Artemis Alpha has suffered a double whammy. It has announced its annual results for the year ended 30 April 2019 and it says that, over the year, its net asset value and share price declined by 8.6% and 8.9% respectively on a total return basis, while its All-Share Index benchmark increased by 2.6% over the same period. In his statement, the chairman, Duncan Budge, says that “The disappointing performance of some of our unquoted investments played a large part in our results, detracting 5.5% from our performance”. He goes on to say that £The decline in value of our holdings in listed companies which are sensitive to the UK economy detracted an additional 2.7%”.
The investment managers review
John Dodd and Kartik Kumar’s investment managers’ review provides a good summary of what has been going on in the portfolio and we’re including this below.
Overview
“Last year, we outlined a revised investment strategy that would focus on investing in companies with an emphasis on the following characteristics: observable competitive advantages and attractive industry characteristics (quality); compelling valuations (value); and outstanding management.
We indicated that the resulting strategy would carry a long-term focus – on companies’ performance over years, not quarters, with a relatively low turnover of investments. The resulting portfolio structure would be more liquid – to allow us to be responsive to changes in business fundamentals and overall investment conditions; concentrated – to allow us to focus more efficiently on threats and opportunities in existing investments; and internationally exposed – to allow us to take advantage of a wider opportunity set and provide diversification.
One year on, we have made substantial progress. We have reduced our exposure to unquoted equities from 21.6% to 8.7% and increased the portfolio’s exposure to mid and large cap equities from 35.1% to 60.3%. 75.5% of the portfolio was turned over in the year as we sold £64.3m worth of equities. We reduced the number of holdings in the portfolio from 91 to 49 by investing further capital in conviction positions and initiated new holdings only after extensive diligence. Our top 10 holdings now account for 44.1% of the portfolio compared to 36.6% a year ago. Overall, we reduced our gearing from 7.1% to a net cash position of 3.1%.
Our revised strategy has had an impact on both the structure and the composition of the portfolio. Where we have made new investments, it has been in stronger businesses – for example, our new holdings in Facebook, Just Eat and Domino’s Pizza are companies with world-class intangible assets and with resilient and growing end-demand. When we have made new investments, we have been unemotional and patient to invest in tough times. We sat on our hands for much of the year, being a net seller of assets before making significant investments in the fourth quarter of 2018 when volatility was high and sentiment low. Our more measured approach means that we have so far made only one new investment in the calendar year to date, compared to a historic run-rate of close to 20.
A significant proportion of the costs of our transformation were borne in this period, whilst the benefits will accrue over time to come. Our NAV declined by 8.6% against a 2.6% rise in the All-Share Index. Our unquoted portfolio detracted 5.5%, partly due to write-downs in valuation and partly our decision not to invest in companies requiring funding when we believed our capital to be better invested elsewhere. Our decision to invest further in companies sensitive to the UK economy detracted 2.7% as share prices continued to weaken. We continue to believe that the uncertainty created by Brexit has excessively suppressed valuations.
We have further work to do to complete the repositioning of the portfolio. However, we are confident the changes made this year will be reflected in time with improved returns for shareholders. The changes in liquidity and structure of the portfolio are easy to see.
What is more difficult to observe is the impact of our revised process where we are concentrating our capital on businesses where we think share prices are most detached from underlying value. In the short run discrepancies can exist, but in the long run share prices tend to catch up.
Our current optimism stems from what we perceive to be a particularly large discrepancy due to heightened investor uncertainty. Given this view and the transition occurring, the remainder of this report focuses on developments in the Company’s holdings, activity, our current positioning and outlook.
Selected Portfolio Developments
Tesco (5.9% of NAV), our largest holding, had a strong year, growing its sales by 11.5% and profits by 34.5%. The company has regained its investment grade status and made further investments in price and range. This has resulted in a sustained recovery in volumes and led to a restoration in the brand’s health. Together with Booker, the company has a uniquely low cost distribution platform in the UK due to its scale both on and offline, with resilient end-demand. The next leg of management’s strategy is to exploit “untapped value opportunities” in areas such as loyalty and own-label products. Such opportunities, with minimal additional capital required, should enhance both returns on capital and consequent returns to shareholders.
Sports Direct (5.5% of NAV), the UK apparel retailer, detracted 0.8% as its share price declined 26.1% over the year due to concerns over the UK retail environment. On an underlying basis, we think the company is performing well – for example, cash flow in the first half of 2019 increased by 15% as the UK sports franchise remains resilient and profitability was improved in the international businesses. In the past year the company acquired House of Fraser, Evans Cycles and Sofa.com at heavily distressed prices. Sports Direct has a low cost distribution platform and so in our view, such acquisitions are a good use of capital. House of Fraser’s footprint also represents a substantial opportunity to expand the group’s growing luxury retail presence. Sports Direct is a good example in our view of a share price falling when we estimate business value to be improving. We increased our position significantly in the year.
