Artemis UK Select Fund update

Review of the quarter to 30 September 2023.

The UK market performed well relative to its global peers over the past three months, with the FTSE All Share’s gain of 1.9% more than double that of the MSCI AC World index, which made 0.6%. The Artemis UK Select Fund made 2% over this time, while its IA UK All Companies sector benchmark was up 0.8%.

The strong performance of the UK market was driven by a combination of lower-than-expected inflation and upward revisions to post-Covid GDP, which helped dispel some of the negativity around the domestic economy. The decision by the Bank of England to pause interest rate increases aided the soft-landing narrative. Away from the UK economy, a rise in the price of oil and a stronger dollar helped both overseas earners and the energy sector.

Risers and fallers

Housebuilder Vistry Group was the biggest positive contributor to performance in the three-month period, rising 38%, after it announced it would run down its conventional housing business and re-purpose many of its sites to accelerate growth in its affordable housing division. As a result, the company will return £1bn of capital to shareholders in the form of a buyback. The current market cap of £2.8bn underlines the size of this return. We have added to our position in the company.

The fund’s position in BP benefited from Saudi Arabia and Russia’s cuts to oil production, which drove up the price of the commodity. Sell-side models predict free cashflow yields in the low teens for the energy giant, assuming an oil price in the $70 to $80 bracket. These could rise to the high teens if the oil price moves towards $100. The rapid retiral of cheap equity should also prove favourable for long-term owners.

Largest holding 3i Group continued its strong performance on the back of further progress from its holding in discount retailer Action. An underweight position in Diageo benefited the fund as the shares fell on fears spirits markets would succumb to downtrading.

Valuations 2011 vs 2023

On the downside, one of our biggest overweights, Oxford Instruments, was also the biggest detractor from performance after it fell 19.7%. There was little news flow around the scientific-tool maker, but its high exposure to China weighed on sentiment. We believe strong growth in other areas of the business should more than offset this weakness and have added to our holding.

Bookmaker Entain was on the receiving end of a higher-than-average number of customer wins in low stakes, longer-odds ‘bet builder’ products. It expects the number of these to mean revert with time. Meanwhile, its decision to tighten limits and checks on at-risk customers had a larger-than-expected impact on revenues as the company lost market share to smaller competitors, which applied less stringent measures.

Vanquis Banking Group, formerly Provident Financial, posted a disappointing set of results after it overestimated its net interest margin and underestimated costs. It fell by more than 30%. It is not all bad news though: impairment trends look relatively stable, the funding position remains strong and the new chief executive has made a promising start.

We believe it has an attractive opportunity to serve around 15 million consumers who don’t meet the credit criteria of traditional banks, while a book value of less than 0.5x and an interim dividend yield of almost 5% make us feel more comfortable holding onto our position.

Activity

We used inflows in September to continue building our holding in Rolls-Royce, as we believe pricing power in its aftermarket business is being underestimated by sell-side analysts.

Elsewhere, we added to HSBC, which is still seeing expansion in net interest margins. Capital generation remains strong with a 10% hike in the dividend, giving a forward yield of 7.9%. With a further $2 billion buyback announced in Q3 and the same likely again in Q4, the total distribution yield for the current year is now close to 13%.

Ryanair recently pointed out intra-EU airline capacity remains about 20% below pre-Covid trends, a gap that will be hard to close considering supply constraints. Despite higher funding costs, we expect pricing power for the sector to remain strong, in contrast with current ratings which imply profits will fall from here. We bought more shares.

In terms of sales, we offloaded more of our holding in Lookers following a 10p bump in the bid for the car dealership. The upside looks more limited here and the downside could be about 25 to 30% if its largest holder (Cinch) changes its mind on the merits of the deal.

Outlook

While UK equities have continued to be buffeted by movements in the bond market and subsequent de-risking of global macro funds, the economic outlook has become clearer over the past few months. The Bank of England has paused interest rate increases and as real wages turn positive, the worst of the cost-of-living squeeze now appears to be behind us.

As their confidence increases, UK consumers are likely to start dipping into their accumulated savings, providing support to economic growth going into 2024.

UK consumer outlook to improve: Real wages have turned positive, leading to an improvement in consumer confidence²
Real wage growth (% change on YoY)¹

Elsewhere we are watching the US industrial cycle closely to see if it is the first to emerge from the huge de-stocking cycle that we have seen over the past 12 months as companies look to unwind inventory built up during the Covid-induced supply-chain issues.

Inflation

We believe the move in the bond market makes sense in the context of the outlook for a softer economic landing. Medium term, the key question remains where inflation settles as the lagged impact of commodities and wage settlements finally wash through official figures.

At this stage, it is too early to say, but de-globalisation and the ongoing push for net zero are likely to reverse some of the deflationary forces that had been seen over the past few decades. In addition, the failure by central banks to foresee the spike in inflation makes it unlikely that the developed world returns to a period of ultra-loose monetary policy and QE any time soon.

The net result is that current medium-term interest rate expectations in the UK look sensible to us.

All else equal, higher risk-free real yields should mean risk assets trade at lower multiples than they have done historically. While this is not the case for most global equity markets, encouragingly, it is for the UK market.

Perfectly positioned

This comes at a time when the UK’s mix of more capital/balance sheet intensive businesses are well placed to make higher returns as they benefit from historic fixed-cost assets in a more inflationary environment, and in the case of financials, access to capital and cheaper funding than their customers and start-up peers.

The opportunity today is that these sectors have de-rated rather than re-rated, leaving distribution yields in some cases in the mid to high teens – among the highest we have seen in our careers.

While the catalyst for a sharp re-rating is not immediately obvious, the good news is that the companies themselves are putting their foot down on distributions, with buybacks in particular moving to centre stage.

At current valuations, we believe the maths on retiring equity is the most compelling that we have seen in our careers and are confident that in time the rapidly diminishing share counts of these stocks will drive a further rise in the distribution yields.

The valuation of the fund has slipped back to 7.8x earnings and a 4.3% dividend yield, a significant discount to the 10.2x and 4.6% yield of the market. In addition, just under 45% of the fund by value is buying back shares. We remain optimistic on the earnings prospects for the companies we hold and believe that, at some stage, global investors are likely to re-visit the UK as the relative outlook improves versus other markets.