1% in the second quarter, underperforming the FTSE All-Share index, which returned -0.5%.

Negatives

Corbion had a tough second quarter. Its first-quarter results were softer than expected and the shares were dragged down further by profit warnings from other European chemicals and ingredients names. At its current valuation (less than 15x earnings) not only is the majority of the bad news priced in - but it remains a potential target for M&A activity given the significant value of its intellectual property.

ITV’s most recent trading update showed slowing advertising spend. This is an industry-wide phenomenon rather being ITV-specific; several advertisers are holding back resources to deploy in the second half of the year when UK consumers start to benefit from falling inflation and when ITV’s content slate – including the Rugby World Cup - will attract large audiences. With the stock trading on six times earnings, ITV may be a potential takeover candidate.

Boliden has been plagued by a series of production issues in recent months, including a fire at one of its facilities. Though we have been frustrated by these recent hiccups, we continue to believe that Boliden has a significant longer-term competitive advantage thanks to its ability to produce copper and zinc with a much smaller carbon footprint than other industry participants.

Positives

3i, our largest position, continues to lead from the front. Discount retailer Action now accounts for 60% of its net asset value. We regard Action as a world-class business, and the numbers – its 100% return on capital employed and Ebitda growth at a 10-year compound annual growth rate of 28% – support this. Action appears to be valued at a discount to some of its publicly listed peers despite being a superior business.

Nintendo’s latest ‘Legend of Zelda’ game sold 10 million copies in its first three days after launch. What excites us most as investors, however, is the success of the ‘Super Mario Bros’ movie, which became the first videogame adaptation to surpass $1 billion in box-office revenues. This is evidence, we think, of our investment thesis bearing fruit: Nintendo is beginning to monetise its intellectual property, and we see plenty more opportunities for this across the business. With a 3% dividend yield and a net cash balance sheet, we continue to see attractive value in the shares.

Sage reported strong first-half results with double-digit growth in both total and recurring revenues. Our meeting with management reaffirmed our conviction in our investment case: we believe its addressable market is much larger than many investors appreciate, which leaves a long-term runway for growth in revenues and margin expansion. Sage’s modest free cashflow yield is offset by the quality and growth of those cashflows.

We met Sage’s management during the quarter and found their comments on the subject of innovation particularly interesting. Their view is that innovation is only worthwhile if it produces a tangible result. This is markedly different from the attitude of many companies during the period when interest rates were ultra-low; many businesses pursued ‘innovation for innovation’s sake’ without producing any results or returns and burning through significant amounts of capital in the process.

Activity

We added to our position in Haleon. We have carried out extensive work on the investment case here recently and believe the market’s focus on Haleon’s relatively high leverage and the regulatory overhang from Zantac litigation has created an attractive buying opportunity for long-term investors. Haleon owns some of the strongest consumer health brands in the world. This, along with significant potential cost efficiencies, could lead to attractive revenue growth, margin expansion and, in turn, compelling shareholder returns over the medium-to-long term. For now, however, performance is likely to be subdued as both GSK and Pfizer need to sell their remaining shares (c.35% of the company).

We trimmed our position in Tesco. The stock had been a strong performer, rallying by 25% from its October lows and we believe that rumours circulating around Amazon’s possible interest in Ocado could cap Tesco’s share-price performance. While no bid for Ocado has yet materialised, we were happy to make this reduction and to redeploy the capital elsewhere.

ESG/engagement

We met Origin’s chairman in the second quarter and discussed a wide range of topics, including:

• capital allocation and its dividend policy;
• the composition of the board;
• succession planning; and
• sustainability.

We explored diversity at length, an area in which Origin has made significant progress in recent years, with female representation in leadership positions having increased from 18% in 2019 to 25% in 2023.

The chair was keen to emphasise, however, that diversity goes far beyond this; Origin regards it as a broader process, promoting an inclusive and collaborative culture across the business. Progress has been faster in some areas than others – which is eminently reasonable, we think, given the company’s wide range of business operations, but several initiatives are ongoing to ensure this progress continues.

External metrics continue to suggest that our portfolio has limited ESG risk/controversies.

The road ahead…

... contains more potholes of unpredictability than we would like, with a wide range of competing macroeconomic outcomes. This is why we remain focused on building a portfolio of resilient companies run by management teams for long-term growth. Pockets of the portfolio are, of course more cyclical in nature, but we believe these companies have structural advantages and so have opportunities to take market share.

Despite a (consistently) grim narrative, the UK economy has held up relatively well and the UK consumer has continued to spend, helped by a stock of excess savings that amounts to around 3% of UK GDP. 70% of UK property debt belongs to the top four income deciles, which should mitigate some of the concerns around higher mortgage rates. In recent updates, Tesco and Sainsbury’s have both indicated that we might have seen the worst of food-price inflation.

A question we have been asked in almost every client meeting recently is what the ‘catalyst’ for a revaluation of UK equities might be. This is highly subjective but an important point, we think, is that 60% of the portfolio has bought back shares over the last 12 months. Many of these buybacks are taking place at attractive valuations – below book value in some cases – which will be highly accretive to shareholders.

Many of our companies are currently delivering high single-digit returns to their shareholders through a combination of dividends and buybacks. Add some capital growth to this equation (something we are optimistic about over the medium-to-long term given the competitive strength of the portfolio) and we believe we can deliver attractive returns to our investors.