Artemis Funds (Lux) – UK Select Fund update

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

Objective 

The fund is actively managed. Its aim is to increase the value of shareholders’ investments primarily through capital growth.

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 of the quarter to 31 December 2024

The final quarter of 2024 saw the UK market weakening, partly thanks to a badly received Budget. It heralded an increase in government spending to be funded, in part, by a sharp rise in employers’ National Insurance Contributions (NICs). The OBR’s view was that the net impact was likely to be inflationary. Moreover, the lack of any material supply-side reforms meant the Budget was deemed to have done little to improve the UK’s long-term growth prospects.

The bond market, meanwhile, took a dim view of the additional gilt issuance that the Budget will necessitate, sending the UK’s borrowing costs higher. Within the UK market, shares of companies whose fortunes are sensitive to interest rates – real estate companies, housebuilders and consumer cyclical businesses – came under pressure. Set against that, banks generally performed well due to a combination of strong third-quarter results and the potential for ‘higher for longer’ interest rates to support their future profitability.

Strongest contributors

International Consolidated Airlines Group (IAG)

Airline holding company IAG continued to rally. Its third-quarter results came in ahead of expectations thanks to the strong performance of British Airways. Analysts, meanwhile, upgraded their earnings forecasts in response to an investor day at Heathrow which showcased the investment it is making in BA. Although it is still early days, it would appear that perceptions among the airline’s customers and its staff are already moving in the right direction. With its pension-fund deficits having been eliminated, IAG will complement its recent decision to resume paying dividends with a €350 million share buyback programme. We welcome this move. As our recent experience with banks such as NatWest has shown, when companies start buying back their shares on a p/e of below 5x, the impact can be very powerful.

Standard Chartered

We have seen a number of encouraging earnings updates across the banking sector in recent months. In Standard Chartered’s case, its better-than-expected third-quarter performance stemmed from the strong performance of its wealth division. The bank raised its target for returns on tangible equity (RoTE) and now plans to return $8 billion to its shareholders over the 2024-26 period, a cash return equivalent to more than a quarter of its current market cap.

Morgan Sindall

An unscheduled trading update highlighted that trading is materially stronger than expectations. This is being driven by the continued strong performance of Morgan Sindall’s fit-out business and by better-than-expected trading in its partnership housing division. The long-term prospects for both of these markets remain strong and the fit-out business appears likely to benefit after the industry’s second-largest player, ISG, collapsed into administration.

Barclays & NatWest

NatWest and Barclays both published strong third-quarter updates in which the positive surprises largely came from interest income; net interest margins (NIMs) are expanding. The interest rate on their 'structural hedges', risk-management tools banks use to manage their exposure to fluctuations in interest rates, should continue to rise significantly over the next two years. This is the chief reason that we expect the earnings of the UK’s domestic banks to continue to rise even as interest rates creep lower.

Largest detractors

Vistry

Vistry was one of the fund’s strongest performers in the second quarter but disappointments through the second half of the year saw it becoming 2024’s biggest negative. The most recent warning, which came on Christmas Eve, was a disappointing end to the year. While previous warnings had been focused on specific sites in Vistry’s southern division, this one was due to weaker sales in private markets as well as delays in completion ahead of the year-end on some of its larger projects. Profit guidance was downgraded again. Three warnings in quick succession is a bad look and we would expect to see a re-set of strategic targets alongside changes in operational personnel soon.

HSBC (underweight)

Having lagged its peers earlier in year, HSBC performed well as investors adjudged that its earnings should benefit from ‘higher for longer’ interest rates in the US. The fund has a c.3% holding in HSBC but, reflecting our preference for Standard Chartered, we are underweight relative to the index.

Mitchells & Butlers

Pub groups were seen as one of ‘losers’ from higher National Insurance contributions and the increase in the National Living Wage. We continue to believe that a tough backdrop will see the strong getting stronger as weaker players lose market share and/or exit. Like our other consumer-facing stocks – Whitbread, Howden and Jet2 – Mitchells & Butlers boasts above-average margins, a strong balance sheet and significant asset backing. This should ensure that it can continue to invest and gain market share should things get tougher over the months ahead.

