Artemis US Smaller Companies Fund update

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

2024 in review:

We started out the year with a real sense of optimism about US Smaller Companies that looked poised to beat their larger peers after a period of sustained underperformance. There were moments that stood out. In July, the Russell 2000 rallied sharply on the news of lower-than-expected inflation data and an expectation that interest rates would begin to fall. The market’s optimism proved to be short lived, with an equally large move downwards occurring at the start of August on a weaker-than-expected jobs report which brought recession fears back to the fore. In November, we had our second dose of euphoria with the election of Trump with his pro-business policies. The optimism was dashed in December when the Federal Reserve cut rates by 0.25% but indicated that the pace of cuts would slow because of renewed inflation concerns. This pushed bond yields higher, particularly hurting smaller companies, which tend to have a higher proportion of floating-rate debt. Volatility in the market belied a very robust economy, defying gravity in the face of high rates and still managing to achieve good growth, low unemployment and falling inflation.

The Russell 2000, despite this volatility in the newsflow, produced a respectable year returning 13.5% (in sterling) although significantly lagging the S&P 500 which returned 27.2%, mainly due to the 'Magnificent 7'. Industrials, financials, and technology were the top contributors, with energy being the only sector that produced negative returns. The respectable, but not outstanding, returns that the Russell produced over 2024 masks the opportunity set that was available for active managers. The Russell 2000, given its make-up of smaller companies, has structurally high levels of dispersion across fundamentals and share price returns. This dispersion presents an opportunity.

Over the year, our up/down process guided us towards winners and away from losers, with the fund returning 25.0% vs. the index's return of 13.5%. Our focus on businesses that have economies of scale, are higher quality in nature, and that can grow their earnings ahead of consensus rewarded us with good performance. From a process perspective, we did well in riding our winners and selling down positions where we had less conviction. If we look at our top five contributing stocks for the year, on average they returned 146.5% and while their weights in the portfolio would have varied through this period those positions on average accounted for 10.4% of the portfolio and contributed 9.1% to relative returns. Some of these we have been trimming. On the ‘losers’ side, our top detractors are a combination of businesses that we have sold (and which went on to underperform) and those where we still see an opportunity.

At a sector level, utilities and industrials really stood out, although it is worth mentioning that there was a broad contribution from a number of sectors. On the detracting side, technology and consumer staples were our worst performing sectors, with Lamb Weston (sold) and Builder FirstSource (maintained) our two weakest stocks.

Q4 summary

• Fund outperforms, returning 12.9% vs. 7.4% Index. Top of peer group quarter.
• Stock selection drives returns across broad array of sectors.
• Top contributors Jefferies, Axon, Affirm Holdings.
• Trump's election boosts markets, but hawkish cut dampens optimism in December.

An election, inflation scares, and to a lesser extent year-end profit-taking resulted in a volatile quarter for US equities and in particular for the Russell 2000, which was up almost 10% and then fell sharply on macroeconomic concerns, ending the year flat (in US dollar terms).

Over the period, the fund outperformed predominantly as a result of our healthcare and financials exposure and to a lesser extent industrials. On the negative side, only technology detracted meaningfully.

Contributors:

Jefferies: A holding we have had in the fund throughout 2024, as we expected capital markets and M&A activity to pick up as interest rates stabilised and then fell. There are two components that are working well for Jefferies. First, they have an attractive M&A backlog (above peers) which should feed into revenue growth in 2025. Second, they should stand to benefit from an increase in trading activity as a result of Trump's election as volatility increases. This remains a high-conviction position in the fund.

Axon: The market-leading security company that produces Tasers performed well over the quarter largely due to a massive beat on earnings ($145m vs $118m) for Q3. In addition to the refresh cycle that is occurring within its Taser business, Axon is also benefitting from its body camera business which is widely used by police forces around the world. They have been an early adopter of AI, offering police report writing software that uses the huge amount of footage they store to draft police reports. In addition to the long-term tailwinds, the business is seen as a beneficiary of Trump's presidency and the greater focus on border security.

Affirm: Another strong performer during the first two months of the quarter that lagged in December. Affirm is a buy-now-pay-later company, and currently the only listed operator in this area. It is continuing to take market share while also having an attractive group of merchants (such as Amazon and Walmart).

Bellring Brands: The protein drink producer is showing the ability to increase household penetration as more capacity is added. The stock has performed well and is tracking with our upside case although with the risk reward becoming less favourable. We have trimmed the position in favour of opportunities with a more attractive risk reward.

Pinnacle Financial: The regional bank produced a strong set of quarterly results mid-way through November, as well as guiding to strong revenue growth in 2025. The balance sheet growth through loans/deposits is predominantly driven by new/recent hires which Pinnacle has continued to do with 37 new relationship managers added in Q3 and 52 added in Q2. This should set the business up well as we move into 2025. Regional banks also stand to be a beneficiary under a Trump presidency who is likely to pursue deregulation.

On the negative side:

Builders FirstSource: The building material supplier had a tough quarter, lagging the aggressive market rally during the first two months and then giving up performance in December on the prospect of higher rates, which restricts housebuilding and therefore demand for building supplies. Despite slower housing activity we were pleased to see gross margin upside which we think highlights some of the through-cycle earnings power of these businesses.

Eagle Materials: The materials supplier continues to execute to a high standard despite poor weather. Pricing power continues to be a source of strength for the stock. We look forward to seeing where management can take these businesses over time.

Avantor: The lifesciences distributor suffered after the election on jitters around the impact that RFK Jr (Trump's proposed health secretary) would have on the healthcare sector more broadly. That being said, we are seeing an improvement in bioproduction and R&D which would be supportive to Avantor given they supply the materials and equipment that feed into these areas.

Western Digital: We are in the midst of a mid-cycle correction in the flash memory markets, specifically within the consumer-orientated end market. We believe that this correction will be short lived as there simply is not enough capacity to create a sustainable oversupply. The risk reward from these levels remains favourable for Western Digital.

Q4 Transactions

We made a number of changes over the quarter, rotating the portfolio into areas that would likely benefit under a Trump presidency. Herc, the construction equipment rental company, was our largest purchase over the quarter and a new position. Within Financials, we added Hamilton Lane and Evercore. The former is a private markets business that is making inroads into the wealth segment (an underpenetrated part of the market), and the latter is an investment bank that should benefit from a pick-up in M&A under Trump. Finally, Boot Barn, the cowboy boot retailer, which has a sticky client base and attractive store growth trajectory.

To fund these purchases, we trimmed our holding in Vistra (independent power producer) after an extremely strong run. We also sold out of APi Group as the investment thesis wasn’t playing out over the time frame that we expected. Within Healthcare, we trimmed our exposure in Natera on a more balanced risk reward.

Outlook

Despite a strong absolute and relative year of performance, we are optimistic about the composition of the portfolio as it stands, in particular given the macro context we find ourselves in. Real rates are likely to remain elevated as the market grapples with the possibility of a larger deficit, higher inflation, and robust economic growth. This will undoubtedly work against companies that aren’t profitable and favour those companies that are higher quality and have the scale and resources to deploy capital in a sensible manner - these are the types of businesses we like. We would also point to areas of the economy that are still depressed, namely industrials and healthcare. The former is still in contraction with the ISM manufacturing PMI below 50, and the latter is host to traditionally high-quality businesses that have been through a torrid time post COVID and are yet to experience that uplift back to pre-COVID levels. In summary, while sectors are following different trends, there remain opportunities for recovery in many.