What can we learn from a decade of Terry Smith

“When I am driving I sometimes see an ice cream van which has emblazoned across the back the advertising slogan 'IT’S QUALITY THAT COUNTS'. The ice cream vendor seems to have figured out one of the great axioms of equity investment. He also does a decent 99 so he has two advantages over most pundits.”

So goes one paragraph from Terry Smith’s introduction to Investing for Growth, an anthology of the manager's writing from the first decade of Fundsmith Equity (GB00B4Q5X527), the blockbuster fund launched in late 2010. The abstract above highlights part of Fundsmith's appeal. While the flagship fund is now extremely well known for its strong performance (see chart), Smith has also been a rich source of clearly written and sometimes acerbic commentary, covering both his portfolio and the wider investment world.

Admittedly, it may only be the keenest investors and Fundsmith fans who work their way through the book. Published in late 2020 to mark the tenth anniversary of Fundsmith Equity’s launch, it pulls Smith’s annual letters to investors together with commentary written for the Financial Times and others. Some of this is already available on Fundsmith’s website and elsewhere online.

Investing for Growth does serve as a good reiteration of the thinking and principles underpinning Smith’s investing approach, including the three-step investment mantra outlined below. But it also highlights the nuances of the process, including why the team favours return on capital employed (ROCE) and free cash flow (FCF) yield as metrics for assessing companies and why Smith is less enamoured of measures such as earnings per share (EPS).

The writings in the anthology also repeatedly tackle some of the main criticisms of the Fundsmith approach, looking particularly closely at the argument that the fund’s holdings look expensive and may lag value stocks amid market rotations. As Smith never tires of noting, the argument for switching from “good” companies into value stocks has persisted for several years, but those that had made such a switch in the early days of Fundsmith Equity would have foregone significant gains while awaiting a value renaissance.

It is entirely fair to say that this and some of the other points made here advance Smith’s cause and that investors should not simply hang on the words of a popular fund manager. Yet Smith is good at acknowledging the limitations he and others face, including the impossibility of forecasting macro developments, as well as his mistakes. This includes a decision to sell Domino’s Pizza (US:DPZ) in 2011, later reversed when concerns about its refinancing plans were proved wrong.

What is perhaps most striking from reading the anthology is how repetitive it can be: the annual letters to investors follow the same format each year, while Smith’s broader writing tends to reiterate many of the same arguments and concerns. Yet this should be viewed as a positive. Smith’s repetition not only gives his points greater weight, but reminds us that simplicity and discipline can pay off in investment. If exciting narratives around trading and esoteric assets have drawn in many new investors over the last year (think cryptocurrency or the Gamestop (US:GME) saga), less exciting investment strategies have prospered in the longer term. Take the strong returns quietly made by index trackers, or the success of Smith’s fund and other concentrated, low-turnover funds such as Lindsell Train UK Equity (GB00B18B9X76).

Some of the anthology does take in the pitfalls that lie in wait for DIY investors. “Ten golden rules of investment”, a piece originally written for the FT, offers some simple approaches, from not buying something you don’t understand to minimising fees, avoiding timing the market, never investing in something simply to avoid tax and avoiding overdiversifying (an issue commonly raised in our Reader Portfolio features).

Smith’s other musings take in a variety of subjects of interest to investors, including issues with ESG investing, the truth behind the Wall Street Crash, the problem with pharmaceuticals stocks, factors behind past disasters at Tesco (TSCO) and the corporate jargon that should prove off-putting.

The three-step investment mantra

The three-step mantra of Fundmith: the team buys “good” companies, or those that regularly make a high return in cash terms on capital employed and can reinvest at least part of that to grow the business and compound the value of your investment. Smith and his team will seek not to “overpay” for a company – although doing so with a good business can involve investing when problems have hurt the share price. The team then seeks to run its winners and avoid churn in the portfolio, to minimise trading costs.