Artemis UK Select Fund update

The fund enjoyed strong returns from its holdings in NatWest and Rolls-Royce

Having spent the second half of 2023 seeing our bank holdings come under pressure, it has been gratifying to see the sector performing strongly through results season. We continue to believe that the upside in this under-owned sector remains substantial. Equally, weakness in some of those areas of the market where our fund is meaningfully underweight, such as the mining sector and fast-moving consumer goods stocks, was also helpful. On a stock level, meanwhile:

Rolls-Royce (up 42%) continued to perform well. Another strong set of results showed it beating expectations on sales, profits and free cashflows¹. Meanwhile, the leaders of GE’s newly demerged aerospace business made some bullish forecasts on the long-term outlook for the industry “We really are at a point in time where demand isn't our challenge […] we think we've got quite a runway in front of us.”² As a ‘pure play’ standalone business, GE Aerospace now provides global investors with a useful comparator for Rolls Royce.

At times last year, our holdings in domestic UK banks such as NatWest (up 27%) frustrated us. But, like its peer Barclays, NatWest has begun to put those frustrations behind it. The main disappointment last year surrounded its net interest margins (NIMs), which fell despite the support higher interest rates should have offered. Although we admit to being surprised by how quickly interest rates moved and by the impact this had on the banks’ deposit mix, we felt confident that this was a timing issue and one that would unwind through 2024. Better-than-expected results from the domestic banks, including NatWest, suggest that this process is now starting to unfold. They also helped to convince investors that the earnings downgrades seen over the second half of last year are a thing of the past.

Housebuilder Vistry reported a new win for its ‘partnerships’ business

A trading update from housebuilder Vistry (up 34%) indicated that it has seen a material increase in reservations across its business. Consumer sentiment towards housing is clearly being aided by lower mortgage rates and by an expectation that the next move in interest rates will be down. It also announced further success for its partnerships business, (where it collaborates with housing associations and public bodies to build affordable homes in mixed-tenure developments) as it was named as the preferred bidder on a £276 million scheme for 739 new homes in Barnet³. We continue to see the move towards this partnership model as leaving Vistry well placed to take advantage of a renewed focus on affordable housing. This may, depending on the result of the general election, be a priority for the next government…

Barclays is currently our largest holding

The story at Barclays (up 23%) is similar to the one unfolding at NatWest: its net interest margins disappointed last year. But, as with NatWest, this is now starting to change. Barclays’ capital markets day offered investors welcome reassurance that it is heading in the right direction:

• It is aiming to return £10 billion (roughly 40% of its current market cap) to its shareholders through dividends and share buybacks over the next three years.
• It raised its target for Returns on Tangible Equity (RoTE) from 10% in 2023 to over 12% by 2026. (This is what really stood out to us).
• It offered a clearer explanation of its vision for its investment bank, something that UK investors had hitherto struggled to grasp.

If it can deliver on these targets, our calculations suggest that Barclays’ book value will likely be somewhere in the 470-490p per share range by 2026, compared to 331p per share today (and a share price of 183p at the end of the quarter). Barclays is currently the fund’s largest holding.

Our holding in DS Smith attracted bid attention

Paper and packaging group DS Smith (up 29%) received a merger proposal from Mondi. Shortly after the quarter ended, DS Smith accepted a counteroffer from International Paper which represented a 48% premium to its share price on 7 February, just before the approach from Mondi became public. We welcome the fact that International Paper’s all-share offer comes with a secondary London listing. If it is accepted, that would allow the fund to participate in the synergies created by the merger and from the improving structure of the paper and packaging market as it consolidates.

Spurious claims about auto financing put Vanquis’ share price under pressure

Vanquis (down 59%) delivered a significant profit warning on the back of the materially higher costs of processing complaints in the wake of the FCA’s motor finance review. Most of the claims that Vanquis is receiving come through claims management companies and are being lodged despite the fact that it does not use the variable-commission model that the FCA is investigating. Vanquis believes that most of these claims are spurious (in many cases, the complainants have never been its customers). But, as we saw when the banks addressed the miss-selling of PPI, the cost of processing claims is significant. If those claims are not answered and resolved within 50 days, they must be referred to the Financial Ombudsman Service (FOS) at a cost to Vanquis of £750 per case regardless of the outcome. The net result is that the profit recovery that Vanquis had hoped to deliver in 2024 will be entirely negated by the cost of processing claims.

If there is good news it is that there is currently a consultation on whether claims management companies should pay the FOS processing fee on unsuccessful claims. If that were to be enacted, it would clearly reduce the costs for Vanquis materially and could also significantly reduce the number of claims it receives. In the meantime, we are holding onto our small (0.3%) remaining position.

Oxford Instruments' share price drifted lower (down 7%) on no particular news. We used the weakness to add to our holding.

Mitchells & Butlers (down 12%) reversed some of its recent gains. As with Oxford Instruments, there was no stock-specific news. Falls in energy costs and food prices since the start of the year should, however, provide a tailwind for its margins and we retain the position.

It was a quiet quarter for activity

We added modestly to our existing holdings in IAG and 888 on weakness.

IAG has been weak due to fears of a capacity glut in long-haul, transatlantic routes. We believe these fears are misplaced and that capacity growth on the key London-US route looks modest heading into the summer. Recent problems at Boeing, meanwhile, suggest that the airlines industry will remain capacity-constrained for a number of years. In the case of 888, we took encouragement from the quality of its recent hires.

We completed the exit from Prudential, preferring to gain our exposure to Asia through banks focused on the region, such as Standard Chartered.

We sold our small holding in Virgin Money following the bid from Nationwide. The offer price was disappointingly low, particularly given that Nationwide is likely to derive substantial cost synergies. We bought this holding close to the lows of the pandemic, so it has proven to be a profitable investment. Equally, however, it has been somewhat frustrating that its poor delivery on costs and IT investments have weighed on its profits.

We continue to believe that economic growth and consumer spending in the UK will accelerate from here

Whether the Bank of England feels able to cut interest rates before the US Federal Reserve will partly depend on inflation. But, given the Bank’s historic reluctance to go out on a limb relative to its peers, we may see only one cut this summer, with improvements in growth giving it room to take a wait-and-see approach. This is an area where we will remain vigilant: any sharp divergence in monetary policy could see the sterling-dollar rate break out of its current range.

Oil companies and banks are exhibiting strong earnings momentum

Sector allocation will be key to determining the fund’s relative performance this year. Asset-intensive and balance-sheet-intensive businesses such as oil companies and financials are currently the sectors with the strongest earnings momentum (helped by commodity prices and higher-for-longer interest rates). They are also seeing the most technical support from share buybacks and offer an attractive level of dividend income.

More broadly, the rally in commodity prices should be beneficial for the UK market as a whole. While the fund is modestly underweight energy it has exposure to both Shell (4.4%) and BP (4.3%) so should participate in any move higher. Given that most active investors are currently underweight in banks and energy, we believe that the rotation out of ‘quality growth’ and into these higher-distribution sectors will accelerate as they scramble to close their increasingly painful underweights.

There is scope for the UK market to see a significant re-rating

While flows out of the UK market remain seemingly relentless, the pickup in M&A activity and ongoing share buybacks continue to reduce the investible pool of equity at an even faster rate. When flows do finally stabilise, we believe there is the strong prospect that the UK market enjoys a significant re-rating.