Artemis Funds (Lux) – US Extended Alpha update

The S&P500 Index rose 8.7% (US dollar total return) in the quarter. The market's return was particularly concentrated in the technology giants which benefited from positive earnings and optimism over the future for artificial intelligence (AI).

The fund outperformed the Index, rising 12.1%, despite having a moderately defensive stance, and either not owning or being underweight some of the tech heavyweights like Apple and Tesla. Outperformance came from positive contributions from Meta (good results and signs of turnaround), Vulcan Materials (strong aggregates pricing), Nvidia (huge beat on AI driven earnings – we benefited from a call option position), Topbuild and Azek (both benefiting from housing recovery sentiment). The principal detractors were Tesla, Gilead and Broadcom.

Buys – we bought several new stocks in the fund

Steris

Steris is a leader in the healthcare sterilisation equipment market. Through its equipment such as sterilizers, washers and surgical tables, and consumables such as detergents, Steris' products help healthcare providers and life sciences companies with infection prevention. Whilst this is normally a steady growth market due to both the defensiveness of the end market, and the regulatory and reputational awareness tailwinds, we believe they are likely to experience above normal growth in the near term from the rebound in hospital procedures post pandemic. We believe the company's long-term earnings growth potential is not reflected in the current valuation.

Valmont

Valmont is a niche company with leading positions in the two attractive markets of electricity infrastructure (pylons) and agricultural productivity (large-scale irrigation equipment). The former is benefiting from the huge investment required in coming years to strengthen the grid, and deal with the increasing electrification demands of electric vehicles, and the latter is driven by increasing awareness, especially in emerging markets, of the productivity benefits of using technology as part of crop lifecycle management. The shares have weakened in recent months due to concerns over the potential impact of soft crop prices on farmers' incomes and hence irrigation investment. We see this as an opportunity to buy into two growth markets at a favourable valuation entry point.

Wesco

We also added Wesco, a leading electrical products distributor, which has exposure to a range of attractive end markets from data centre construction through to utilities electrification. The stock trades at a very low multiple due to apparent investor concerns over their historical earnings volatility. We believe the profile of the company has improved in recent years because of its increased exposure to secular growth markets and increased scale, and that its valuation looks attractive relative to a peer group consisting of many expensive stocks (which we are avoiding or short).

McKesson

McKesson is a drug distributor which has a leading franchise in specialty and especially oncology drugs and services. Like its peers, it aims to deliver consistent mid to high single-digit sales, and solid double-digit earnings growth, which we believe it is likely to achieve, making the current valuation very cheap.

CSX

CSX, the railroad company, is second position in a sector that we see as trading on trough valuations and potentially trough fundamentals. Transport is early cycle and so if we are right, activity rates may soon start to recover which will likely raise spirits in the sector. We continue to hold Norfolk Southern, and at the same time we initiated a short in another railroad which is trading a high valuations compared to history, and where due to its geographical profile, activity levels are not currently so depressed.

Moody's

Moody’s, the credit rating and information services company, has seen depressed fundamentals in its issuance business (roughly half of sales) for the past two years. High yield debt issuance in particular has collapsed to near historic trough levels of activity. Not surprising due to low levels of corporate activity and with companies having refinanced at low rates a few years ago when rates were low. However, the beauty is that debt unfortunately does not go away, companies need to refinance, and we believe there is pent up demand for balance sheet restructuring once or if funding costs moderate. We believe this is giving us an attractive valuation entry point into a high return, high growth franchise which is cyclically depressed.

Eagle Materials

Eagle Materials is a building products supplier with a focus on the wallboard and cement markets. The cement industry is capacity constrained at a time we are seeing a stabilisation in the depressed housing market, as well as ongoing infrastructure growth. While Eagle operates in high carbon emitting industries, it is making changes to its production process which is leading to impressive improvements to the carbon intensity per volume produced. We believe the fundamental outlook is not reflected in the valuation.

Netflix

Netflix, the video streaming company. We should clarify that this is not due to our view on the latest release of Bridgerton, The Diplomat or Stranger Things. Rather, having followed the company for years, we believe that the company is potentially at an important inflection point in terms of revenue and profitability acceleration.

