Artemis Funds (Lux) – UK Select Fund update

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

Objective 

To grow capital over a five-year period.

Benchmark

FTSE All-Share Index TR

The benchmark is a point of reference against which the performance of the fund may be measured. Management of the fund is not restricted by this benchmark. The deviation from the benchmark may be significant and the portfolio of the fund may at times bear little or no resemblance to its benchmark.

Review

The third quarter was a rollercoaster ride for the UK market, albeit one that ended with it back in positive territory. The ride became particularly bumpy in early August, when weaker manufacturing numbers in the US and a decline in payrolls data prompted sudden fears of recession in the world’s largest economy. This coincided with a decision by the Bank of Japan to raise interest rates, catching some investors off-guard and prompting them to hurriedly unwind their yen carry trades.

As markets fell, our view was that the changes in the outlook were comparatively modest. We therefore regarded the sell off as an opportunity to add to the fund’s holdings in some of our favoured names, such as Standard Chartered and Intermediate Capital.

Helped by the Federal Reserve’s emphatic, 50-basis-point interest-rate cut, markets subsequently regained their composure and, by the end of the quarter, were setting new highs.

Contributors

International Consolidated Airlines Group (IAG)

Results from airline holding company IAG beat expectations thanks to strong trading by British Airways (on routes to North America) and by Iberia (on routes to Latin America). In addition, net debt came in significantly lower than expected through a combination of higher profits, strong bookings and lower capital expenditure (a result of delays in the delivery of new aircraft). With the company having already reclaimed its investment-grade status, it can now start returning capital to its shareholders, initially through a (modest) dividend. In our view, a price-to-earnings multiple of just 4.5x does not adequately reflect the returns profile of this business.

AstraZeneca (not owned)

Index heavyweight AstraZeneca fell in September as the market reversed some of the rotation into defensives seen in August. Stronger sterling and a weaker-than-expected trial result for one of its new oncology drugs also weighed on sentiment.

WH Smith

An encouraging trading update highlighted both the continuing strength of WH Smith’s UK travel business and its improved performance in the US. It also announced a £50m share buyback to be funded by the release of £75m from its (over-funded) pension scheme. The business is steadily returning to its pre-Covid model of rolling out concessions at travel hubs while slowly shrinking its legacy high-street business, all the while returning a steady stream of cash to its shareholders through dividends and buybacks.

NatWest

In late July, NatWest reported an impressive set of earnings for the second quarter, underpinned by a combination of lower-than-expected provisions against bad loans and better-than-expected interest income. It has now delivered a total return of 67% to its shareholders over the year to date. We remain highly positive on the prospects for the group, partly because the interest rate on its 'structural hedge', a risk-management tool used by banks to manage their exposure to fluctuations in interest rates, will continue to rise over the coming years. Some £35 billion of maturities are due to roll in 2025 and 2026. These currently yield just 0% and 0.4% respectively; those yields are set to rise to more than 3%. This is the chief reason that we expect earnings for UK domestic banks to continue to rise in the coming years even as interest rates fall.

Detractors

Oxford Instruments

There was no concrete news from Oxford Instruments to explain the 13% decline in its share price over the quarter. Equally, trading in its shares tends to be quite thin, so they can move somewhat erratically in the short term. If we were to look for an explanation for the weakness we saw over the summer, we might cite the sell-off in some industrial stocks in response to weaker survey data and increased fears of a ‘hard landing’ in the US. Equally, the recent strength of sterling represents a slight headwind for this export-focused business. We believe this is largely noise and retain our holding in this unique company.

Melrose

Aerospace company Melrose came under pressure as a result of weaker guidance on future cashflows. Melrose needs to increase its capital expenditure to support its new business wins (which we view as a good thing) and to pay for rectifying metallurgy problems in Pratt & Whitney GTF engines, in which it is a minor partner. These problems were already known, but Melrose is now less confident that it will receive compensation from RTX, which led the development programme.

In addition, some hedge funds called Melrose’s accounting practices into question. These questions surrounded the way it accounts for future earnings from its revenue and risk sharing partnerships (RRSPs) with engine makers. Having discussed this matter with the company, we believe its accounting assumptions make sense. It is contractually prohibited from disclosing the financial details of its partnership deals, so we are obliged to take some of its assumptions on trust. We would note, however, that results from engine manufacturers such as GE, Safran and Rolls-Royce showed that projected sales growth and margins are materially higher than they were a year ago. Melrose will be a beneficiary of these improvements.

