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- Super investor Terry Smith
Dear Investors,
Terry Smith is a well known UK investor and the founder of Fundsmith - an investment management company.
Terry has been referred to as the UK’s Warren Buffett. It’s not hard to imagine why when you hear him speak. He is clearly a student of Buffett.
Terry’s fund has produced fantastic results. Since inception (Nov 2010), the fund has delivered returns of 16% per annum. This is a healthy lead over its benchmark, the MSCI World Index, which delivered returns of 11.1% per annum.
The fund’s investment philosophy gives a lot of insight into how they think about companies and investing.
Here are my notes on Fundsmith’s investment philosophy.
Terry Smith
1. Buy and hold
Fundsmith aims to be a long-term, buy-and-hold investor.
They aim to own stocks that will compound in value over years.
Therefore, they are very careful about the stocks they pick.
They share Warren Buffett’s belief that as investors, they will not have a good investment idea every day or even every year.
2. Invest in high quality businesses
Many investors do not have a definition of a high quality business.
Fundsmith’s definition of high-quality is a business that can sustain high returns on operating capital employed, in cash.
An important contributor to sustainability is to get repeat business, usually from consumers.
To Fundsmith, a company that sells many small items each day is better able to earn returns than a company with cyclical business.
3. Invest in businesses whose assets are intangible and difficult to replicate
They seek to invest in businesses that break the rule of mean reversion - which states that returns must revert to the average as new capital is attracted to high return businesses.
These businesses can do this because their most important assets are intangible assets such as brand names, dominant market share, patents, distribution networks, installed bases and client relationships.
4. Never engage in “Greater Fool Theory”
Fundsmith never invests with the hope that someone more gullible will come along and pay an even higher price.
Fundsmith assumes “there is no greater fool than us”.
5. Avoid companies that need leverage
Fundsmith only invests in companies that earn high returns on capital on an un-leveraged basis.
The companies may have debt, but must not require borrowed money to function.
In assessing leverage, they include off-balance sheet finance such as operating leases.
6. The business must have growth potential
It is not enough for companies to earn high rates of return.
In Fundsmith’s definition of growth, companies must be able to reinvest a portion of their cash flow back into growing the business.
7. Invest in resilient businesses
An important contributor to resilience is a resistance to product obsolescence.
Consequently, Fundsmith does not invest in industries which are subject to rapid technological innovation.
Innovation often creates value for some investors, but a lot of capital gets destroyed for others.
8. Only invest when the valuation is attractive
Many investors who invest in good businesses underperform because they overpay for those investments.
Fundsmith aims to invest when the free cash flow yield is high relative to long-term interest rates and the free cash flow yields of other investment candidates.
9. Do not attempt market timing
Getting market timing right is a skill Fundsmith does not claim to possess. So they do not time the markets.
Fundsmith points out that studies demonstrate that most successful funds managers avoid market timing decisions.
10. Do not fixate on benchmarks
Fundsmith does not think it is helpful to make comparisons over the short term.
In their view, even a year is a short time to measure things.
They point out that a year does not have its foundations in the business cycle, instead it is the time it takes the earth to go around the sun. Therefore, a year is of more use in studying astronomy than investment.
11. Invest globally
Fundsmith invests globally.
Some of the companies invested in derive revenue from developing markets.
This allows the fund to obtain the benefits of developing market exposure whilst also benefiting from the governance structure of a large international company.
12. Do not over-diversify
The fund seeks portfolio diversification, but strict investment criteria means that the portfolio will be somewhat concentrated and hold 20 to 30 stocks.
Research shows that optimal diversification can almost be achieved with 20 stocks.
13. Currency hedging
Fundsmith does not hedge currency exposure because:
Currency hedging has a cost.
You cannot know the individual company’s currency exposure.
You cannot permanently hedge a portfolio against movements in any commodity.
14. Management versus numbers
Fundsmith is more comfortable analysing numbers than trying to gain insight into a company by meeting management.
That is not to say they do not meet management. They merely expect management’s words to be borne out by figures in the reports and accounts.
15. Investments are liquid
The companies that Fundsmith invests in have large market capitalisations and are easily tradeable.
A few facts from the fund’s holdings (April 2023)
The fund size is £24.3 billion.
The fund holds 27 stocks.
The average company in the fund was founded in 1917.
The median market capitalisation of the companies is £112 billion.
The fund holds 3.3% in cash (i.e. 96.7% is invested).
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