Artemis Income Fund update

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

As readers will know by now the portfolio’s prospects rest more on the individual characteristics of the stocks we own, rather than the ebb and flow of the global economy. However, the economic backdrop is of importance as it has a bearing on the appetite for risk and therefore equities.

Global equity markets posted their strongest first quarter of performance since 2019. A resilient global economy, led by the US, as well as inflation that has continued to moderate, created a supportive environment for equities. This is something of a mixed blessing in that although in March the Federal Reserve reiterated plans to cut interest rates by 75 basis points in 2024, the strength of the economy and the labour market has been sufficient to sow some seeds of doubt around the timing – if not the extent – of the downward move in interest rates.

Happily, the economic backdrop in the UK has defied the sceptics and naysayers and continued to improve. Inflation has continued to fall, and the UK recession, forecast by many, has been avoided. In fact, the ONS forecasts that UK inflation is likely to fall to the 2% target within months, and real GDP is predicted to grow by almost 2% in 2025 - not something to write home about, but certainly a welcome improvement on 12 months ago. As a result, the Bank of England may now be able to cut rates and indeed this may happen sooner than in the US. You will recall that although the domestic economy is of only modest importance to many UK companies (and your portfolio), in the eyes of the international investor the health of the UK economy plays an important role in their thinking and as a result the UK now looks increasingly ‘attractive’ to the global equity manager.

By and large, the management teams of the companies we hold have struck a quietly confident tone in their full year results, outlooks and meetings with us. In as much as it affects some of our companies, inflationary pressures, particularly with respect to labour, continue to subside. Supply chain conditions continue to improve (Smiths’ CFO suggested that supply chain normality had returned, for example) and most importantly, competitive positions across the portfolio continue to strengthen as weaker industry participants remain under pressure from a higher cost of capital. As a result, in our view the portfolio is delivering its highest calibre of cash flow in a number of years.

Performance

The Artemis Income Fund returned 5.8% net of fees in the first quarter, outperforming the FTSE All Share which rose 3.6%.

On the positive side

3i shares enjoyed a strong first quarter, encouraged by Action’s capital markets day that continued to showcase the company's particular qualities as a retail format. EBITDA margins are increasing, despite further investment in lower prices and further high single digit/low double-digit sales growth is expected. In addition, management now believe that the total number of stores could reach 7,300 (from a current base of 2,600). Action’s high returns on capital and rapid payback periods are to say the least reassuring and at over 60% of 3i’s value Action remains the key driver of the share price.

UK banks posted their strongest quarter of performance in some time

In part this may have something to do with the better prognosis for the economy but more likely it was the realisation that the scale of capital returns and valuation were difficult to argue with. In addition, thus far share repurchases have left the shares unmoved but – and here we speculate – it may be that the power of the buyback is being met with a dwindling supply of sellers.

The appointment of Paul Thwaite (whom we saw as a highly credible candidate) as NatWest’s permanent CEO meant that the government’s intention to sell its remaining 33% stake was able to progress. The appointment hopefully signals the end of a tumultuous period for NatWest and kicks off another in which the organisation can focus on delivery and value creation. Significant cost saving opportunities and the structural hedge should support what will likely be compelling cash returns to shareholders over the medium term.

Good results from Wolters

Wolters Kluwer’s full year results exhibited many of the characteristics including organic revenue growth, 100% cash conversion, margin expansion and increasing returns on capital that have been central to our investment rationale. An area of focus across our portfolio, but with respect to our data and analytics holdings in particular, (Wolters, LSEG and RELX) is how these companies are applying artificial intelligence across their various business lines. Our thesis remains, after much stress testing and inquisition, that given enviable, proprietary data sets and well-organised, flexible systems, AI should open up (yet) more avenues for value creation for customers and growth in cashflows. Last year, Wolters added a range of generative AI-enabled features across its portfolio (it is important to remember that Wolters has been working with large language models and machine learning techniques for 10 years) and we expect this rollout to gather stream over the coming years.

