Artisan Value Income Fund Q1 2024 Commentary

Investing Environment

US equity markets reached new all-time highs in Q1 supported by a resilient US economy, a general trend of disinflation and an acceleration in corporate profits growth. Given mostly benign economic data offering little indication that a recession is near, interest rate markets pared back the number of expected Federal Reserve rate cuts in 2024. The S&P 500® Index (SP500, SPX) rose 10.56%, continuing the strong rally that began in late October of last year. There was broad-based strength across sectors. Communication services, financials, energy, industrials and technology stocks were each up double-digit percentages. Higher yielding sectors (real estate, utilities and consumer staples) trailed.

The market’s move higher has been an unusually smooth one. In Q1, the S&P 500® Index experienced only three down days of one percent or greater. Over the five-year period from 2019 to 2023, the average quarter had nine such days. There are plenty of risks that could upset the apple cart, whether geopolitical or macroeconomic. The ongoing conflicts in the Middle East and Ukraine continue to rage, and inflation—though trending lower—remains above the Federal Reserve’s 2% target. Markets during the first three months of the year showed relatively little concern, however. Earnings—the bedrock of business values—are growing soundly once again, and the recession that many predicted would have started by now has yet to emerge. However, volatility has picked up in April as we write this letter.

Performance Discussion

In Q1, the portfolio performed in line with our total return expectations—delivering a strong total return comprised of premium income (a portfolio current yield that is greater than or equal to 2X the average current yield for stocks in the S&P 500® Index) and solid capital appreciation. Our Core Value, Dividend Recovery and Dividend Growth holdings drove our overall return as bond proxies and fixed income securities trailed the broad equity market.

Our top contributors were nVent Electric (NVT), Corebridge Financial (CRBG) and Lamar Advertising (LAMR). nVent Electric provides electrical connections and protection solutions. These are mission-critical elements in commercial electrical and mechanical systems and civil infrastructure. nVent has shown consistent and steady growth since the pandemic, having reported 12 consecutive quarters of year-over-year sales growth supported by the secular tailwinds of electrification, sustainability and digitalization. Growth has come from a combination of volumes and pricing, with the company successfully offsetting inflation with pricing. Due to the low cost of its products relative to a project and high failure costs for customers, nVent has good pricing power and sustainable margins. In the recent quarter, the company’s data centers business (~14% of sales) was a standout, growing 20% year over year, as the acceleration in artificial intelligence infrastructure investments has created increased demand for the company’s liquid cooling solutions. Though nVent is no longer selling as cheaply as when it first drew our interest, the stock still sells at a lower P/E multiple than the S&P 500® Index despite better earnings growth.

Corebridge, a life insurance and retirement solutions company, was previously a unit of AIG and a September 2022 IPO. AIG still owns ~51% of the company following its recent secondary sale in November 2023, equaling 9.1% of shares outstanding. Since adding Corebridge to the portfolio in Q1 2023, it’s been among our top performers as the “higher for longer” interest rate environment has driven an increase in spread income. Our investment thesis has been that Corebridge would benefit from the current interest rate environment following ZIRP (zero interest rate policy) and would also have plenty of room to improve its competitive position and wring out efficiencies to improve ROE now that it is a standalone entity that is no longer part of a large inefficient and capital-constrained parent. Even after recent stock price gains, Corebridge yields 3.2% on its dividend, with a double-digit free cash flow yield. In addition to Corebridge’s regular dividend, the company paid two special dividends in 2023 totaling $1.78, which is 7.6% on the March quarterending stock price. Besides dividends, we expect free cash flow will be used to ensure holding company liquidity, retire diluted shares and support modest growth expectations.

Lamar Advertising—our largest position—operates outdoor advertising structures such as billboards, digital billboards and transit ads. Results have been relatively steady, with strength in local/regional sales lifting the top line, while margin improvement drove better-than-expected earnings growth. In addition to returning cash to shareholders (the dividend yields 4.7%), management is focused on delevering the balance sheet given limited M&A opportunities. While the company’s growth can ebb and flow, over the long term, the company has experienced average annualized organic growth in the high single digits, supplemented by small tuckin acquisitions. With a record of consistently generating free cash flow and prudent capital allocation that includes high return of capital to shareholders, this stock fits our process.

Our bottom contributors were Cable One (CABO), Philips (PHG) and Universal Health Realty Income Trust (UHT). Cable One, a small cable company operating in rural US markets, was our biggest detractor in Q1. Shares have remained weak due to concerns about competition from wireless providers and depressed subscriber growth, driven in part by fewer residential moves in a frozen US housing market. Broadband subscriber additions picked up in the latest quarter, but increased promotions and discounting reduced average revenue per subscriber, and an end to the ACP (Affordable Connectivity Program) accepting new enrollees creates an additional headwind to growing subscribers. While wireless companies are entering new markets, 5G is not currently competitive with cable’s download speeds, and based on the physics of wireless data delivery, 5G is unlikely to be competitive with cable for many years, if ever. Cable continues to have a competitive advantage with respect to network speeds, reliability and capital intensity. Despite recent growth challenges, free cash flow conversion remains solid, and the valuation is highly attractive, having a free cash flow yield of ~12% and selling below our estimate of 8X normalized earnings. We like the cable business in general due to its high recurring revenue, pricing power and healthy operating leverage.