WH Smith

Despite announcing what we viewed as a good set of results, WH Smith came under pressure for reasons similar to Mitchells & Butlers. The impact of the higher staffing costs that will result from the Budget will be greatest on businesses that employ a lot of people who are either part time and/or on a pay rate near the National Living Wage.

Workspace

Real estate companies tend to underperform whenever bond yields move higher. Workspace trades on a c.45% discount to book value and, with a 6.5% dividend yield covered by a growing rental stream, we continue to see value here. Workspace offers valuable portfolio diversification should the Bank of England change tack and cut interest rates more aggressively as we go through 2025.

Activity

New holding: Aviva

We initiated a new holding in Aviva following its bid for Direct Line. The deal appears to make both strategic and financial sense:

• It will increase its exposure to ‘capital-light’ general insurance earnings.
• We see scope for the combined entity to enjoy substantial cost synergies given the overlap between the two businesses (no need to have two IT systems, call centres, repair networks, head offices and so on).
• The deal will increase the combined business’s bargaining power with its suppliers and distributors (MoneySupermarket etc) by doubling its share of the motor insurance market to around 20%.
• Higher real gilt yields and tight credit spreads should be positive for the solvency positions of the UK annuity writers.
• Finally, with a market cap approaching $20 billion, the shares will begin to appear on the radar screens of global investors.

Reduce: DS Smith

We funded the holding in Aviva by taking profits in DS Smith, which has performed exceptionally well courtesy of the rally in the shares of International Paper following the US election. We remain enthused about the story but are increasingly struggling with the valuation relative to other opportunities available in the UK market.

Reduce: Quanex

Last year, we sold our holding in door-and-window producer Tyman when a takeover bid from Quanex completed. This was a part-cash, part-stock deal and the fund was left with a small holding in Quanex’ US-listed shares, which we have begun to reduce.

Outlook

Interest rates may need to fall by more than the market anticipates. Weaker economic growth and (potentially) higher unemployment should reduce inflationary pressures, and we expect the Bank of England will respond by cutting rates in the second half of the year. The market is currently pricing in fewer than two rate cuts in 2025. That does not feel enough to us, particularly if the economy is as weak as the current narrative suggests. This should, in turn, provide a re-rating opportunity for stocks in longer-duration sectors (housebuilders, real estate companies) in the second half of the year and, for this reason, the fund retains some exposure to this part of the market.

The gloom surrounding the UK economy is likely to make consumers cautious about spending their savings. So, despite strong household balance sheets and rising real incomes, we expect little help to UK economic growth from a decline in the savings ratio in the short term. This stands in contrast to our more constructive view six months ago.

Slower economic growth and lower interest rates are likely to see further weakness in sterling. This also stands in contrast to our view before the Budget. We have therefore reduced the portfolio’s overweight in sterling-sensitive assets by reducing NatWest and Next and adding to holdings in Shell, Smurfit Westrock and HSBC. The net result is that we have reduced the fund’s large overweight to domestic earners by around 3%.

We are less pessimistic than the consensus and believe that the UK is likely to ‘muddle through’. The hit to corporate and consumer confidence from the Budget has, when combined with the inflationary impact of the National Insurance and National Living Wage increases, certainly put the Chancellor and the Bank of England in a tricky position. Thankfully, the rise in gilt yields seems to be re-focusing the government’s attention on de-regulation.

In a world of higher real risk-free rates, the price you pay for an asset becomes even more important. All else being equal, we would expect the multiple compression we have seen between the most expensive and cheapest assets to continue. This is a backdrop that should favour both the UK market (defensive, high dividend yield, low valuation) and our portfolio. The valuation gap between the UK and the US markets has continued to widen since the US election. In relative terms, the UK market remains cheap relative to most other markets as well as its own history. The fund now trades on a multiple of just 9.2x forward earnings despite having returned 25% over 2024. This is a significant discount to the 10.8x forward multiple on which the wider UK market trades.