Artemis UK Select Fund – 2023 in review

• Positive stock selection and sector allocation drove the fund’s strong absolute and relative performance.
• We have not seen distribution yields (dividend payouts plus share buybacks) this high in 20 years of investing in UK stocks.
• 2024 could be the year in which both the UK market and our fund benefit from the re-ratings they deserve. 

As investors looked past the inflation shock to the recovery, good stock and sector selection saw the fund delivering substantial outperformance

As has been the trend of the last few years, the performance of markets was determined by changing economic narratives and by second guessing the actions of central bankers. The inflation shock seen in 2022 was without recent precedent and subsequent interest-rate hikes drove compression in valuation multiples across the stockmarket. In 2023, however, inflation fears started to fade, allowing investors to look towards the recovery.

In the Artemis UK Select Fund, our focus on both bottom-up and top-down insights combined with a three-year investment horizon allowed us to deliver a return of 19.1% versus 7.9% from the FTSE All-Share index – outperformance of just over 11 percentage points. That outperformance was evenly split between stock selection and sector allocation. It was pleasing to have more than fully recovered the ground lost in 2022, which was a difficult year for relative performance.

Review

As 2023 began, we were vocal in our rejection of the doom and gloom of most forecasters towards the UK economy

When 2023 began, forecasts suggested that the UK economy would contract by 0.5% over the year. The Bank of England was forecasting the longest recession since the Second World War. We were never that pessimistic. Early in the year we had strong corroborative evidence that Christmas 2022 hadn’t been cancelled, and from there the positive economic news built steadily through the year as headwinds from the cost-of-living crisis abated. Although the final numbers are not yet in, consensus has shifted dramatically and expectations now are that the UK economy grew by 0.4% in 2023.

By way of contrast, Germany, often seen as the leading economy in Europe, fell into recession. In part, this was due to being an industrial rather than service-focused economy, which left it more exposed to higher energy prices and significantly reduced the competitiveness of its large industrial base. We flag this in part because the performance of the UK economy since Brexit has been much maligned – often unfairly.

The second half of the year saw the inflation narrative start to turn

Year-on-year comparisons to the elevated energy, utility and food prices seen in the wake of Russia’s invasion of Ukraine were always going to help the prime minister to deliver on his promise to cut inflation in half. With wage demands beginning to follow inflation lower, the UK began to shed the narrative that it had a ‘sticky’ inflation problem.

A speech in the summer in which the Bank of England’s chief economist compared the path of interest rates to the profile of Table Mountain (rates remaining at a high altitude for the long term) aged rather badly. A shift in the yield curve showed the bond market anticipating interest rates would quickly move lower, both in the UK and globally, triggering a strong rally across equity markets into the end of the year.

Real wages have turned positive 

Real wage growth (% change on YoY)¹

Our overweight in consumer discretionary stocks – and our underweight in staples – was helpful

At a sector level, the fund’s relative performance was principally driven by the consumer sectors. First, consumer discretionary stocks, in which the fund was overweight, meaningfully outperformed. 

Second, our pronounced underweight stance in consumer staples was helpful. In the world of QE, this positioning was often a headwind for the fund’s relative returns. In 2023, however, staples meaningfully underperformed. This was not just because higher interest rates weighed on valuations, (although it helped). More broadly, we note that the sector has in general relied too much on pushing up prices to make up for falling sales volumes. In our experience, this rarely ends well: new products and promotions are needed to re-balance the growth and these invariably bring higher costs and lower margins before any top-line benefits. For now, we remain cautious on staples but there will be opportunities here in the fullness of time. 

Non-bank financials made a useful contribution but our UK banks made limited headway

Over the year, our holdings in 3i, Intermediate Capital, Hiscox, Conduit and IPF all performed strongly. Frustratingly, however, our overweight position in banks did not contribute. While the sector just about held its head above water in total-return terms, its relative performance disappointed. Why? 

In the first half of the year, the issues at US regional banks and the demise of Credit Suisse weighed on sentiment. In the second half of the year, meanwhile, deposit migration from current accounts to term deposits happened more quickly than the banks had expected. In part, this was due to the unprecedented scale and pace of the interest-rate rises and aggressive competition from NS&I. This has delayed the benefits of the rise in interest rates on the earnings of the banks as deposits have been re-repriced faster than their hedge book. 

In 2024, we expect the deposit headwind to fade as the re-pricing of the banks’ hedge books continues. In doing so, we should see earnings momentum at the banks turning positive as we go into the second half of 2024, with further growth in earnings likely into 2025. 

