Three cheap UK shares and a ‘magic bean’ investment

Nick Shenton, co-manager of Artemis Income, explains how the £5 billion fund stands out from the crowd, and why its sweet spot is targeting companies at the lower end of the FTSE 100 index.

In an interview with interactive investor’s Kyle Caldwell, Shenton names a stock, held for more than a decade, that has performed very well in recent years and which he is continuing to back, describing it as a “magic bean”.

He also outlines the investment opportunity to take advantage of the UK stock market’s cheap price tag, and names three shares that are looking undervalued.

Artemis Income I Acc is one of interactive investor’s Super 60 fund ideas.

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Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. I'm Kyle Caldwell, and today in the studio I have with me Nick Shenton, co-manager of the Artemis Income fund. Nick, thanks for coming in today.

Nick Shenton, co-fund manager of Artemis Income: Kyle, it's great to be here. Thanks for having me.

Kyle Caldwell: So Nick, to kick off, could you talk us through how you invest and how the fund stands out from the crowd in terms of investing differently from other UK equity income funds?

Nick Shenton: Well, I suppose the starting point is that we know we've got to be more than just an income fund. We've got to be a great, trusted home for people to place their hard-earned savings, and we've got to create the wealth.

So, we think very much about running in our own lane, and we focus on free cash flow. That's the key, really, of the philosophy. Free cash flow first, dividends second. The reason we do that is [because] you pay the dividends from cash. The owners of the company get money back in cash. You can't pay a dividend with an accounting profit. So, it seems common sense to us.

Then we focus on the long-term characteristics of the companies we're investing in. By that we really mean understanding, quite deeply, the industry structure, their value creation and looking out over three, four, five years. So, it's a long-term process, and it's one that's been iterating and evolving for 24 years now. We think it's tried and tested and the process, we believe, works in different market environments, and we have the evidence to back it up.

Kyle Caldwell: Is there a particular investment style that you lean towards, such as value investing? And how many stocks do you hold?

Nick Shenton: We don't think about a specific style. To us, that wouldn't make sense. The reason is pretty simple; why would you reduce your investable universe? What we do instead is look for characteristics, kind of pattern recognition. Characteristics we like, in terms of fundamentals being under-appreciated, or where there's hidden value in the business, the way the shares trade. We're agnostic between, let's call it value and growth, we just see opportunities.

The main point to note, of course, is that we don't get to project on the market what we're going to buy. Stock markets move around and sometimes there's value on offer in cheaper stocks, sometimes there's value on offer in faster-growing stocks. So, really, we're pretty agnostic.

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What we do like is what we call tension in the portfolio. If you were to go back eight or nine years, there would have been around 70 stocks in the portfolio. We reflected hard on that and felt it was too many. We've taken it down to around 50 stocks.

The reason we've done that is because it really focuses our mind. Are our best ideas backed with enough capital to really make a difference? When you have 70 stocks, you can have quite a long tail of companies that aren't really working for you, or where you're spreading out your ideas a bit too thinly. So, we like that, what we call, capital tension. It focuses the mind and really drives us to make better decisions.

Kyle Caldwell: You're one of three co-fund managers. One of the managers, Adrian Frost, has been managing the fund for around 20 years. Is succession planning in place for when he retires?

Nick Shenton: I hope it's me! That's been the plan. I've worked on the fund for over half the lifetime - more than 12 years. Andy [Andy Marsh, co-fund manager] has been with us for, I think he's in his seventh year. It's a pretty long duration in this strategy.

I don't think Adrian will ever retire because he loves this. I think we all do. We're really fortunate to do a job which is more than a job, it's a kind of a vocation. You are just always learning. It's a fascinating profession. And if you've got the right structure, the right team around you, I think you can have a long duration.

A lot of investors have been asking us that question for a long time; when will Adrian retire? And we're seeing a lot of those folks retire before him. So, he'll be around for quite a while. But, Andy and I, we've had the best seat in the City, we think, working with Adrian. He's been an amazing mentor and continues to be. We see this very much as a team sport, and so does he. We've really milked him for every last drop of knowledge you can get about investing and income investing.

