Artemis Funds (Lux) – US Extended Alpha update

Inflation trending downwards

The start of the fourth quarter saw significant volatility in markets with higher bond yields, unstable energy prices and geopolitical risks all conspiring to sour market sentiment. The spike in bond yields caught many observers by surprise, since many inflation indicators were already moderating or were soon expected to. A combination of technical forces including the Bank of Japan’s announced reversal of their yield control policy and increasing US budget deficits were blamed for the spike in 10-year US Treasury yields.

As we moved into November, expectations of a ‘Goldilocks’ outlook trumped the bearish sentiment that had dominated October with the Federal Reserve signalling a more dovish stance, moderating inflation, and falling oil prices. This optimism about the inflation, and interest rate picture continued into December with the Fed confirming the market’s expectations that the tightening cycle was most likely over and forecasting a series of rate cuts in 2024.

Bullish sentiment drive markets higher

With optimism coming to the fore, the S&P 500 finished the year up 26.3% (in US dollar terms) which represented more than twice the average 10% annual total return for the past three decades.

In this 'risk on' environment, the fund underperformed the index, returning 9.8% (in US dollar terms) vs. the S&P 500's 11.7% over the quarter. We continued to maintain a relatively defensive positioning, with a net exposure of around 96%. Our longs have tended to be either resilient 'discounted compounders' or early cyclicals and our shorts have been spread across the market but as a group tended to have higher levels of debt than the longs. With that backdrop and positioning in mind, the main reason the fund lagged during the month was the negative contribution from the short book.

While the fund slightly underperformed the index over the quarter, we were encouraged to see a number of our long-term theses playing out.

Falling interest rates lift housing-related stocks

Our housing-related holdings performed strongly over the quarter, buoyed by the expectation that interest rates would start to fall. Of particular note was our holding in TopBuild (insulation and building materials) which was the top contributor over the month.

Discount retailers perform well

We have held positions in 'off-price' (discounted) retailers for some time. We have a cautious outlook on consumer spending because of the lagged impact of higher interest rates, the running down of 'excess savings', rising defaults on credit cards and car loans and the restart of student loan repayments that were frozen during the pandemic. Against this backdrop, consumers will trade down and off-price retailers should benefit. We expect same-store sales growth to remain healthy, as well as continuing expansion in the number of stores, and margin recovery back to pre-covid levels. This thesis continued to play out over the quarter with our holdings in Burlington Stores and Ross Stores performing well.

Rest of the best

Outside of these two themes we had strong relative contributions from Gartner (IT business), Amazon and Lam Research (semiconductors). Our underweight to the worst performing sector, energy, also helped relative performance.

Shorts hold back performance as challenged businesses receive lifeline

While the market had been strong for much of the year, in December there was a particularly dramatic rotation. Data from Goldman Sachs indicates that long-short hedge funds experienced the second largest performance unwind of the last decade, as suggested by the ‘Goldman Hedge Fund VIP vs Most Short Index’ where the most widely held longs underperformed the most shorted stocks by 16% during the month. From a factor perspective, the best performers within the S&P 500 were both high beta and high volatility, with the worst performing factors being low volatility and quality. The ‘Profitless Tech’ and ‘GS Most Shorted’ Indices for instance, were both up more than 21% during the month.

In this environment, our short book proved to be the largest detractor over the quarter causing a 1.4% hit to performance in December. The particularly large impact was due to the sharp rotation and correlated market style inflections detailed above. Thematically many of our shorts had higher financial leverage and lower quality and hence rallied particularly strongly in the risk-on environment.

Within our long exposure, it was in those businesses that were lower beta and lower volatility that underperformed, shunned in favour of businesses that would be more exposed to the rotation in the market. Holdings that fall into this category would be AON, McKesson, and Elevance.

Outlook

At the time of writing the Fund has net exposure of 96%, consisting of 117% on the long book, 19% shorts and 2% delta-adjusted S&P500 put options.

We enter the year with the S&P500 trading at a 19x PE multiple, with consensus expectations for 11% EPS growth. Both of these numbers are historically high.

There are four dominant themes in the fund. First, continuing recovery from post-pandemic disruption, which includes Avantor, Thermo Fisher and Icon Labs in life sciences through to Amazon. Second, early cyclicals such as mortgage-related companies, trucking, housing and semiconductors, all of which have heavily depressed fundamentals and varying degrees of discounted valuations. Third, exposure to infrastructure through aggregates and cement. Lastly, the main body of the fund is in ‘discounted compounders’ which tend to be great resilient businesses, many of which have become even more discounted recently. From a sector perspective, the above translates to being overweight utilities, healthcare and materials, while being underweight staples, tech and real estate.