Rocket Internet (5.4% of NAV), the conglomerate of internet businesses, was a seller of assets through the year. It listed three of its assets successfully and realised investments in existing public companies. The company’s net cash increased from 50% to over 90% of its market cap at €3.4bn – meaning that on a ‘look-through basis’, this holding in the portfolio is substantially backed by cash assets. We estimate that the company is trading on a large discount to its net assets as it has over 200 stakes in private companies. This ‘hidden value’ and the considerable optionality in management being able to deploy its cash counter-cyclically make for attractive prospects.
IWG (4.7% of NAV), an operator of serviced offices globally under the Regus and Spaces brands, has continued to expand its footprint. It has made significant progress in its strategy to shift to a capital-light, franchised model, akin to that of the large hotel groups such as IHG or Marriott. In April 2019, the company announced the sale of its Japanese operations. Although this accounted for only 4% of group sales, the price received (c.£320m) represented over 13% of its market cap. This has served to reduce the company’s debt by over 60%. The company’s share price has responded well, rising by over 37% over the year, contributing 1.5% to our NAV. We think investors are still underestimating the value that would emerge as a result of a successful refranchising in other parts of the business: the company is trading at just over 1x sales compared to the multiple achieved in Japan of 3.4x sales, and franchising is likely to accelerate growth and improve returns on capital.
Dignity (4.3% of NAV), the UK funeral services operator, was a large detractor (1.5%) as its share price fell 33.4% in response to the announcement of a full investigation by the Competition Markets Authority (CMA) into the sector. We increased our position materially as we believe the company is well placed to prosper sustainably under a number of possible outcomes from the regulatory process. The business commands a unique position in the industry, with a national network of funeral directors and crematoria. For example, this means that it is able to provide simple, low-cost funerals entirely through its own network, likely at the lowest marginal cost in the industry. In the growing low-cost offering, the company’s market share is more than double its share in the traditional area, which we view as an indicator of further gains to come and the company’s ability to adapt to change.
Polar Capital (4.1% of NAV) and Liontrust (2.6% of NAV) have continued to grow their assets under management due to positive market tailwinds and growth in market share. Collectively these holdings contributed 1% to performance with their share prices rising by 15% and 21% respectively. Polar hired a new Emerging Markets team from Nordea demonstrating the potential for these boutique managers to expand into new verticals.
Hurricane Energy (4.0% of NAV), the oil exploration company, achieved several milestones towards commercialising and monetising its prospective resource base in the West of Shetland basin. Following the completion of the offshore installation phase and a successful vessel hook-up, the company is due to produce first oil in the Greater Lancaster Area (GLA) imminently. This will provide cash flow but more importantly, long-term production data to establish the commercial viability of a full field development. Given the company’s current market capitalisation of £1.1bn against resources in the GLA alone of over 1bn barrels, the potential is significant.
Reaction Engines, our largest unquoted holding (3.5% of NAV), announced a positive test result for its pre-cooler technology which was able to cool airflow from an engine replicating thermal conditions corresponding to Mach 3.3 flight in less than 1/20th of a second. The technology will now be tested at higher speeds. Further progress should enable the company to accelerate commercialisation of the technology.
Nintendo (3.2% of NAV) announced its intention to enter the Chinese market, which has for some time been a region where Nintendo’s franchises are popular but provide limited commercial benefits. The opportunity to partner with Tencent and introduce mobile games may change this. Google and Microsoft announced plans to introduce cloud gaming – allowing consumers to play games without the upfront costs of consoles. This would be similar to what Netflix did to set top boxes – democratising and increasing usage of content, thereby increasing its value. Nintendo seems well placed in this environment given the universal appeal and popularity of its franchises and hence we have been increasing our holding.
Hornby (3.1% of NAV) made solid progress in its turnaround under new Chief Executive Lyndon Davies. The company has streamlined its cost base and is working through legacy issues that led to a suppression in gross margins. The renewed energy in the business is being focused on revenue initiatives such as the signing of an agreement with Warner Brothers to bring its franchises to Hornby products. The holding contributed 0.8% to NAV in the period as its share price rose by 50%.
Delivery Hero (3.0% of NAV) announced a transaction in December to sell its German business to Takeaway.com for a multiple representing close to 10x sales. This has allowed the business to invest further in growing its positions in markets where it is a clear leader. This seems to be working as in the first quarter of 2019 revenue growth accelerated to 93%. We had increased our position in December as the company’s multiple contracted sharply in the wider sell-off of technology shares in the absence of any change to company fundamentals.
The year was characterised by abnormal activity as we sought to implement our revised investment policy. In aggregate we sold £64.3m worth of equities, reinvesting £27.1m into existing holdings and £22.7m into new holdings. In total we sold out of 49 holdings and started 7 new holdings.
We invested the majority of our realised capital in existing holdings. The most significant additions were to our retail holdings – in Sports Direct and Dixons Carphone. In our view, investors are failing to distinguish between a traditional capital cycle and industries in structural decline, resulting in depressed valuations for market leaders. Arguably this is similar to what took place in the grocery industry in 2015/2016, allowing us to invest in Tesco at attractive prices. However, we have been too early in some of our investments where current market prices are below our entry levels. We are constantly reappraising our valuations and continue to believe in the prospects for these companies.
