Artemis Income (Exclusions) Fund update

Source for all information: Artemis as at 30 June 2024 unless otherwise stated.

The largest mega-cap technology companies dominated global equities once again in the second quarter. Hopes that US inflation has resumed its downward trajectory and more mixed macroeconomic data suggesting that economic growth is beginning to normalise propelled global indices to new highs.

Despite this, the UK was one of the best performing markets globally, with the FTSE All Share returning 3.7% over the quarter. The macroeconomic headlines have continued to improve, with inflation falling to target, and Q1 GDP growth being revised up to 0.7%.

The calling – and conclusion – of a general election which saw the Labour party winning a majority turned out to be something of a non-event for financial markets. In fact, many of our portfolio companies have commented on constructive engagement with what appears to be an increasingly pro-business and fiscally sensible Labour party. In comparison with other parts of the world, namely France, which looks to be set for political paralysis after a snap election ended up a hung parliament, the UK looks to be relatively stable from a political perspective.

Performance

The Artemis Income (Exclusions) fund returned 2.6% (net of fees, sterling) in the second quarter, underperforming the FTSE All Share index which returned 3.7%.

What worked well

3i boosted by Action

A pre-AGM portfolio update from 3i revealed yet more robust growth from discount retailer Action, in which it has a 55% stake. Like-for-like sales growth of 9% and net new store openings of 107 year to date (vs. 84 for the same period last year) reaffirms the pace and quality of the roll out of Action’s highly successful, cross-border retail format. Action’s approach of passing on price reductions to consumers and not pushing margins too high as a result is a key ingredient in Action’s value proposition and the outstanding growth in cashflow it has been able to deliver. 3i has been a key contributor to portfolio returns since we invested more than 10 years ago, with dividends per share increasing fivefold over this period. Action’s management team believe that its store footprint can still triple in Europe, which suggests to us that this rollout (and resultant growth in cashflows) has some way to go yet.

Bank shares enjoy strong performance

NatWest shares – and indeed other UK banks – have enjoyed a strong period of performance. NatWest’s share price has climbed by almost 50% in 2024 thus far, illustrative of investors waking up to the high cash returns on offer and the effect of share buybacks at low valuations. Interest rates are likely to have peaked, but as long as they do not return to zero (a scenario that looks increasingly unlikely) the earnings power of a bank is transformed. Furthermore, earnings should be supported by the structural hedge – a proportion of a bank's portfolio that is invested in fixed income instruments to smooth earnings volatility. As these instruments roll off and are invested at higher rates (much of the hedge still yields 0.5%), the aggregate yield of the hedge (and its effect on earnings) will increase, with sell side analysis suggesting that the benefit to earnings from the hedge could amount to several billion pounds over the next two to three years.

What didn’t work well

SSP shares have been weak this year, reflecting the market’s lack of confidence in SSP’s investment in the significant growth opportunity it has before it (particularly in North America). This increase in investment has depressed near-term free cashflows, but our analysis suggests that SSP is investing this cash at attractive returns, potentially in the region of 25-30% return on capital. A cash-generative company with a multi-year runway of growth at highly attractive, self-funded returns seems an attractive setup to us, yet the UK stock market is not prepared to value SSP by looking beyond the next three months of earnings. We anticipate the shares are likely to trade on a double-digit free cash flow yield by 2025/2026 as these growth investments start to translate into earnings and cash. SSP is one of the most global mid-cap businesses listed in the UK, and in the past has been private equity owned. SSP’s prior owners were more comfortable with higher leverage and appreciated SSP’s global nature and growth characteristics. The fact that the UK market does not – and the current market capitalisation is £1.3bn – renders SSP vulnerable to a takeover in our view. As a result, the risk reward looks attractive to us at this juncture. We have been adding to the position.

Pressure on Easyjet

EasyJet H1 results were fairly solid, with yet more strong performance from the holidays business (>40% profitable customer growth in the first half) and a confident tone from management around the delivery of the medium-term target of achieving over £1bn profit before tax. Demand has remained resilient too, with passenger growth of 11% year over year in the first half. However, the shares were dragged lower by the unexpected announcement that chief executive Johan Lundgren will depart in early 2025 (and be replaced by Kenton Jarvis) and guidance from industry peer Ryanair that growth in summer fares will be more modest than expected. We remain of the opinion that EasyJet shares are too cheap, trading on around 7x forward P/E and below the replacement cost of EasyJet’s fleet.

And weakness in Pearson

Pearson shares have been rather subdued recently. But we believe the longer-term prize – substantial growth in cashflow growth and a re-rating of the shares – remains highly attractive. We see several parallels between Pearson today and RELX and Wolters Kluwer almost a decade ago (two of our most successful investments) when these businesses embarked on their transformative transition from print to digital. New chief executive Omar Abbosh continues to bed down well, and we believe that, given his prowess and experience in technology and AI, he is the right person to take Pearson into its next phase of growth and build upon the strong foundations laid by his predecessor Andy Bird. Considering the share’s current valuation of an 8% free cash flow yield, the risk/reward ratio remains attractive from here.

Activity

We added to Tesco. Its competitive position continues to strengthen, at the expense of several industry peers that are suffering from high debt loads. We also expect the company to buy back around 8% of its market capitalisation over the next 12-18 months, which should support dividend growth from a current dividend yield of more than 4%.

We also added to Legal & General. A safe, 9% dividend yield that should grow at mid-single digits looks attractive and the announcement of a share buyback at new CEO Antonio Simoes’ first capital markets day was welcome.

Finally, we added to SSE. We believe the market underestimates its structural growth opportunity as a beneficiary of decarbonisation and growing demand for power.

With respect to sales, we trimmed 3i and RELX, given strong share price performance, and exited Boliden and Indivior. Boliden has plenty of attractive attributes, most notably the strong sustainability credentials of its mines and smelting facilities but concerns around the medium-term delivery of cashflows have resulted in these characteristics not being recognised by the market. The shares have bounced this year in line with metals prices, so we used this strength to exit the position. We reduced Indivior significantly earlier in the year and given ongoing concerns about the potential for GLP-1s to disrupt Indivior’s business model, we believe there to be more downside risk to the shares and as such the risk/reward ratio has shifted. We therefore sold our remaining shares.

Outlook

The relative political stability of the UK today would have been difficult to imagine a short while after the tumultuous events of late 2022. Yet here we are, with a Labour government with a convincing majority that has so far sought to reassure both the public and investors about the importance of fiscal discipline. Boosting economic growth has been central to Labour’s manifesto and campaign, and we welcome the chancellor’s commitment to reforming Britain’s planning system which a number of our portfolio companies have cited as a barrier to investment. What is also important to consider is the UK’s political stability relative to other parts of the world, particularly Europe and the US where the future course of both domestic and foreign policy looks highly uncertain.

If we combine this stability with an economy that has already performed better than widely expected, and a consumer that remains in reasonable health with a high savings rate, the set up for the UK looks compelling from here, we believe.

The fact that an increasing number of international investors are showing up on UK shareholder registers – not just in the larger global businesses listed here in London but also in the more domestic areas of the market – suggests that sentiment behind the much-derided UK is beginning to change. This also corresponds with the recent acceleration of bids for UK companies, a trend we believe we will continue given a UK market which in large parts remains materially undervalued versus international peers. Buybacks remain a powerful catalyst, too, with record numbers of companies buying back their own shares. As a result of these factors, we see tangible evidence that the conditions surrounding the UK equity market are beginning to improve.