Kyle Caldwell: It's a big fund. Assets are around £5 billion. Does this restrict your ability to invest in mid- and small-cap firms. And could you tell us what company is the smallest in terms of market capitalisation?

Nick Shenton: Our sweet spot is the lower end of the FTSE 100. So, market caps in the billions. The reason we like that, and the reason we've had success there, is these are companies that are big enough [for us to] analyse them and really understand them well. But small enough that they have still got a long runway of growth.

We don't feel we have to go down the cap scale. We've never done it and we've generated what we think is a decent return over the long run, which shows that size hasn't been an impediment.

If you flip it on its head, we think it's a huge advantage. The advantage of the scale is that if we're respectful of the companies we interact with. We invest in companies, we don't trade shares, and the average holding period is over six years.

We build relationships and we're partners to these companies. We share information patterns that we see. We can ask them challenging questions and really hold them to account, but also back them to create wealth.

Over time, that's compounded into a really powerful network of contacts for when we want to understand an industry or just have a general conversation. We've got former CEOs, current chairs, non-executives, some really outstanding people who we can network with to understand the business landscape better. So, we think it's a real advantage.

That said, we get things wrong, and when we get things wrong, share prices go down, so the valuation becomes smaller.

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We do have some small companies that we have got wrong. A couple of examples of smaller companies? Origin Enterprises (LSE:OGN) is an agri business that provides advice and products in the agricultural industry. That hasn't performed as we'd hoped, but it has delivered pretty good cash flow and dividends. It's just that the valuation has got a lot cheaper. That's around a £300 million market cap.

There are quite a few stocks in the UK that are trading at very low capitalisations, and we think that's probably a signal of value.

Kyle Caldwell: The fund's top holding is 3i Group Ord (LSE:III), the investment trust. It's had a really good run of performance over the past couple of years, predominantly due to its position in a Dutch retailer called Action Group. So, what are the prospects for 3i Group going forwards? Today, it's sitting on a very big premium. Is that premium too hot to handle?

Nick Shenton: It's a fair question. I think you're very kind and too polite to ask me, 'Well, if your average holding period is over six years, what do you do all day?' The answer is that we stress test our investment cases. So, we build an investment case and then we're just sifting through information. It's like panning for gold in a river. Just finding information that could contradict or confirm the investment case.

With 3i, my goodness, we have stress-tested that investment case because it's performed very well. I've got to say that in an investment career, you get very few magic beans. It's just a handful, if that. I've been doing the job for almost 21 years, and I hope to do it for at least another 21 years. 3i is a magic bean, and they're very precious, and you take care of them.

What's so special about it is this investment they have in a business called Action, which is not known in the UK, but is increasingly well known in Europe. It is a discount retailer.

We've owned shares in 3i for 12 years, and the business started in the Netherlands. It's doing something really unique because it's travelling and working in different markets. So, going from the Netherlands to Belgium and then to France, Spain, Italy, Poland and Germany. Very few other businesses have managed that because Europe is culturally so diverse.

But there's something about this business which is special. We still think it's got a very long runway of growth.

On Tuesday evening, I was running home; I like to run and cycle. I saw the chief executive, Simon Burrows, and stopped and had a chat. I said that I'd been in some competitor stores and some Action stores in Europe, and he started talking about the opportunity in the US, which we think could potentially be vast as well. So, it still has option value, and that's a long way of saying that we continue to run our winner there.

Kyle Caldwell: You touched on that valuations are very cheap, particularly compared to history across the UK market. Could you provide some examples of companies that are looking cheap at the moment?

Nick Shenton: Yes. And if I may, I'll just explain why we think there's this opportunity. Broadly, it's that the UK has been very unpopular as an investment market and we think that's more emotional than it is logical.

