Artemis Funds (Lux) – US Extended Alpha update

The S&P500 Index fell -3.3% (in US dollars) over the quarter. Under the surface this moderate gain masks the shift in market sentiment that took place. The index gained during July and early August and then retraced much of that performance over September. Initially a strong corporate earnings season supported the index, along with the added tailwind of a possible soft landing for the economy. This changed over September as markets were forced to digest macro concerns around rising oil prices, skyrocketing Treasury yields, a strengthening dollar and resurfacing fears of an economic slowdown.

The fund outperforms, led by utilities

During the quarter the fund outperformed the index, returning -2.0% vs the S&P500 Index's performance of -3.3% (in US dollars). We were encouraged to see that despite fluctuations in the economic outlook, the main driver of the fund's performance was stock selection from a diverse range of companies.

At a sector level, utilities led, with communication services and consumer discretionary also adding to relative performance. The strongest subsectors included automobiles, consumer durables, and media & entertainment. Financials, industrials, and healthcare were the main detracting sectors.

At a stock level, our largest contributor was Constellation Energy, which we will cover in more detail below. Our holdings in Jacobs Solutions, Autoliv, TFI International, and Capri Holdings also performed well during the quarter. The main detractors were Equifax, Zimmer, WillScot, and TransUnion.

Positive contributions from…

Autoliv - the market leader in seatbelts and airbags reported a good set of results which gave investors increased conviction in the margin recovery story. It remains on a low multiple of what we think normalised earnings should be in 2024.

Constellation Energy - this business is the largest provider of nuclear energy in the US. It runs reliable baseload power and thus is the largest provider of carbon-free clean electricity in the country. As a result, it is a huge beneficiary of the Inflation Reduction Act (IRA) which provides downside protection to power prices for at least the next nine years. We like the downside protection to earnings and there are also a number of idiosyncratic drivers which could result in further upside. These include an increase in prices in Illinois which are under a lower-priced legacy contract, continued M&A in nuclear, share buybacks and lastly the potential for expansion into hydrogen production, using their nuclear fleet as a power source.

TFI International – we initiated a position earlier in the quarter in the company TFII, which generates nearly half of its profits in the less-than-truckload (LTL) sector. This stock’s PE multiple of 16x is nearly half that of peers, although it is a well-run company, with a healthy balance-sheet and will likely see a powerful boost to its profitability due to the industry consolidation that is occurring as a result of the collapse of the largest player in the LTL space, Yellow. We believe TFII offers an attractive valuation with a potentially dramatic profit inflection in the future.

Detractors

Equifax - the company reported a sluggish set of results which introduced a few concerns on the growth profile of its largest division, Workforce Solutions. We think a lot of this is transitory (e.g lower mortgage market & weaker white collar hiring). Indeed, we think we are at the bottom for revenue growth and expect a big step up in the next few quarters and into 2024.

Zimmer - underperformed when the CEO announced he was leaving the company and as he is a major part of our investment thesis, we sold out of the position.

WillScot - lagged the market following results which cited weaker volumes than expected. We see this as a very idiosyncratic business with lots of initiatives to drive up rental rates, so have maintained the position.

TransUnion - the financial data services business's negative performance was predominantly driven by macro concerns during September.

New positions

As well as TFII as described above, we initiated a number of positions during the quarter, some of which we outline below:

Bath and Body Works (BBWI) - BBWI is a differentiated business in consumer retail given its vertically integrated model. By producing its own products, controlling distribution, constant innovation and streamlined supply chain it operates with a high teens operating margin which is much more akin to a consumer staples business than BBWI's perceived peers.

EQT - the largest and one of the lowest-cost producers of natural gas in the US. We view natural gas as a long-term transition fuel, and while one cannot get away from the high carbon intensity of EQT's operations, we are impressed by the sharp improvements the company has made to improve its scope 1 and 2 emissions over recent years.

Oddity - we participated in the IPO of Oddity, a beauty platform whose primary brand at this point is Il Makiage. The IPO came at a very attractive valuation compared to relevant peers and the business has compelling revenue growth prospects with optionality on more brand launches. During the quarter, we did take profits after our purchase of Oddity given the risk reward had changed following strong share price performance.

Sherwin Williams - we added to our housing repair and remodel exposure with this leading paint company. Historically it has been seen as a high-quality business given it controls its own distribution with retail stores and has a very tight relationship with the professional customer who cares more about quality and service than price.

Blackstone - we started a small position in Blackstone, the leading alternatives asset manager, which gives us exposure to the enviable growth that is likely to continue in private equity and credit asset gathering. We believe that Blackstone has one of the best brands to achieve this due to its leading historic investment returns. The stock is likely to work well once yields start falling back down again and the IPO market recovers.

Sales

Sells during the quarter were in large brought about by either a reassessment of our risk reward after strong share price performance or reallocating capital to businesses where we saw a higher likelihood of success:

Norfolk Southern - we consolidated our rail holding in order to increase the position in CSX, which we consider to be a better operator as evidenced by their service metrics and are encouraged by the appointment of its new chief operating officer, Mike Cory, who is extremely highly regarded in their industry.

Eog - the company is an oil shale producer, where we are concerned by the peaking productivity in US onshore shale, and therefore find better opportunities elsewhere in the energy sector with EQT and our other recent purchase, Baker Hughes, the oil services company.

Netflix - the company has had a strong run since we bought it as the market started to price in the benefit to the company from cracking down on password sharing. With the move in the stock and more buoyant sentiment we sold our position given the deterioration in the risk reward.

We also sold out of Restoration Hardware which was a small position. RH is one of the leaders in luxury home furnishings, predominantly in the US. When we bought it in December the stock was depressed but had net cash which gave some protection to the downside. Since then, it has done significant share buybacks, which, whilst perhaps the right thing to do, has now put the company in the position of being levered with net debt to EBITDA at 3x in a still uncertain market environment. Given the strong move in the shares we have sold out.

After a volatile few months, we also exited our position in discount retailer Dollar Tree. While we think the new management team led by industry veteran Rick Dreiling are doing a good job turning around the Family Dollar concept, the reality here is that the turnaround is going to cost more and take longer than we hoped.

Shorts

Our short book exposure has continued to increase, with a broad range of exposures from 'overearning' cyclicals through to highly levered 'value traps'. On the cyclical side we introduced new shorts including a real estate focused bank, several retailers on elevated margins with signs of slowing revenue, and capital goods companies where there is evidence of increasing inventories and falling demand. On the value trap side, we introduced several dangerously levered low-growth businesses in a range of areas such as home products, food equipment, used industrial equipment and eyecare.

Outlook – Dispersion in market leading to opportunities on long and short side…

The net exposure of the fund is 96%, made up of 118% in long equities, 21% in short equities and 1% in delta adjusted S&P 500 put option exposure. We believe the 21% short book contains many companies that would have significant downside risk in the event of a weaker economy given their high leverage, low growth and weaker-than-average business models.

We continue to see great valuation among a broad swathe of discounted compounders which have relatively low economic sensitivity. These companies represent roughly two thirds of our long exposure. Within the more cyclical areas of the market, we continue to favour early-cycle sectors which have already experienced a recession and these would include areas like housing, trucking and parts of retail. On the other hand, we have shorts in a range of sectors which we believe are overearning and being late-cycle are likely to see their fundamentals deteriorate from here.