Artemis Income Fund update

Review of the quarter to 30 September 2023.

The resilience of the global economy and continued high inflation resulted in a narrative that interest rates would remain ‘higher for longer’ taking hold during the third quarter. Bond yields rose across much of the world, with the 10-year US Treasury yield climbing to its highest level since 2007. As a result, the more richly valued, growth-oriented areas of global equity market relinquished their earlier gains. The weakness in the share prices of a small group of US-listed mega-cap technology companies that had led the market for much of the first half of the year was particularly notable.

Higher borrowing costs remain a challenge for highly levered and cash-hungry business models. Once again, we have been reminded of the importance of sensible balance-sheet management and organic cashflow generation. While such cashflows are abundant in the UK equity market, share prices remain depressed and the discount on which the UK trades relative to other global markets remains unusually wide.

Undoubtedly, a number of enduring challenges continue to face the UK economy but the picture is brighter than it once appeared. Revised GDP figures published by the ONS in September showed output climbing back above its pre-pandemic levels by the end of 2021– far sooner than previously thought. The UK no longer appears to have been the slowest-growing economy in the G7 since the pandemic.

Performance

The Artemis Income Fund returned 2.9% in the third quarter, slightly ahead of the 1.9% return from the FTSE All-Share index.

What worked…

Private equity group 3i continues to feature among the top contributors to the fund’s returns. Its holding in Action, a discount retailer, continues to deliver exceptional growth in both sales and cashflow. We see huge scope for Action to continue to expand in Europe; it could comfortably add several thousand more stores to its network. 3i’s aggregate portfolio leverage is less than half that of the average level seen across the private equity industry and is at its lowest level in more than 10 years. In a world where borrowing costs are expected to remain higher for longer, 3i’s balance-sheet strength constitutes a growing competitive advantage.

BP shares added 17% in the third quarter, supported by an oil price that climbed to its highest level since November 2022. We continually weigh and debate the relative merits of BP and Shell. As a result of lower debt and a business mix that is more heavily skewed to LNG, we decided to transfer some of our oil & gas allocation into Shell. And while we are confident that BP’s strategy and commitments remain unchanged in the wake of the departure of its chief executive, we would acknowledge that there are increased uncertainties around both future leadership and company culture.

Direct Line’s shares added more than 25% over the quarter. After a tumultuous 12 months for the business, selling commercial insurance business NIG to Canadian insurer Intact Financial for £520 million eased the market’s worries that it might need to raise fresh capital. Furthermore, after a lengthy search, it appointed what appears to be a strong chief executive in Adam Winslow, who had led Aviva’s UK and Ireland general insurance business since mid-2021.

What didn’t work…

SSP Group operates catering and retail units at airports and railway stations. Its shares fell after the market focused on a downgrade in earnings per share as a result of currency movements. These headwinds from sterling’s strength masked the continued progress being made across the business: full-year cash earnings (Ebitda) are still expected to come in towards the top of the guided range. We have long articulated the US opportunity in front of SSP, with $700 million in new business won since Covid and a strong pipeline for further expansion. Although its revenues have risen to some 130% of their pre-pandemic levels, SSP’s enterprise value has fallen. In our view, therefore, its shares offer attractive value.

Corbion’s shares endured another tough quarter. The market remains focused on its balance sheet and its share-price performance is likely capped until it pays down some debt. Management remains committed to doing precisely this: they will offload non-core assets in the short-to-medium term and so streamline Corbion’s portfolio. The intellectual property Corbion has developed remains of material value, especially its algae business (a source of lower-carbon fish feed). The shares currently trade at a nine-year low. If management can execute the de-leveraging of the business, the balance between risk and reward from here looks attractive.

EasyJet’s shares fell in the third quarter. Those falls, however, were broadly in line with those seen across the travel sector, an area that had been among the market leaders in the first half of 2023. Several airlines have suggested that demand this winter is likely to be strong. This could provide a material boost to earnings in the short term. Looking further into the future, an industry that remains heavily capacity constrained versus pre-pandemic levels should mean the pricing environment remains favourable.

Activity

We added one new position in the quarter: Lloyds Bank. As with NatWest, we believe the market is underestimating Lloyds’ earnings power and the potential for it to return capital to its shareholders through a combination of dividends and share buybacks. This addition was partially funded through our exit of Nordea, which has delivered healthy total returns for the portfolio since we invested over five years ago.

Elsewhere, we continued to trim the holding in 3i following continued strong performance. We also reduced Phoenix Group, where the position size was too large given the strength of our investment thesis.

On ESG

Most of our meeting with Anglo American in late July focused on its progress with respect to sustainability and the effects of the US Inflation Reduction Act on its business. From 2025, 60% of its portfolio will be run on renewable energy – significant progress from around 10% five or six years ago. Moving all of its South African operations to renewables is a priority. Beyond the obvious sustainability benefits, this conversion will also result in both improved reliability and greater certainty around costs given the volatility of energy prices in South Africa. According to Anglo American’s management, the stimulus provided by the Inflation Reduction Act is encouraging a nascent hydrogen economy to form. This is likely to feed into demand for the platinum group metals Anglo American produces and which are a key component of hydrogen fuel cells.

Outlook

The fundamentals of the majority of our companies have held firm through a challenging environment and the portfolio has continued to deliver healthy growth in free cashflows. Set against this, indiscriminate, price-insensitive selling continues in the UK. As a result, valuations across the UK stockmarket remain depressed, at a discount both to its own history and relative to other international markets.

As a result, many of our companies are putting their cashflows to work by buying back their own shares. As their share counts are shrinking, their earnings and dividends per share are growing. This growth will be amplified if our companies grow their earnings as our forecasts suggest they will. All we have to do is hold onto our shares (and let other impatient sellers sell their holdings back to the company) to benefit from this trend. To this point, this growth in cashflows and value per share has been roundly ignored by the market. This neglect won’t last: the market will eventually wake up to the ever more extreme valuation discount on which UK equities trade – a discount that is being amplified by this buyback activity.