Artemis Income (Exclusions) Fund
Q4 2024 update

Market review

The macroeconomic news flow was as volatile as ever in 2024. In the UK, inflation declined then began to reaccelerate, interest rates were cut (twice) but the timing and extent of future reductions remains up for debate. The wave of optimism in the run up to the general election in July now seems something of a distant memory as sentiment has soured in recent months. As ever, we have tried to focus on running a portfolio centred on doing what we know about, which is building a diversified yet focused portfolio of companies that can generate attractive long-term free cash flows and is not overly exposed to any single factor or investment style.

The fact that contributions to returns over the year were from a wide range of areas – both some of our longer term winners like 3i and Wolters Kluwer, as well as some more ‘value’ oriented names like the UK domestic banks, Imperial Brands and IG Group – in our view reinforces the merits of our investment approach. Another we would make is that the UK stock market is not the UK economy, and with less than 40% of our revenues derived from the UK the fortunes of our portfolio companies are not tied to the Bank of England’s next press conference.

Finally, we are confident that our portfolio is not ‘one and done’ after a particularly strong period of performance. We believe that we have built a portfolio of high quality (and in many cases globally relevant companies) that should be able to compound cash flows over time and as such continue to generate attractive returns above and beyond the shorter-term horizons.

Performance

The Artemis Income (Exclusions) fund returned 1.8% (net of fees, sterling) in the second quarter, underperforming the FTSE All Share index which returned -0.4%.

Past performance is not a guide to the future. Source: Lipper Limited/Artemis as at 31 December 2024 for class I accumulation GBP. All figures show total returns with dividends and/or income reinvested, gross of charges. Performance does not take account of any costs incurred when investors buy or sell the fund. Returns may vary as a result of currency fluctuations if the investor's currency is different to that of the class.

Positive contributors

Pearson’s third-quarter trading update was particularly positive, with all divisions delivering underlying sales growth. The North American higher education division - often a focus for Pearson's critics - grew for the first time in many years. While a more benign industry backdrop was helpful, this growth was in large part delivered by innovation, including radical product overhaul to improve the user experience, the application of AI and market share gains. We believe Pearson sits in a relatively unusual group of stocks where AI is a clear and demonstrable opportunity to enhance the user experience and create significantly expanded revenue streams. Previous CEO Andy Bird repositioned the business, and new CEO Omar Abbosh brings deep understanding of digital transformation, AI, and an execution playbook from his time at Accenture and Microsoft. We have engaged with senior leadership at length and believe the calibre of personnel gives cause for optimism.

We expect to see revenue growth continue to improve, with the low marginal cost of digital revenue leading to accelerating return on incremental capital and high and improved cash conversion. Finally, we see several patterns between Pearson today and the early stages of some of our successful investments in digital transformations like RELX, LSEG and Wolters Kluwer. The primary risk – as always – is execution. However, as Pearson’s weight in the portfolio suggests (it is nearly our largest position at present), we are optimistic as to Pearson’s opportunity to create meaningful global leadership in substantial and growing markets.

NatWest’s third quarter profits beat expectations by almost 20%, with full year income guidance increased. An £8.4bn increase in lending in the third quarter perhaps reflects the underlying strength of the UK economy and consumer, with our interactions with the likes of the banks, Tesco and EasyJet suggesting that the UK consumer is in far better health than portrayed by the media. This in turn raises the prospect of banks growing their loan book. As above, we see the fact that no additional taxes were announced on the banking sector in the Budget as positive, and indicative of the government understanding the role the banking sector must play in fostering economic growth. The thesis for the UK domestic banks that we hold remains the same: the market continues to underappreciate both the uplift in earnings from the 'structural hedge' (whereby banks invest a portion of their earnings in fixed-income instruments to smooth earnings volatility) and the longer-term impact on earnings and dividends per share of significant share buybacks at low valuations. We note with interest that NatWest bought back a further £1bn of the UK government’s stake in early November.

The fund also benefited from a possible approach by Moncler for Burberry.

Activity

We have been building a position in Whitbread. Whitbread’s market cap has fallen over the last 18-24 months. We believe the shares to trade below their book value and they offer a dividend yield of c.3.5%. We think there is a path for Whitbread to improve returns on capital employed, through transforming pub sites into hotels. Furthermore, Whitbread’s German business – currently loss-making – could begin to generate profits as the model is rolled out, with investors potentially beginning to think about Whitbread’s presence in Dublin and Vienna too if the profitability of the German model is proven to be successful.

Outlook

Looking to 2025, the outlook seems to be as incomprehensible as ever. But we would note a starting point where sentiment in US equities has rarely been this bullish, US consumer confidence in stock prices is increasing at its highest level ever and on a price-to-book-value basis the S&P 500 is trading at a record valuation. Consensus this bullish has rarely been a precursor to strong performance, hoever, some of the same could have been said at various points in the rise of the US market in recent years. Finally, we have been reminded in recent days – through a Truth Social barrage on the topics of the Gulf of Mexico (or America?), Greenland and Canada - of what we can expect with ‘Democracy with Donald’ and just how disruptive the incoming administration could be.

With all of this in mind, we believe our portfolio to have several attractions. A valuation of 12x forward earnings provides something of a margin of safety, as does a c.3.7% dividend yield that is between 1.5x and 2x covered by free cash flow. We believe this yield should be able to compound at mid-single digits over the medium to long term. The UK market, however, continues to increasingly focus on the short term and as such is as inefficient as ever. As a result, much of our portfolio remains misunderstood and we are therefore optimistic as to our ability to generate attractive long-term returns for our investors.