Artemis UK Smaller Companies Fund update

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

Performance - Ahead of the index and most of our peers

The fund ended 2023 on a strong note, returning 9.4%, outperforming both the index (up 8.3%) and the peer-group average (up 6.7%).

For 2023 as a whole, it was up 4.9%, placing it in the top quartile of its peer group (where the average return was zero) despite being behind the index (up 10.1%). For reasons we examined in our last quarterly report (principally an unusually narrow market), only one of the 47 funds in our peer group was ahead of the benchmark index in 2023. 

Top contributors

Consumer discretionary stocks - Our overweight position in consumer discretionary stocks was helpful for relative returns over the quarter. The sector benefited from falling inflation, declining bond yields and a return to positive real wage growth. On The Beach said that “summer 2024 was trading significantly ahead of 2023” even at this early stage in the booking season for summer holidays. Its shares jumped by 65%. Hollywood Bowl, meanwhile, rose by 24% after it published a strong set of interim results.

Kin & Carta - Private equity group Apax Partners made a recommended cash offer of 110p per share (41% premium) for Kin & Carta, the digital transformation consultancy. This was subsequently revised up to 120p (54% premium) before BC Partners came in with an offer of 130p (67% premium). We no longer hold the shares but this may yet not be the final offer. These premiums demonstrate just how undervalued some areas of the UK smaller companies market are.

ScS - During the quarter, Poltronesofà (a European sofa retailer with a strong presence in France and Italy) offered 270p per share for ScS. This represented a 66% premium to the pre-bid price. Taken together, the bids for ScS and Kin & Carta took the total number of recommended bids we have received for our holdings since 2019 to 27 at an average premium of 50%. We regard this is as further evidence of the underlying value in our portfolio and, indeed, in the wider UK smaller companies market.

Biggest detractors

Alliance Pharma – Shares in the consumer healthcare group fell by 15% over the quarter. There was no news and we took advantage of this weakness to add to our holding. Our clear preference for companies with strong balance sheets means we find Alliance Pharma’s current level of indebtedness to be uncomfortably high. Set against that, however, we expect leverage to fall quickly as sales of Kelo-Cote into the key Chinese market rebound following recent disruption. The shares generate a free cashflow yield of over 10%.

Other detractors included Alpha (no news but lower interest rates are a potential headwind); Ebiquity (no news) and Carr’s (trading in line albeit speciality agriculture remains challenging and change of CEO).

Activity – Profit-taking and new additions

We used the proceeds from the cash takeovers of Curtis Banks, Kin & Carta and Lookers to start two new positions, in JTC and Next 15.

JTC provides administration services to funds and private clients and benefits from a high degree of recurring earnings. A combination of high organic growth, high margins and minimal capital employed drives its high returns on capital and strong growth in earnings. This growth has been supplemented by acquisitions in what remains a highly fragmented market.

Next 15 is a technology and data-driven growth consultancy. Concerns about an economic slowdown have driven the valuation multiple down to what we regard as a very attractive level despite Next 15's excellent long-term growth record. Its balance sheet is strong (with virtually no net debt at year end) and it generates a free cashflow yield in excess of 10%.

We added to Alliance Pharma, QinetiQ and SSP. We also participated in an equity raise by Videndum (camera and video production accessories) which we believe addresses concerns about its balance sheet and leaves the business well placed to benefit from the recovery in activity following disruption the US writers' and actors' strikes.

We took some profits in defence company Chemring, after its share price bounced on good results. We also trimmed our large position in Computacenter, whose shares had risen by over 40% on the year. We reduced our holding in SigmaRoc, whose acquisition of CRH's lime businesses changes the risk profile of the business.

Outlook – Explaining our bullishness towards UK small caps

Most people we speak to agree that the UK stockmarket looks cheap. Most of them also accept that small caps outperform over the long run. Understandably, however, they are looking for the catalyst that will spark outperformance by small companies. Where might they find it?

The weaker-than-expected inflation reading in October may come to be viewed as marking the turning point for UK smaller companies. Inflation in November continued to surprise on the downside. Inflation is now under 4% compared to 11% in September. The current rate-tightening cycle looks to be over and investors have moved to speculate about the timing of the first interest-rate cut. We think this reduces the chance of a UK recession in 2024 and should be supportive for UK small caps.

While flows into UK equity funds were negative in 2023 (and small caps followed a similarly negative pattern) this could change quickly when sentiment changes. Over the last five years, the market capitalisation of the constituents of the FTSE Small Cap (excluding investment trusts) index shrunk by almost 50%. This has been the result of lacklustre returns, a falling number of constituents (thanks to M&A) and cash returns to shareholders (we cannot remember a time when a greater number of small cap stocks were buying back shares). This will multiply the impact of the inflection from outflows to inflows when it happens and have a disproportionately (positive) impact on share prices.

Value or growth? The most important question now is how to play the small-cap rally

The last decade saw growth companies outperforming handsomely as their valuation multiples swelled under the influence of QE and ultra-low interest rates. This process was turbo-charged by the volume of money pouring into growth-oriented funds. The last couple of years, however, have seen this trend reversing as the interest-rate cycle turned, ending the era of ‘free money’.

And now? The majority view seems to be that a run of poor performance from growth funds over the last couple of years represents a great buying opportunity. We are not so sure. Admittedly, companies that can compound their earnings (and cashflows) at high rates deserve a high rating. The snag is that we’ve been looking for these companies in the UK for 30 years – and have concluded that genuine, long-term compounders are rare beasts. Many would-be quality growth compounders make promising starts. Experience suggests, however, that most of them struggle to keep the initial momentum going. Even after the most recent decade in which growth outperformed, small-cap value shares have outperformed growth shares by a wide margin over the last 50 years.

Value outperforms long terms²

Cumulative performance of value vs growth stocks within NSCI XIC, 1955-2022

Still, after their collapse in the last year or two, we have been looking for value among de-rated growth companies. Over the last year or so, we bought into companies such as GB Group, Future, Gamma and Alpha Group after their share prices fell significantly. So at this juncture we see a balanced approach as providing the best way forward. We are happy to buy growth companies, but only if the price is right.