Discounted valuations, the likelihood of inflation falling “markedly” and an abundance of durable inflation-hedged franchises are some of the reasons Artemis’s John Dodd and Kartik Kumar are positive on the opportunity set within UK equities.
In their £101m Artemis Alpha Trust’s latest annual financial report, published on Wednesday (12 July), the managers said they still anticipate attractive returns from their portfolio, despite the fact it lagged its FTSE All-Share benchmark by 4.8 percentage points over the last year with a total return of 1.3%.
Dodd and Kumar said a torrid combination of rising energy prices, then-Prime Minister Liz Truss’s Budget, and rising inflation and interest rates all bruised the shorter-term performance of the trust.
“This series of events has damaged consumer, corporate and investor confidence. Confusingly, despite this, employment trends have remained robust and corporate profitability has been better than expected,” they said.
“Idiosyncratic events in the UK hurt sentiment that was already fragile since Brexit. Markets are now pricing an idiosyncratic inflation problem in the UK, leaving the UK with higher long-term bond yields than Greece or Italy.
“We continue to anticipate attractive prospective returns from our portfolio owing to a combination of macroeconomic and bottom-up factors.”
The managers explained the trust has exposure to a combination of structural growth opportunities, discounted assets and cyclically exposed stocks.
See also: “Janus Henderson: Global company debt reaches record $7.8trn“
With the latter, Dodd and Kumar said their holdings in airlines such as easyJet and Ryanair, retailers such as Frasers and Currys, and financials including Lloyds, Natwest and Hargreaves Lansdown, should all benefit from interest rates remaining higher than they have been in recent years.
They are also confident that they are well diversified in the sources of return across the portfolio and therefore in its liquidity, with more than 80% of the company’s holdings able to be sold within one day.
“We judge the greatest visible risks to our outlook to reside in energy markets and geopolitics,” the duo said. “Energy markets are fundamentally tight due to underinvestment following the 2014/15 downturn and disruptions to European gas supply provoked by the war.
“Higher demand or an unforeseen reduction in supply would be damaging to economies with limited domestic supply. Both the UK and US will have elections next year and US-China relations remain strained.”
Inflation and risk premia
That being said, Dodd and Kumar believe inflationary pressures are likely to ease, given that energy prices have fallen over recent months, Europe has had an “unusually warm winter”, and that Russian oil production has proven more resilient than people feared.
“These factors suggest downward pressure on goods inflation, when mathematically, inflation should decline from its peak level, as the high rates of inflation seen in the second half of 2023 cease to form part of calculations,” the managers reasoned.
They added that the equity risk premium among UK stocks is more than 10%, given the earnings yield on the FTSE All Share is 11%, while UK 10-year index linked government bonds yield 0.5%.
“In our judgement, this difference is not justified by the long-term fundamental prospects for corporate profit growth but reflects weak sentiment towards UK markets,” Dodd and Kumar explained. “While this point might have been made at any point in the last five years, it remains valid.”
Profitability in cyclicals
Pandemic-induced disruption and heightened volatility means there is a more attractive case for the companies that survive the turbulence, according to the managers.
For instance, while Boeing and Airbus produced almost 2,000 fewer planes than expected during the Covid crisis, it now means they have full order books to the end of the decade.
“Demand has rebounded strongly, resulting in a strong pricing environment where it is hard to see how supply can respond,” they said.
See also: “AIC: Investment company fundraising falls 76%“
Elsewhere, Dodd and Kumar said the impact of share buybacks have been “underestimated”, given companies can use the repurchases to pay out excess capital as dividends, capital gains taxes are lower than income tax, and that growth in earnings per share may subsequently be valued more highly than capital returns.
“Consider a company that trades on 10x earnings and grows earnings by 5% per annum over 10 years,” the managers explained. “Assuming a constant multiple, if 35% of net income is used to repurchase shares, the company’s growth in earnings per share doubles from 5% to 10%.
“This highlights how lower valuations increases the compounding effect of share repurchases, which in our view is relevant to the UK equity market and our portfolio today and why Charlie Munger once said, ‘Pay close attention to the cannibals – the businesses that are eating themselves by buying back their stock’.”
Over the last five years, the Artemis Alpha trust has lost 4.5%, compared to its average peer in the IT UK All Companies’ sector’s loss of 5.8%.