In a market where investors’ time horizons are short, bank shares continued to de-rate and are now on distribution multiples (buybacks plus dividends) that we have never seen in our careers as fund managers. In 2023 alone, the UK banks returned circa 15% of their market value to shareholders through dividends and share buybacks. At present, the market value of the UK’s ‘big three’ banks is £66 billion and over the next three years they should return circa £30 billion to investors through dividends and buybacks. The latter will be highly accretive to growth in their earnings per share, particularly given their current modest (mid-single-digit) price-to-earnings multiples.

What AI means for the UK market

Conversations about the opportunities – and threats – posed by AI dominated the market narrative for much of the year. In the US, a handful of AI beneficiaries led the market higher, resulting in a further significant narrowing in its breadth. Here in the UK, there are fewer direct ways to invest in AI. But we do see opportunities for companies to enhance their productivity, particularly those with significant numbers of white-collar staff and large pools of their own data. We have seen some interesting early trials of AI by financial services and travel companies. Some of the early results have been eye-catching. We suspect the early advantages will be derived by large companies with sufficient resources to invest in the new technology. At the same time, we are unsure whether these gains will accrue to shareholders over the medium term or simply be competed away. 

Holdings in oil companies give the fund a hedge against geopolitical instability

On aggregate, moves in the oil price were minimal over 2023, as geopolitical tensions and production cuts by OPEC were offset by lowered expectations for global economic growth. Our base case envisages the price of crude remaining broadly flat. But if there is a risk, the improved economic narrative and ongoing geopolitical tensions mean it is probably to the upside. That would still leave our holdings Shell and BP on very attractive low-teens distribution yields, while also offering an attractive hedge should the current conflicts in Ukraine and the Middle East escalate.

This year’s key contributors

3i led the way, returning 85%

Earnings at Action, 3i’s low-cost discount retailer, continue to compound at a brisk clip. In 2023, that was supported by stronger-than-expected like-for-like sales and, crucially, by higher margins than the market had expected (and higher than its management had indicated). Our analysis suggests there is yet more to come here.

Melrose was also a strong performer

We met Melrose’s acquisition of GKN back in 2018 with enthusiasm: we liked the various assets in this business and thought their value was not being maximised. The auto components portion of the business has now been spun off, leaving Melrose as a clean ‘tier 1’ supplier to the aerospace industry. The tenure of its RRSPs (revenue and risk sharing partnerships) is extremely impressive, with cashflows set to increase rapidly from here and with contracts that stretch out to 2060 and beyond. 

Holdings in the consumer discretionary sector made significant contributions to returns

The fund enjoyed strong returns from airlines IAG, Jet2 and Ryanair as rising demand combined with reduced capacity to produce a sharp increase in profits. A similar dynamic is playing out in leisure stocks Whitbread and Mitchells & Butlers. 

Near term UK consumer cash flow benefits from rising rates

Change in interest income and mortgage payments (£bn)²

Lookers, the motor retailer, was acquired by Canada’s Alpha Auto Group Holdings, which helped remind us that global companies can sometimes see value where UK domestic investors cannot... 

Vistry, meanwhile, benefited from an easing of worries about the future path of interest rates and, on a more stock-specific basis, from moving its business model towards ‘partnership housing’, which focuses more on private rental and social housing. This will see it winding down its housebuilding division, freeing up significant capital currently tied up in land to be returned to shareholders. The remaining business will be smaller but faster-growing and with a much higher return on capital. It should also be well placed to capitalise on any move by a new Labour government to build more homes to solve the UK’s housing crisis. 

There were few significant detractors

Synthomer suffered from overcapacity due to a post-Covid rebalancing in the medical glove market which is one of its core products. Capacity in this industry is resizing, and we look to a recovery here in the coming years. However, financial leverage took its toll and required a rights issue to support the business through these leaner times. 

NatWest underwhelmed. While this company made the headlines for the wrong reasons, we would note that it has already returned nearly half its market value to shareholders through dividends and share buybacks over the last two years. We expect that net interest margins will start to inflect around the middle of the year, and the capital return prospects continue to look strong. 

Entain’s focus on M&A came at the expense of its day-to-day operational performance. A circa £600 million fine resulting from an SFO investigation into its previous management team further weighed on sentiment. After a disappointing year, several activist investors are now involved and have presented the company with a clear remit:

• halt M&A 
• focus on integrating previous acquisitions
• reinvest in the core business to drive growth
• de-lever

A new chief executive has already been appointed. If operational performance can be turned around, then the outlook should be very positive.