Unilever (not owned)

In general, we remain wary of the challenges facing fast-moving consumer goods (FMCG) companies such as Unilever. Its latest set of results showed volumes growing by just 2% despite the fact that circa 60% of its sales are to (rapidly growing) emerging markets. This is suggestive of the structural headwinds facing these types of businesses. On the positive side, however, Unilever’s margins surprised positively as it benefitted from a sharp fall in soft commodity prices which it has been slow in passing on to consumers. In addition, its new management team is working hard to shake up the business, putting its ice cream division up for sale and taking an axe to the ‘matrix’ operating structure to cut costs in Europe.

Evoke

The gaming group formerly known as 888 issued a profit warning on the back of weaker margins in the UK. The main disappointment would appear to be that marketing investments around events such as the Cheltenham Festival and the Euro 2024 football tournament did not deliver the hoped-for returns. Some customers took up Evoke’s introductory ‘free bet’ offers but did not return to bet again. The company’s management expects to see a much stronger performance in the second half of the year.

Activity

Add: Entain

We added to our holding in gaming group Entain. Recent management changes are beginning to show signs of stabilising its operating performance. If metrics continue to improve, it may encourage MGM Resorts, its US joint venture partner, to pay up for full control.

Add: Morgan Sindall

We added further to the fund’s holding in construction group Morgan Sindall after another set of strong results. We believe this business is phenomenally well placed to benefit from many of the spending priorities of the new government.

Add: Smurfit Westrock

This global packaging company was formed by a merger between Irish-based but UK-listed Smurfit Kappa and US-based WestRock. Following the merger, its primary listing moved to New York resulting in its exit from the UK index and forced selling by index trackers. It retains a secondary listing in London. We continue to believe that the deal will prove to be value accretive. A change in management at the two largest players in the packaging market (circa 60% market share between them) will see the previous strategy of sacrificing price for market share reverse, resulting in sharply improving returns across the industry.

Reduce: DS Smith

We part funded our addition to Smurfit Westrock with a reduction in its rival DS Smith, which has performed well and is now trades on a premium in price/earnings terms, despite being a very similar business facing into the same end markets.

New holding: Rosebank

We started a very small holding in cash shell Rosebank at its IPO. This is the new vehicle for the highly regarded management team best known for leading the impressive turnaround at Melrose. By participating in this cash shell, the fund will be at the front of the queue to fund the next deal if it finds a suitable acquisition target. The share price is already significantly up on its IPO price.

Reduce: NatWest

For reasons outlined above, we remain extremely positive on the prospects for NatWest. The shares’ strong performance over the year to date, however, had seen the holding growing to account for more than 6% of the fund. We have taken some profits.

Sale: Tyman

We sold our holding in door-and-window producer Tyman when the takeover bid from Quanex completed. This was a part-cash, part-stock deal and the fund now has a small holding in Quanex’ US-listed shares. In these situations, it is typically a good idea to ‘warehouse’ the residual equity positions for a few months to try to maximise value rather than immediately rushing for the exit. In this instance, we are inclined to wait to see if rate cuts in the US generate more investor interest in companies exposed to the housing market.

Outlook

We have become more cautious on the outlook for global growth in recent months. Economic data in a number of countries has looked weaker. Businesses in some traditionally ‘early-cycle’ sectors, such as recruitment companies and short-cycle industrials, are reporting tougher trading conditions. In addition, it seems prudent to dial back some cyclical risk ahead of the US election. Irrespective of who wins, the twin stimulus supplied by strong consumer demand and government spending that has supported US growth up to this point seems likely to fade going into 2025. Over the last six months, we have sold Ashtead, Tyman and M&G and added new holdings in National Grid and Plus 500. This has reduced – but not eliminated – the fund’s pro-cyclical tilt. For now, we continue to watch economic and company news closely to decide if we should move further in this direction.

Closer to home, we continue to believe that, in a global context, the UK economy is a relative bright spot. British consumers are well-placed to spend more, and it is already clear that the cut in interest rates is feeding through to improving activity in the housing market. Historically, the health of the UK housing market has been a big driver of consumer confidence.

Despite the gloomy press narrative about the new government, we taken some encouragement from our recent meetings with companies in the housing and electricity sectors. They have been pleasantly surprised by the new government’s attempts to attract private capital and to tackle long-term problems with the planning system.

While we wait for some clarity on the US election to emerge, we take comfort from the fact that, despite its strong performance over the year to date, the fund still trades on just 9.2x earnings, a level we continue to believe offers plenty of scope for a re-rating if sentiment towards the UK continues to improve in the way we believe that it should.

Having been in the relative wilderness for the best part of a decade, we are hopeful that the changing narrative on the UK economy – particularly at a time of increased uncertainty elsewhere – will provide the catalyst for the UK market to finally start to close the valuation discount to its global peers.