Gilead Sciences

Gilead Sciences is a biopharma company which is known foremost for dominating the HIV market with a broad range of drugs used for both the treatment and prevention of the disease. Gilead has spent more than two decades since its first HIV drug was approved, improving the efficacy of treatment through new combinations and more convenient administration which ranges from daily pills to less regular injections. Its HIV franchise represents nearly two thirds of sales, and recently extended patent protection for another 10 years, which is a long time compared to most large pharma stocks. This is important since it underpins potentially low to mid-single digit annual growth over that period, due to increasing penetration of its prevention therapies. On top of this the company has been building out a strong position in cell therapy which is a complicated but high growth area, and has a promising franchise and pipeline in oncology drugs. Since the stock has been disappointing over recent years, the market is sceptical and it trades at a PE of 11x. We believe the downside is limited by the duration of the core HIV franchise and its low valuation, but the upside could be quite substantial in comparison should the growth in HIV prevention, cell therapy and oncology continue.

Ross Stores

Ross Stores, the ‘off-price’ retailer. We wrote late in 2022 about our purchase of Burlington Stores, the smallest of the three off price retailers in the US. After very strong share performance in Q1 we reduced the holding given the less attractive risk/reward profile. In the last few months, the high frequency data on the retail sector has been coming through and it looks concerning. Given most of these companies have a January year end, we do not get results for Q1 until the end of May. Industry wide retail sales continues to decelerate, in March low-income consumers saw headwinds from the ending of SNAP benefits and lower tax refunds, credit card balances and the interest rates on those balances continues to rise, traffic trends are weak and despite the industry doing a huge amount to clear inventories in Q4, promotions remain very high through March and April. So against that backdrop it may sound counter intuitive to add a position in a retailer exposed to these trends. Due to all these headwinds, Ross’s margins are currently depressed as is its valuation, and we believe there is scope for substantial recovery in fundamentals in coming years for this well positioned company.

Sells

We sold Advanced Micro Devices, whose shares have been on a tear on the back of excitement over the AI boom, and in particular since some hyperscalers like Microsoft have implied that they want a second supplier of AI chips alongside Nvidia. The issue for us is that we bought AMD when it was cyclically depressed at the end of last year, and we now find the valuation less attractive.

Aramark, the catering services company, on the basis of valuation, having waited years for the impressive turnaround to bear fruit.

Ralph Lauren, the luxury clothing company, we sold due to having performed exceptionally well in share price and profit terms compared to most of their retail peers and hence we see better value and a better risk profit elsewhere in the sector.

Bristol-Myers Squibb and Darling. In both we have reduced conviction in the fundamental outlook and hence risk-reward profile.

T-Mobile, on reduced conviction in their future growth from increased sector competition.

Shorts

We were active on the short side in a broad range of sectors from IT services, railroad, consumer lending, several data services companies, medical devices and a beer company. All we believe have high expectations for growth which may disappoint, and valuations which are unattractive at this level. Moreover, several such as the data services and railroad provide what we believe to be an attractive hedge on our large long positions in railroads and data services companies like Transunion and Equifax.

Outlook

Our view is that we are in the midst of an economic slowdown with certain later-cycle areas such as capital goods or consumer cyclicals still at risk of seeing deteriorating fundamentals, while at the same time other earlier cycle areas such as transport, housing and retail have already experienced a downturn, and may be close to a trough.

In terms of positioning, the majority of the fund on the long side is invested in discounted compounders. These are secular growth companies with relatively low economic sensitivity. As a theme these have lagged the market strength of the past year. Both steady growth and high-quality companies have become relatively quite substantially cheaper over the year and we believe this represents an attractive ‘catch-up’ potential for a significant portion of the fund’s holdings. This includes Icon in outsourced pharma research, through to Intercontinental Exchange, and Autozone the autoparts retailer.

The cyclical side of the portfolio is biased on the long side to early-cycle areas such as transport, advertising, retail, and housing, which have already seen a fundamental slowdown. This is set against a short book of late cycle cyclicals in capital goods, autos and some parts of retail. The overall positioning of the fund is moderately defensive with an overall net exposure of 98% at the time of writing. This consists of 99% in equities, offset by 1% delta adjusted S&P500 put option exposure. Importantly, our 16% short book includes many stocks where we see asymmetric risk to the downside from both economic weakness, and high financial leverage.