Artemis UK Select Fund update

Source for all information: Artemis as at 31 December 2023, unless otherwise stated.

• The fund outperformed its peer group and the wider UK market over the quarter.
• Our holdings in Rolls Royce, 3i and Ryanair led the gains.
• 2024 could be the year in which both the UK market and our fund finally benefit from the re-ratings they deserve.

An excellent year in both absolute and relative performance terms ended on a suitably positive note

Despite it being a quarter of geopolitical tension and conflict in the Middle East, the dominant event from a market perspective was that larger-than-expected falls in inflation led to a significant move lower in bond yields. The US Federal Reserve acknowledged the improvement in the inflation picture and made little effort to push back against the bond market’s growing expectation that it would begin cutting rates in 2024. As investors moved to debate the speed and scale of the cuts needed to ensure a ‘soft landing’ in 2024, risk assets – including UK equities – rallied.

Within the UK market, meanwhile, cyclical stocks outperformed more defensive areas. That, in combination with positive news on number of our holdings, aided the fund’s performance. It returned 5.0% over the quarter, versus a 3.2% return from the FTSE All-Share and 4.5% from its peer-group average. The net result was that the fund returned 19.1% over 2023 as whole, more than double the return from both the All-Share (up 7.9%) and from the average fund in its peer group (up 7.2%).

The quarter’s key contributors included our holdings in Rolls Royce, 3i and Ryanair

Rolls-Royce continued its strong run, moving 36% higher as it announced new targets for margins, earnings and cashflows that were significantly higher than expectations. In particular, its target of delivering cashflows in the £2.8-£3.1 billion range in 2027 was some £1 billion above consensus forecasts. Clearly, Rolls-Royce has a long way to go to hit those targets, but its management has provided an impressive level of detail about how it intends to get there and the strength of demand in its end markets is clearly in its favour.

3i delivered another set of impressive interim results. These were driven by a continued strong performance from its largest asset: European discount retailer Action. Over the first nine months of the year, Action’s total sales grew by 30%. With its fixed costs being amortised over an ever-larger sales base, cash earnings (Ebitda) grew by 43%. A virtuous circle is evident here: growing sales are allowing Action to invest more in keeping its prices low, thereby deepening its advantage relative to its peers and driving further growth in footfall through its stores.

Ryanair (up 26%) and Jet2 (up 16%) bounced on good results and the fall in the oil price. Ryanair has seen limited impact on bookings from the turmoil engulfing the Middle East. Jet2, meanwhile, did see a brief slowdown in bookings but these have since recovered. Although it is still early days, both companies are reporting that sales volumes and prices for the coming summer holiday season are ahead of the same period last year.

Our relative returns also benefitted from not owning British American Tobacco (BAT, down 9%) or Diageo (down 6%). BAT downgraded its profit forecasts for the year on the back of weaker sales volumes in the US. It would appear that the rapid rise of disposable vapes is starting to cannibalise cigarette sales. Diageo, meanwhile, fell following a profit warning on the back of de-stocking in Latin America as its distributors adjust their inventories to reflect weaker demand.

There were relatively few negatives over the quarter, but our banks and BP lagged

NatWest, Barclays and Standard Chartered fell amid pressure on the wider banking sector. Net interest margins for the UK retail banks were weaker than expected while Standard Chartered wrote down its stake in Bohai Bank (by $700 million) and took an additional $200m of provisions against potential losses on Chinese commercial real estate loans.

In our view, valuations in the banking sector now look extremely low. The UK’s big three domestic banks now have a market cap of just £67 billion despite being forecast to deliver £13.5 billion of post-tax earnings this year. We believe these earnings will grow over the next couple of years even if the interest-rate cycle turns. Meanwhile, earnings and dividends will grow even faster on a ‘per share’ basis as they continue to buy back their (undervalued) shares.

BP’s shares fell by 11% as the oil price moved lower. It also suffered as investors rotated into more cyclical areas of the market as bond yields fell. Weakness in oil prices appeared to be driven by investor positioning, as macro funds liquidated positions after being caught out by the sharp moves in bond markets. Speculative positions in crude oil are now very low relative to history. This should, in combination with OPEC’s decision to increase production cuts in Q1, put the market in balance through the first half of this year before demand picks up seasonally over the summer. In the meantime, we continue to like the oil majors for their free cashflow yields and see them as offering us a cheap hedge against further global geopolitical instability.

Activity

We used profit warnings as opportunities to add to our positions in Ashtead and Anglo American

We see the lack of hurricane activity this year and a collapse in rentals of high-margin film equipment work due to the Hollywood writers’ strike as temporary headwinds to Ashtead’s earnings. The structural drivers (increased penetration of the equipment rental model and market consolidation) that helped to make it one of the fastest-growing companies in the UK market over the last 10 years remain unchanged.

Meanwhile, the production issues seen across Anglo American’s business were disappointing. But we added modestly to the fund’s small holding after its share price fell. In part, this was to reduce the fund’s substantial underweight in the mining sector. In part, it was because, with a market cap of less than $30 billion, we view Anglo American as a potential candidate for consolidation and / or break up given its attractive portfolio of Tier 1 (large, low-cost) copper, platinum group metals and diamond mines.

On the domestic side, we added to our holdings in Tesco and Legal &General

Both companies are trading well and are well placed to benefit from a re-rating should investors become more positive on the outlook for the UK economy. To fund these additions, we took some profits in 3i and sold our small position in AstraZeneca. We viewed its recent results as slightly disappointing in terms of the sales growth of some of its newer oncology drugs.

Outlook

We remain more optimistic than consensus on UK consumer spending

A year ago, we were significantly more optimistic on the prospects for the UK consumer than the (very bleak) market consensus. And we are still relatively optimistic, the gap has narrowed as the consensus has slowly shifted towards our view. From here, falling inflation, low unemployment, rising real wages and a reduced headwind from mortgage refinancing should see concerns about the ‘cost-of-living crisis’ fade.

As confidence improves, we see scope for the savings rate to begin to fall and for consumer spending to improve. Any pre-election tax cuts could provide a further kicker. (It looks likely that there will be a general election in the second half of the year which, depending on the outcome, could potentially reduce the discount that international investors currently apply to UK equities.) Taken together, we see UK GDP growth in 2024 starting with a one rather than the current consensus for GDP growth of just 0.3%.

A stronger domestic economy should be supportive for our consumer cyclical stocks and domestic-focused financials

By sales, our portfolio is just over 15% ‘long’ domestic exposure versus the benchmark. Any uptick in domestic demand would directly benefit those holdings and help our UK-focused banks through higher loan growth and reducing impairments. It also has the potential to be supportive for sterling: at current exchange rates, the UK’s overseas earners will be facing into a year-on-year foreign exchange headwind over the first half of 2024.

Beyond the UK, there remain numerous uncertainties

A number of important 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 as an underpriced hedge against some of these risks. Elsewhere, we will remain vigilant for any change in the narrative and will react rapidly to any changes.

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 2022-23 (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 that, this might finally be the year in which both the UK market and our fund benefit from the re-ratings we believe they merit.