Artemis US Smaller Companies Fund update

Tough environment for US smaller companies…

The fund returned 1.2%, outperforming the Russell which returned -1.2% (in sterling terms).

Investors' focus for much of the quarter was on the prospect of easing inflation and the direction of interest rates moving forward. As the quarter began, the prevailing sentiment was that a 'soft landing' would allow the Federal Reserve to cut rates towards the end of 2023. By the time it drew to a close, however, it had become clear that certain parts of the economy continued to run too hot. Oil prices were rising, and job growth remained strong. In response, the central bank signalled that rates would need to remain higher for longer.

Typically, during times of heightened economic uncertainty, smaller companies tend to underperform their larger peers which they did during the quarter. This brought the valuation discount between US large cap and small cap to near historic levels. As we entered Q3, we were confident that despite the tighter financial conditions that US smaller companies found themselves in, there were opportunities for businesses that either had already experienced a recession in earnings and/or had strong enough fundamentals to weather the storm.

Contributors - strong stock selection underpins outperformance…

It was therefore encouraging to see that our focus on company fundamentals came out in strong stock selection. The companies in question also came from a wide variety of industries.

Constellation Energy - This nuclear power/clean energy supplier is one of our highest-conviction holdings. We were pleased to see our thesis continuing to play out over the quarter. Good news on earnings is being driven by its customers' willingness to pay more given volatility in energy prices and, perhaps more importantly, by the fact that Constellation is seen as a reliable supplier. Its reliability and focus on clean energy also make it an indirect beneficiary of the AI wave as energy-intensive data centres are being built in the states that Constellation serves.

Less-than-truckload - we spoke in depth last quarter about the opportunity that presents itself within the less-than-truckload (LTL) subsector and how we have positioned ourselves through Saia and TFI International. During the third quarter, there was a major change in the LTL industry. Yellow Corp (formerly a top five carrier by revenue and volume), filed for bankruptcy following years of financial challenges. Typically, LTL bankruptcies end up being a liquidation process, rather than a reorganization process. Customers (shippers) tend to leave at the first sign of trouble: nobody wants their freight sitting by the roadside in the middle of nowhere. Technically, Yellow is currently under a reorganization process, rather than a liquidation process - but it seems to have played out in a fairly similar way to outright bankruptcy, with drivers being laid off and terminals closed. Yellow's freight is now being shipped by other companies. Based on intra-quarter conference calls and regulatory filings, we believe both of our holdings have seen a good sequential step up in volumes. We are hoping to see a positive impact on pricing (as capacity has been removed from the industry) and profitability (as networks that were underutilized during the economic downturn were well positioned to accept new volume). Third quarter results from Saia and TFII should be very interesting.

Detractors - higher interest rates hit faster-growing stocks….

The majority of stocks that underperformed during the quarter, did so during September. With the picture looking more troubling, and central banks around the world committing to maintaining rates higher for a longer period of time than the market had anticipated, it was those stocks whose business models were viewed to be vulnerable in this environment that suffered.

NextEra Energy - NextEra Energy is growing its renewables base and will benefit from the Inflation Reduction Act over time. We are reviewing this position after the company cut its dividend-growth outlook as higher rates made financing the development of wind farms more costly. However, we do believe we will be able to sell at higher prices.

Planet Fitness - We sold our holding in Planet Fitness, following the sudden departure of the longstanding CEO, who held significant relationships with the franchisees. Given the increasing concern about franchisees' ability to fund growth (given higher interest rates), we felt the thesis was no longer applicable and we sold the position.

Transactions - Buying ELF Beauty and reducing Hostess Brands

We bought ELF Beauty. While the stock had already done very well year to date, we believe this innovative, high-growth company will continue to gain category share.

We significantly reduced our holding in Hostess Brands. Following rumours of a potential sale, an acquisition was announced in mid-September.

Outlook

There are risks on the horizon as the market contemplates higher interest rates and their likely impact on economic growth. The small-cap index has underperformed the S&P 500 on fears that slowing economic growth will disproportionately affect smaller companies. We believe this will present active managers the opportunity to find mispriced businesses. For example, we continue to see long-term value in the life sciences area, which has struggled this year owing to near-term cyclical concerns. The next key event on our calendars is third-quarter earnings. We will be looking out for signs of bottoming order trends for our life sciences companies, along with evidence of improved profitability at our trucking companies following the Yellow Corp bankruptcy earlier this year.