On the negative side

Smiths Group

Smiths' CEO Paul Keel announced his departure with immediate effect late in the quarter. Though his destination has not yet been announced, we do know that he has taken a role in the US, his home market. We were of course disappointed to hear this news. We have engaged extensively with him since he joined the business three years ago and believe he has been instrumental in improving processes and execution across the Smiths portfolio. However, he leaves Smiths in a strong position, and it remains a high-quality portfolio of businesses that are at the forefront of innovation in their respective industries. Companies in the more economically sensitive areas like industrials are of course subject to the ebbs and flows of the macroeconomy over the short term but Smiths should be well supported by these structural factors looking further out into the future. We look forward to meeting with the newly appointed chief executive – a Smiths ‘lifer’ who has been with the company for over three decades – in the coming weeks.

RS Group

RS Group (industrial equipment) marginally missed earnings estimates in its full year results, prompting some further downgrades from the analyst community. We are not sure this negativity is warranted, however, given robust economic activity and purchasing managers indices that look to be bottoming in several regions. Looking to the longer term, we see RS as a structural winner, given a leading digital offering (making it a more obvious AI beneficiary than its competitors) and the opportunity to extend market share in what remains an extremely fragmented industry. A pristine balance sheet (likely leaving ample space for share buybacks) and a dividend yield of over 3% look attractive for a business of this quality. We added to the position through this period of weakness to maintain our target weighting.

Spectris

Spectris delivered some robust annual results, though the market focused on a slowing trend in like-for-like sales as the year progressed. Comparisons with 2022’s outstanding growth were always going to be a challenge, but over the longer term we believe Spectris to be well equipped to deliver mid to high single digit revenue growth and faster margin expansion. The company’s portfolio is comprised of a number of first-rate businesses operating across a range of industrial, medical and technological applications, underpinned by a range of structural growth drivers across precision measurement, safety and the energy transition. 17x forward P/E therefore looks attractive with a long-term view, and at this valuation, there are likely several large global peers that would look to bid for the company.

Activity - adding to Barclays and GSK

We added to our position in Barclays, given its announcement of what looks to be a credible plan to re-focus the business and create significant shareholder value over the medium term. This was supported by a strong meeting with management. Like Lloyds and NatWest, Barclays has the potential to generate double digit shareholder returns through a combination of dividends and buybacks for several years.

We also topped up GSK. Our extensive engagement with the company in recent months suggests the R&D pipeline to be healthier than the market gives credit for. Furthermore, we think there has been an improvement from a cultural perspective, which logically should support better innovation and outcomes going forward.

We trimmed our Nintendo holding, given some strong share price performance, as well as Indivior. The rapid growth in GLP-1s, which suppress cravings and addictive tendencies, could present a challenge to Indivior’s business model.

Outlook – signs of overseas interest in the UK market

While the announcement of the plans for a British ISA was a welcome indicator from the government that reinvigorating the UK stock market is moving up the list of priorities, it is unlikely, in our view, to play any significant role in lifting UK valuations. The return of international capital is most likely the crucial catalyst, and we are seeing mounting evidence that this might be beginning with global investors continuing to buy and add to positions in a number of UK companies. The likes of LSEG and RELX have attracted overseas capital for some time, but this buying is now broadening out into some of the more ‘value’ oriented parts of the market.

With respect to the companies we own, their competitive positions continue to strengthen, as outlined above. Tesco remains one of the best examples of this, with Morrisons and Asda feeling the burden of heavy debt loads and Lidl’s rapid expansion slowing considerably with the end of easy money. As a result, the quality of cash flow Tesco and other portfolio holdings are delivering grows stronger by the day, and provides a sturdy margin of safety to the portfolio’s c.4% dividend yield. We must not forget share buybacks either: portfolio companies continue to repurchase significant proportions of their own equity at attractive valuations and pushing up earnings and dividends per share as a result.

All in all, therefore, in our view there is tangible evidence that the conditions surrounding the UK equity market are on the up and this is not lost on global investors. Little by little, it looks as though at long last the tried and tested patience of UK equity investors is being met with some reward, and the substantial valuation gap versus peers is on its way to being recouped.