Artemis UK Smaller Companies Fund update

Review of the quarter to 30 September 2023.

The fund fell 0.3% by over the third quarter, holding up better than the average fund in its peer group (which was down 1.9%) while lagging the benchmark index (which rose by 0.3%).

This fits with a broader pattern: although our fund is in the top quartile of its peer group over the year to date, it has lagged the index. In that, it isn’t alone: in fact, every fund in UK Smaller Companies sector has failed to keep pace with the Numis Smaller Companies index over the year to date. We explore the reasons for this anomaly below.

Top contributors

Wilmington – with return of 16.2%, Wilmington – which provides training and data in the governance, risk and compliance markets – was the biggest positive contributor over the third quarter. We were initially attracted by its strength of its cashflows – but it is now becoming a faster-growing business with higher margins as it shifts to digital training (rather than face-to-face). We have been impressed by the way in which Mark Milner, the company’s chief executive, has transformed the business in his four-year tenure. You can find a recent interview with him, along with interviews with leaders of a number of the fund’s other holdings (including Fullers, Gamma Communications and H&T) on the Artemis website.

NCC – rose by 22.0% over the quarter, recovering some of ground lost earlier in the year. The cybersecurity specialist’s full-year results were in-line with expectations and management said they were confident the business will be generating double-digit revenue growth and operating margins in the mid-teens within three years.

Babcock – rose by 46.4% on the quarter, as the market reacted positively to a trading update which said that revenue, profit and most importantly cashflow were ahead of the previous year. The company is making good progress towards its medium-term targets: mid-single digit revenue growth at an operating margin of at least 8% while converting at least 80% of its profits into cash.

Computacenter – gained 11.6%. In part, this was a response to interim results that were seen to have increased the chance that it will reward its shareholders with a significant cash return in early 2024.

Future – such was investors’ concern that it might lower earnings forecasts, its shares added 29.6% over the quarter, partly in response to news that its profits would be in line with expectations. Even after that rally, its share price is only around half level it was back in February; we have been using this weakness to add to our holding.

Biggest detractors

RM – fell by 39% over the quarter as the education technology group warned on profits. That profit warning made us uneasy about the health of its balance sheet, so we sold the position.

Videndum – fell by 51.9% in response to an announcement that the writers’ strike in the US was having a larger impact on profits than had been expected, raising the spectre that it may need to issue shares.

Brooks Macdonald – ended the quarter 20.9% lower. Investors have been worried about lower short-term fund inflows as well as the possible negative implications of the FCA’s new Consumer Duty regulations.

Explaining an anomaly: Why every fund in the IA’s UK Smaller Companies sector is lagging the index this year

The Numis UK Smaller Companies index, the most commonly used benchmark for funds in the IA’s UK Smaller Companies sector, has performed better than every single fund in our peer group this year. How are we to explain this anomaly?

An unusually narrow market – the index is +1.7% over the year to date. In fact, most (1.2 percentage points) of the index’s positive returns have been driven by just two stocks:

• Aston Martin – up 86%; and
• Carnival – up 72%

Infrequent rebalancing of the Numis indices – Whereas FTSE rebalances its indices quarterly, Numis rebalances its indices only once a year. This means that a nominally small cap index actually contains companies that are, in reality, large caps. This year, Carnival has performed extremely well, with the result that it now has a market cap of over £15 billion compared to an index cut-off of ~£1.6 billion.

So why don’t own these two companies?

Poor track records - Despite its strong performance over the year-to-date, Carnival is down 76% over the last five years. Aston Martin is down 92%.

These stocks are currently lossmaking – Both of these companies are expected to lose money this year.

Both companies’ balance sheets are stretched.

Activity: Regaining our appetite for Hilton Food

We started a new holding in Hilton Food Group.

The fund has invested Hilton Food before, holding its shares from 2009 to 2018. We sold that position when we felt the valuation had become a little too stretched. More recently, the business has struggled to pass on cost inflation at Seachill, a business it acquired a few years ago, to its customers. We believe these issues are temporary and will ease as cost inflation abates and as automation/efficiency projects come to fruition. The business has an excellent long-term record and, in contrast to many of its peers, it is well invested. The balance sheet is fine and the valuation – the shares trade on a free cashflow yield of over 8% – looks attractive once again.

Elsewhere, we added to our existing holdings in:

• On The Beach
• Alpha Group
• SSP
• GB Group
• Future
• FDM

We took profits in Computacenter and Babcock.

We sold the holding in EMIS Group whose share price had approached the price offered by United Health, whose bid has now received provisional approval from the Competition and Markets Authority (CMA).

Outlook: Three reasons for optimism

One - The UK is not the laggard that the media often portrays

The ONS recently revised its assessment for the performance of the UK economy in 2020 and 2021. The cumulative impact was to increase GDP by 1.8%, meaning the UK economy is now estimated to be 0.6% above its pre-Covid levels rather than 1.2% below. This matters: once the narrative that the UK is an economic outlier no longer holds, it will become harder to justify the (extremely) low valuations on which UK equities trade.

Two - Business investment is rebounding

Despite the gloomy tone of many discussions of the UK economy (and its equity markets) businesses are increasing their capital expenditure. Investment slumped in the wake of the global financial crisis and then was stalled by the uncertainty surrounding Brexit. The Covid-19 pandemic and lockdown dealt it another blow. Since then, however, business investment has surged and is 35% above the nadir reached in the second quarter of 2020. Capital spending is now back on its pre-GFC trend and business investment was 6% above its pre-Brexit-vote high by the second quarter of this year. This increase in capital investment should boost productivity, increase the economy’s supply potential and help to hold down cost-push inflation.

Three - The fund’s valuation is at a decade low

The fund’s valuation is at its lowest level in over a decade. This is not because we are compromising on quality. The portfolio maintains a quality tilt with higher returns, lower leverage and greater stability of earnings than the benchmark average.