Activity – We added four new holdings to the fund in 2023

• Rolls-Royce
• Lloyds Banking Group
• HSBC
• Workspace

We bought Rolls-Royce, which is becoming a global engineering champion 

Like Melrose, Rolls-Royce is exposed to powerful long-term demand trends in the aerospace industry. A new management team, meanwhile, has set about improving the company’s operational performance and the early signs have been encouraging. Rising defence budgets are providing a strong tailwind to demand and airlines are adding to their fleets. There is also the prospect of the UK government providing support to help commercialise its small modular reactor technology. In short, Rolls-Royce finally looks set to deliver on its long-term potential by becoming a genuine global engineering champion. 

We added new positions in Lloyds and HSBC 

We saw the sharp deterioration in sentiment towards the banks in response to the problems at SVB and Credit Suisse as an opportunity and used it to add holdings in Lloyds Banking Group and HSBC. Both have strong capital-return prospects and high-quality deposit franchises. We also added to existing holdings in Barclays and NatWest, thereby significantly increasing the fund’s overweight in the banking sector. 

The final new position was in UK property company Workspace

A sell-off in March provided the fund with an attractive entry point into a stock we had long admired for the rental growth it has delivered across the cycle through its flexible, ‘multi-letting’ of London office space to SMEs. Trading on a near 50% discount to net asset value, the underlying business offers a see-through rental yield of close to 10%, underpinning its attractive dividend yield. This position also offers a useful hedge in the event that bond yields fall much further than we currently expect. 

We sold holdings in Lookers, Numis, AstraZeneca, BAT, Dowlais and London Metric Properties

Lookers exited the portfolio following a takeover bid. Similarly, Numis received an offer from Deutsche Bank, providing a useful reminder that we are not the only ones who see value in the UK’s capital markets. We sold AstraZeneca, British American Tobacco, Dowlais and London Metric Properties simply because we could find more compelling instances of value elsewhere. 

To control stock-specific exposure, we took some profits in 3i. Reflecting our ongoing conviction in the growth story unfolding at Action, it remains the fund’s largest active position. 

Outlook 

We remain positive on the outlook for stocks exposed to the domestic UK economy
Just as we were as 2023 began, we are more optimistic on the prospects for UK consumers than the broader consensus (albeit the gap has narrowed over the last 12 months). We would concur with recent comments from Lord Wolfson of Next: “On the face of it, the consumer environment looks more benign that it has for a number of years.” Indeed, we expect consumer discretionary spending to be positive as rising real wages, falling utility bills and tax cuts more than offset the headwinds from higher mortgage rates. 

UK savings ratio remains high

Household saving¹

From here, we see scope for consumer spending to rise as increased confidence should see the savings rate start to fall from its current, elevated levels. There should be a further kicker to come from a round of pre-election tax cuts in the March Budget. Taken together, we see UK GDP growing by 1% or more this year (versus consensus expectations of just 0.3%). 

A stronger domestic economy should be supportive for our consumer cyclical stocks. Higher loan growth and lower impairments, meanwhile, would help our UK banks. A stronger-than-expected UK economy also has the potential to be supportive for sterling. Even at current exchange rates, the UK market’s overseas earners are facing a year-on-year currency headwind over the first half of 2024. 

2024 could be the year in which international investors begin to reappraise the UK market

It looks likely that the UK general election will take place in the second half of the year. If this results in a clearer medium-term plan for domestic policy and a less confrontational approach to relations with Europe, it could reduce the risk premia that international investors apply to UK equities. 

Beyond the UK there are numerous uncertainties. Elections, on-going trade tensions and conflicts in the Middle East and Ukraine all have the potential to change the investment backdrop. At a portfolio level, we continue to view oil companies as an underpriced hedge against some of these risks. Elsewhere, we remain vigilant for any change in the narrative and will react rapidly to any changes should the need arise.

Even after 2023’s gains, the fund trades on a discount to the wider UK market
Despite the 19.1% return it generated over 2023, the fund’s valuation multiple remains similar to its level a year ago: it trades on 8.4x earnings versus 10.8x for the UK market. In large part, this reflects the strong earnings growth our portfolio companies delivered over 2023 (as well as the dividends we received). 

We expect our companies’ earnings to continue to progress from here, albeit at a slower rate than in 2022 to 2023 (we will not benefit from the sharp post-Covid rebound in earnings at our leisure-related stocks). Dividends seem likely to grow, share buybacks should continue and we are hopeful this might finally be the year in which both the UK market and our fund benefit from the re-ratings they deserve.