There's a number of reasons for it, it might be Brexit, it might be bad PR globally, it might be lack of interest in the UK market, it might be the pension reforms for one reason or another. There are good-quality companies in the UK which trade significantly cheaper than they would do, perhaps, if they were listed in the US.

There's an abundance of examples. Just to give you two or three, easyJet (LSE:EZJ)'s share price and the valuation of the business is less than what we think their planes are worth. This is a crazy thing. It shouldn't exist, but it does. You could buy easyJet in the stock market now, take it private, sell all the planes and make money. That doesn't make sense to us.

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Another is SSP Group (LSE:SSPG). If you're in the airports and you're going to get a cup of coffee or a sandwich, SSP is the world's leading food and beverage concession operator. They've got years and years of structural growth ahead of them in North America, India, Indonesia, and Saudi Arabia. The valuation of that business is £1.3 billion. It's a world leader in a £25 billion market and we think it trades at about 10 times its cash flow with a lot of structural growth ahead of it. That, again, seems pretty cheap. 

I could go on and on, but if I give you one more example, Informa (LSE:INF) is a long-term holding, I think over 10 years in the fund. If you are in the pharma industry, you go to CPHI Europe [a global pharmaceutical exhibition] and you will be there with 50,000, 60,000, maybe 100,000, other people. Informa own that event. It's very powerful.

When we look around at other events, we think, could Informa buy some of those and create value? They might, but then Informa shares trade cheaper than those other assets in the market, and they've got the best portfolio. So, they may as well buy back shares, and that's what they're doing. So, there's quite a lot of disconnects that we think offer value.

Kyle Caldwell: Given that you're seeing a lot of opportunities in the UK market, have you been making more changes to the portfolio than usual? I know you've got a six-year time horizon, but have you been looking to increase positions in stocks that you don't own, or have you been looking more at your portfolio and thinking you'll top up positions?

Nick Shenton: Well, that's a great way to frame it, and that is actually what we've been doing. We've just been slicing perhaps some of the better performers, the more highly valued stocks and recycling the capital.

We do believe in running our winners. That's been a big learning for us over the past 10 years, but also we see this point about compelling value, and the best place to start with new ideas is your own portfolio. So, what do we already own - and this is very scientific, and I'm sharing trade secrets here -  where we are hotter on the investment case?

We have the very scientific process of 'Are we hotter or colder?' When we're hotter, we think we should allocate more capital to it. And so that's largely what we've been doing.

There's a really unusual phenomenon happening, which we've never seen in our investment careers, which combined I think is 90 years-plus, that we want to take advantage of, and it's share buybacks.

So, companies buy back shares when that is the best use of their profits, when you can create a lot of value. In other words, when your shares are too cheap. In the past 12 months, over 60% of the portfolio by value has bought back shares, and we want to take advantage of this.

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So, we recently bought a UK small-cap called Shell (LSE:SHEL). I don't know if you've heard of that?! I say small-cap because it is in comparison to some of the global competitors, completely overlooked. In the past two and a half years, they've bought back 18% of their shares. So, these companies are gobbling up their own shares. BP (LSE:BP.) [is doing] something similar. So, we actually bought Shell recently.

The reason for that is we think that the share buybacks are not being observed by the market, they're not understood. In simple terms, we think that because of the collapse in share count, we could own the last share in Shell in seven or eight years’ time. Which seems crazy, seems unlikely, and it probably is. But the way for it to be proved unlikely is that the shares go up a lot.

So, that's maybe a really strong theme that we see currently, and we've been backing that in the portfolio by increasing the banks' positions, for instance, where they're doing something similar. I think NatWest Group (LSE:NWG) has bought back over 25% of its own shares in the past three and a bit years.

Kyle Caldwell: Nick, thank you for your time today.

Nick Shenton: Thanks very much for having me.

Kyle Caldwell: That's it for our latest Insider Interview. I hope you enjoyed it. Let us know what you think. You can comment, like, and do hit that subscribe button for more future videos, and hopefully I'll see you again next time.