Artemis Income Exclusions Fund update

Source for all information: Artemis as at 31 December 2023 unless otherwise stated.

As inflation eased, bond yields fell and equity markets rallied

The continued downward trend in inflation prompted the US Federal Reserve to issue the clearest signal yet that US interest rates have likely peaked and that it would begin to cut rates in 2024. This triggered a strong rally in financial markets, with bond yields compressing and some of the most interest-rate sensitive areas of the equity market – sectors that had hitherto endured a challenging 2023 – posting strong recoveries.

In the UK, the Bank of England held base rates at 5.25% but inflation fell by more than forecast in November, dipping below 4%. In response, the gilt market posted strong gains, with the 10-year gilt yield collapsing by 100 basis points over the quarter. To this point, the UK economy has remained largely impervious to rising rates, with UK consumers defying forecasts of recession and continuing to spend.

The fund outperformed the UK market over the quarter

The Artemis Income (Exclusions) Fund returned 7.1% (gross of fees) in the fourth quarter, outperforming the FTSE All-Share index, which returned 3.2%.

What worked

3i capped another year of stellar returns with another strong quarter

Private equity group 3i performed extremely well once again, concluding a year in which its shares returned 85%. Its largest holding, European discount retail chain Action, continues to deliver impressive growth in revenues coupled with high cash conversion (c.80%). Action is demonstrating just how powerful a truly cross-border retail format can be when it is stewarded by a high-quality management team. Its average price point is materially lower than its competitors and, as disposable incomes have been squeezed by inflation, footfall in Action’s stores has increased. The majority of its products (around two-thirds of its range) are not fixed, providing shoppers with a ‘treasure hunt’ experience familiar to anyone who has visited the middle isles of Aldi or Lidl.

Wolters Kluwer generated a total return of 34% in 2023

We first invested in this business back in 2016. At that time, our judgement was that it was embarking on a similar ‘print-to-digital’ transformation that RELX had already begun to navigate. We thought that process would, in time, result in a larger addressable market protected by higher barriers to entry. Our expectation was that this would ultimately result in Wolters Kluwer’s cashflows growing and trigger a re-rating of its shares. RELX and Wolters Kluwer have been among our most successful investments, with the latter company’s shares having delivered 370% since we first invested. As with 3i, this has reminded us of the importance of ‘running our winners’, and not being fearful of apparently lofty valuation multiples – providing that the underlying business and investment case remain strong.

IG shares bounced back strongly

IG endured a challenging 2023 but the final quarter of the year brought an announcement that erstwhile CEO June Felix would be succeeded by Breon Corcoran, the former chief executive of Flutter Entertainment. With Flutter having been held in a number of Artemis’ funds over the years, Breon is well known to us and we would suggest that he is a high-quality appointment. His understanding of technology is a clear positive and we are looking forward to re-engaging with Breon in the coming months. IG has delivered compound annual growth in revenues of 18% over the past two decades, has net cash on its balance sheet and which is buying back a significant proportion of its own equity each year. Despite this, however, the shares currently trade on a free cashflow yield of 12%. We are hopeful that its new chief executive can begin to unlock some of this value.

What didn’t work

Dr Martens was the biggest detractor over the quarter

Disappointingly, Dr Martens issued its third profit warning of 2023. It continues to make progress in direct-to-consumer sales in Europe and Asia, which is a key part of its strategy. At the same time, however, it saw sluggish performance across both wholesale and direct-to-consumer sales in North America as a result of company-specific execution issues and a tough environment in the US. In a recent meeting, the chief executive outlined initiatives designed to fix these problems, including several personnel changes. Fundamentally, Dr Martens remains a unique brand with global resonance. Its shares now trade on an almost distressed valuation multiple (an enterprise-value-to-sales ratio of just over one). The obvious catalysts for improved share-price performance would be better guidance and improved execution.

Indivior’s shares de-rated

The market is still attempting to wrap its head around the implications of GLP-1 weight-loss treatments. Anecdotal evidence suggests that GLP-1 drugs supress cravings and change drinking and eating behaviours. Perhaps investors are extrapolating this suppression of cravings to opioids, whose misuse Indivior seeks to treat. If so, this may explain the de-rating of its shares. Enhancing our understanding of GLP-1s (and their significant potential impact across equity markets) is one of the team’s major priorities for 2024.

ITV’s shares fell amid US strikes

Weakness in ITV’s studios division as a result of strikes in the US and subdued demand prompted analysts to downgrade their earnings estimates. Andy Marsh attended a dinner with ITV’s management team in early November. They share our frustration over the company’s recent share-price performance. One step they could take would be to sell part of the studios business (we believe this is worth more than ITV’s current market cap) and use the proceeds to buy back shares. We would be supportive of any such attempts by management to realise value.

Activity

We reduced our allocation to NatWest

Lloyds is now our largest UK bank holding. It has a high-quality management team and has invested sensibly in its technology stack, enabling better digital engagement with its customers.

We added to GlaxoSmithKline and reduced our allocation to AstraZeneca

We have engaged with GlaxoSmithKline extensively in recent months and believe that there are more positive developments taking place here than the market is currently giving it credit for. AstraZeneca’s growth remains impressive, but we have some concerns around the magnitude of its cash conversion. The valuation disparity between the two stocks remains wide: GSK trades on a forward price-to-earnings ratio of 10x versus 17x for AstraZeneca.

ESG

We had a meeting with EasyJet during the quarter. Our overarching conclusion from that meeting – one that corroborates our own analysis – is that it is going to be challenging for the energy sector to supply enough sustainable aviation fuel (SAF) for the airline industry to decarbonise. If the European airline industry is to reach its stated targets for sustainable fuels as a percentage of the total fuel mix, huge tracts of land (several times larger than the entirety of the UK’s arable land) will be required to produce feedstock. This ‘cannibalisation’ of land does not necessarily align with a world in which population growth is driving demand for increased food production. In a meeting with Shell (not held in this fund) it suggested that SAF will remain more expensive than conventional jet fuel for some time, which ultimately means consumers paying more for their plane tickets.

Outlook

Over the year, our portfolio – with its with high ‘active share’ and its exposure to diversified sources of cashflows – delivered a notable margin of outperformance. This outperformance was derived across a number of stocks (including 3i, Next, Wolters Kluwer, Informa and Tesco) and sectors. In our view, this demonstrates the advantages of building a portfolio that is not overly exposed to any single industry, sector or investment style. Many of these companies have benefitted from their incumbency and strong competitive positions. Tesco, for example, has begun to grow its market share (from a high starting point of 35%) as the burden of too much debt has stunted rivals Asda and Morrisons.

We continue to believe that a number of tailwinds could support returns from the UK equity market from here.

• Inflation continues to fall.
• The UK economy has shown its resilience to higher interest rates.
• Share buybacks continue, driving growth in both cashflows and dividends per share.
• International investors are starting to wake up to the value on offer in the UK and are appearing on the shareholder registers of UK-listed companies.
• Valuations remain low, with the UK market (and our own portfolio) trading on a price-to-earnings multiple of less than 11x.

We would not be surprised to see some M&A activity taking place in 2024. The valuation disparity between UK and US companies of similar quality is simply too large. A takeover bid for a high-profile UK company may have more potential to re-ignite interest in the UK stockmarket than every positive macroeconomic datapoint combined.