We increased our holding in Plus500, the online trading platform. Our first investment in this company was in December 2016 amidst regulatory uncertainty and we have followed it since its flotation in 2013. We had reduced our holding following a large appreciation in its shares in 2018 but we misjudged the extent that new regulation would impact near-term trading. Following a negative trading statement in January and a sharp fall in its share price we increased our holding. We believe that the company continues to possess strong competitive advantages over its peers with a lower cost to serving customers and strong balance sheet. As the industry consolidates following the impact of new regulation, we expect Plus500 to benefit.
Our new investments in the year broadly fell into two categories: companies with strong intangible assets such as Just Eat, Domino’s Pizza and Facebook, and cyclically exposed companies such as Barclays, easyJet and Ryanair.
We made investments in Just Eat and Facebook in the second half of the financial year. Both companies have strong network effects in their businesses which we expect to endure. Given heightened investor demand for such assets, it required some sort of negative public issue to create a compelling investment opportunity – in the case of Facebook, the Cambridge Analytica scandal, and in Just Eat, its corporate governance issues and fears over competition in the UK market.
As for our other investments, we do not mind cyclicality so long as its impact can be understood, quantified and reflected in the price paid; and as long as there is a fundamental aspect of the company that is competitively-advantaged.
We have invested in European budget carriers as the airline industry has been pressured by high oil prices and weak consumer confidence. In easyJet and Ryanair we have two industry leaders with market values that are underpinned by their asset bases. Each has their own unique attractions: Ryanair has leading scale and low-cost operations, and easyJet has a strong brand and capacity constrained network positions.
Legacy carriers (e.g. Air France/Alitalia) still command a 60% market share of intra-European flights which represents an attractive opportunity for low cost carriers, given their relative cost base advantages and efficient operations. In the US market, the top four airlines have an 80% market share vs. 43% in Europe and so, in tough times, we expect consolidation to accelerate.
Our new investment in Barclays is the first bank investment in the Company’s portfolio for over 10 years. We think the core UK deposit/mortgage, payments and credit card franchises are strong, consistent cash-generative businesses. The value of these businesses has historically been suppressed by regulation, complexity and the bank’s investment banking operations. We believe the pressure on management from activist Ed Bramson will result in introspection that will release value.
In terms of sales, we reduced a number of holdings that did not fit our revised investment criteria. Our sales were largely in small caps and unquoted equities. We sold five unquoted holdings realising 8.2% of NAV – most notably, Metapack and Gundaline. Metapack was sold at a 25% premium to carrying value, representing an attractive 5.4x return on investment. Our investment in URICA was impaired following a one-off event that restricted the company’s prospects for raising funds. For further details see our most recent Half-Yearly Report.
We have further rationalisation to do and expect our number of holdings and unquoted exposure to continue to decline, albeit at a slower pace and, as already stated, new unquoted investments will only be made in exceptional circumstances. Commensurately, the underlying portfolio liquidity will continue to improve, giving us more flexibility.
Sector exposure
The table provided further depicts our current positioning based on our sector classification. We have increased advantageously diversification across geographies and sectors, despite now having a more concentrated portfolio. This has reduced the portfolio’s sensitivity to any one given risk. For example, historically we had large exposures to oil and asset prices, with positions in oil exploration companies and asset managers. These two sectors now account for 14.4% of our assets vs. 22.0% last year. We have reduced our exposure to asset managers, in particular to reduce sensitivity to global asset prices. As a result, we can now expect returns to come from a broader set of industries with the aim of generating more consistent returns.
We have a bias towards the UK as, on a bottom-up basis, we are finding good evidence to suggest that concerns over the outcome of Brexit has created myopic pricing of UK assets. On our estimates, 46% of the portfolio has revenues derived from the UK and 54% from overseas. Looking at the UK exposure, we estimate that 40% of this is sensitive to the economic cycle – such as our exposure to commercial property (Helical/Capital & Counties), travel (easyJet/Ryanair), and discretionary retail (Dixons Carphone).
However, this means that we judge the majority (60%) of our UK assets to be relatively resilient in tough times. For example, 9% of the portfolio is centred on the provision of food (Tesco/Just Eat/Domino’s Pizza). This balance should mean that the portfolio can prosper under a variety of economic outcomes, and we retain scope to alter the balance of our exposures, based on changes in the environment.
Outlook
In the UK market, the recent period has continued to be characterised by uncertainty because of Brexit, which has resulted in elevated volatility and certain sectors underperforming materially. We think that the premium being placed on good, predictable businesses that are seemingly insensitive to political outcomes is, on the whole, ‘sky high’.
By contrast, the aversion to uncertainty means that businesses which are economically sensitive or perceived to be challenged are very lowly valued. In this environment we are aiming to adopt an approach that is both patient and rational. We are using the opportunity to invest as bargains are unlikely to remain once obscurities clear. Our liquidity is strong and we have an unutilised gearing facility – meaning we are well-placed to capitalise on further opportunities as they arise.”