Since Philips, a health care technology company, initiated a voluntary recall of its first-generation CPAP machine more than two years ago, investors have shunned the stock due to the uncertainty related to potential litigation liabilities. That has left the stock extremely undervalued. In January, Philips agreed with the US government on a proposed consent decree providing a roadmap of required actions and prohibitions—a process likely to take three years to conclude. As part of the consent decree, Philips is prohibited from selling CPAP or BiPAP sleep devices in the US. However, Philips may still service sleep and respiratory care devices already with health care provider and patients and may continue to sell other products in the US. Further, it does not impact the company’s sales outside the US. The overall terms are as expected, and there is now a path forward for Philips to eventually return to the market. We appreciate that until there is greater clarity on the total settlement cost, the stock may remain under pressure, but at the current asking price, shares sell at a significant discount to our estimates of intrinsic value.

Universal Realty Income Trust (UHT) is a health care REIT (real estate investment trust) specializing in health care facilities, including acute care hospitals, behavioral health centers and medical office buildings. Our initial purchase was in June 2023. Like other high income producing stocks, UHT has been out of favor given higher interest rates. Besides the stock selling at low levels relative to its historical valuation and other REITs, we liked UHT’s track record of execution, low leverage, reduced cyclicality and consistent annual dividend growth. It currently yields nearly 8%. Recent results have been strong, with revenue growth up over 5% driven by annual lease price escalators, a better mix of assets, increased occupancy and M&A. However, UHT was down in Q1 along with the broader real estate sector as interest-rate sensitive areas badly lagged the rest of the market.

Portfolio Activity

In Q1, we added two utilities to the portfolio: Alliant Energy (LNT) and Evergy (EVRG). Alliant Energy is a US-regulated electricity and natural gas utility operating in the Midwest. Evergy is a Kansas-based, fully integrated, fully electric utility. As the sector has lagged significantly over the past year, leading to an above-average earnings yield relative to the broader market (Exhibit 1), we’re finding more opportunity.

Exhibit 1: Utilities Sector: Mispriced Yield

As a group, utilities have been out of favor for a few reasons. The interest rate environment has made bonds more appealing, and higher inflation has increased labor, equipment and commodities costs while also raising utilities’ costs of capital. Utility companies can pass on a lot of their costs to customers; however, rates are regulated, and regulators have strived to limit the rise in customers’ utility bills, which have already experienced large increases in the post-COVID inflationary period. Consequently, utilities haven’t been able to increase their ROEs as recent rates cases have gone against them.

Alliant Energy serves approximately 995,000 electric and 425,000 natural gas customers through two public utility subsidiaries, Interstate Power and Light (operates in Iowa) and Wisconsin Power and Light. Despite little change in the company’s regulatory or operating environments, the stock has retrenched over the past year, and it now trades for about 16X P/E compared to an average of 18X over the past 10 years and has a 3.6% dividend yield. The company continues to invest in rate base, and a positive outcome on its current rate case in September could give it a boost.

Evergy serves more than 1.7 million customers in Kansas and Missouri. In addition to the aforementioned dynamics weighing on utilities share prices, Evergy had two key rate cases in 2023, one in Kansas and the other in Missouri, that presented risk for investors. The Missouri case went better than expected, but the returns allowed by the Kansas regulator were punishingly low. Though Evergy operates in a subpar regulatory environment, the utility is a good operator, with strong customer satisfaction scores, below-average capex needs and a clean balance sheet. The regulatory environment may improve at some point, but even if it does not, Evergy trades for just 13X 2024 earnings, which is below average relative to its history and peers— and pays a dividend yielding 4.7%.

We also added Ryanair Holdings (RYAAY), an Ireland-based low-cost airline focused on the European market. The airline’s low-cost, high on-time, high-efficiency model has helped it to take share from inefficient legacy and state-sponsored carriers over the past 20 years. Ryanair keeps a net cash balance sheet to opportunistically purchase aircraft countercyclically when it can do so at cheaper prices. Additionally, the company’s economics are favorable. It has pricing power due to industry consolidation, capacity growth that is below demand growth and a lack of overlap on key routes. This leads to strong returns on equity and margins. Ryanair recently initiated its first dividend policy, and we estimate the dividend could yield 2%–3%. In addition to the dividend, Ryanair is expected to repurchase stock. Over the last decade, the company has retired 20% of its share count. This is remarkable considering it was a growth-focused airline and still had net cash after a pandemic. The stock sells at an attractive low-doubledigit P/E, but we do not need multiple expansion for this investment to contribute well to our portfolio income and capital appreciation objectives. We believe simply continued execution of the business should lead to solid returns.

Perspective

With market-cap weighted indices hitting new highs and the S&P 500® Index selling for 23X (FY1) earnings, value-conscious investors—a group in which we proudly admit to being members—may feel some trepidation regarding forward return expectations for the asset class. However, we believe it would be a mistake to focus solely on the S&P 500® Index, which has become increasingly concentrated among a few mega-cap stocks, and in our view, no longer represents the diverse opportunity set that exists within our value investment universe. As we’ve noted in prior letters and on our blog Artisancanvas.com, value is historically cheap. Aside from the pandemic years of 2020 to 2021, large-cap value hasn’t been this cheap relative to large-cap growth since the aftermath of the tech bubble. The Russell 1000® Value Index trades for 16.5X FY1 estimated earnings. The Russell 1000® Growth Index trades at 28.8X FY1 estimates. The average and median valuation spreads between these indices have been 7.8 and 6.1 percentage points over the past 26 years. Today, it’s 12.2 percentage points. We don’t know if the valuation premium for growth stocks will revert in a year or over the next 10, but we do know that the current spread positions value stocks favorably from here.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.