Can Smithson emulate its parent?

The Smithson Investment Trust IPO takes place this month. The fund will be run using a similar philosophy to Fundsmith Equity, but will be managed by Simon Barnard and Will Morgan – two recent recruits. It will target companies with a market capitalisation of between £500m and £15bn, aiming for an average of £7bn across the portfolio. For comparison, Fundsmith Equity has an average market cap of around £50bn across its portfolio, according to Morningstar.

On the face of it, the new investment trust makes sense. Fundsmith Equity has grown to such a size that it cannot make investments in smaller stocks. Mr Smith’s strategy is focused on taking large bets on a relatively small number of stocks, and given the size of the current fund, even a 2 per cent holding in the fund would amount to an investment of over £320m – meaning it would own almost 5 per cent of a £7bn market cap company. This is not necessarily a huge issue, but size can prevent managers from taking meaningful stakes in smaller companies and also act as an influence on share prices when they come to buy or sell.

The aim for the new investment trust is simple: replicate the performance of the parent fund but using smaller companies. Fundsmith Equity launched in 2010 and has outperformed the MSCI World index in every calendar year since, and cumulatively over three and five years – the latter period producing a 160 per cent return versus an 88 per cent rise in the index.

However, this is certainly easier said than done, so one has to ask what the outlook is like for the Smithson Investment Trust.

What it will buy?

To begin answering this question, we need to break down the investment strategy behind Smithson. The main sectors it will focus on are cash-generative software and technology stocks, consumer companies and healthcare firms, situated mainly in North America, likely to be 50 per cent of the portfolio, and Europe which is estimated at 38 per cent. 

The investment philosophy does not really allow for investment in real estate companies or banks, the former because it’s difficult for one real estate company to build a sector-dominant business model, and the latter because they require too much leverage. It also avoids cyclical stocks – ones reliant on strong economic growth – such as miners, construction and oil. Mr Smith has also never really liked car manufacturers and airlines – because these industries have too many players and no one company can build a dominant position – and utilities and telecom stocks because they are too capital intensive.

Smithson’s managers say: “We will only invest in companies which can compound in value over many years, if not decades, where we can remain a happy owner. We work on the principle that you should choose investments with the highest probability of an acceptable profit rather than those with a small probability of a very high profit.

“We do not attempt to achieve this by picking winners, but selecting companies that have already won. They may have a dominant market share in their niche product or have brands or patents which others find impossible to replicate. We will only look for investments in industries which we know will create shareholder value over the long term.

“Good businesses that can sustain a high return on operating capital employers and generate substantial cash flow, as opposed to only earnings per share.”

Smithson has identified Spirax Sarco Engineering (SPX), listed in the UK, along with US companies Sabre (NSQ:SABR) Masimo (NSQ:MASI) and Verisign (NSQ:VRSN) and Swiss companies Geberit (VTX:GEBN) and Temenos (VTX:TEMN) as typical potential holdings.

The managers have identified 83 companies that match its criteria, which when blended into a portfolio would have easily beaten the MSCI World Small and Mid Cap (SMID) index and the MSCI World index over one, three and five years when back-tested. Once launched, however, the fund will be more concentrated, with between 25 and 40 investments – with a maximum of 10 per cent in one holding.

Smithson's investible universe

Source: Fundsmith, includes ongoing charges of 1.1 per cent, as at 31/07/2018

Issues to consider

So it seems Smithson could replicate if not exceed the performance of its larger company peer. However, it could be that Mr Smith’s strategy has worked because he's been in the right place at the right time – and the stocks he aims to buy have simply been in favour in a quantitative easing and low-yield-fuelled environment.

And Investors Chronicle’s in-house economist Chris Dillow has often warned that investors have finally cottoned on to the valuable cash flow and defensive traits of companies that Fundsmith is likely to invest in (but he also suggests there is still room for valuation errors with some of these companies, particularly where their business models are hard to replicate).

But the Fundsmith investment house counters current valuation concerns by highlighting the long-term nature of the investments. They also point to their strict rules on valuations and accept that attractive companies can have a price that makes it unattractive. According to the prospectus, Smithson will only invest in companies whose free cash flow (after tax and interest but before dividends) yields (cash flow divided by market capitalisation) more than a bond, which they say should keep valuations in check.

Mr Smith isn't the first fund manager to launch their own fund firm, and then launch an investment trust focusing on small-caps despite having made their name investing in larger companies. Neil Woodford, manager of the Woodford Patient Capital Trust (WPCT), launched his trust in April 2015, and to date the share price has fallen nearly 13 per cent. However, the nature of Patient Capital Trust is suitably different to Smithson for these comparisons not to stick. Mr Woodford runs a much more speculative investment strategy than the “already winning” names touted by the Smithson prospectus. Nonetheless, it is worth bearing in mind that new ventures do not always work.

Mr Smith has also tried something similar before, converting his successful global equity strategy from Fundsmith Equity into an emerging markets one. However, the Fundsmith Emerging Equities Trust (FEET) has not done as well. Mr Smith launched the vehicle in June 2014 and since then the share price has risen 15 per cent, substantially behind the 37 per cent rise in the MSCI Emerging Markets index.

Mr Smith argues that what has driven the index returns – mega-cap Chinese tech stocks – are not areas he will ever be exposed to, and so FEET will always differ from the benchmark. The trust favours Indian companies, and emerging market consumer stocks, which have underperformed the wider benchmark but which Mr Smith expects to come good over the longer term.

The trust share price has also been supported by loyal Terry Smith followers – and has operated at a premium to net asset value (NAV) for the majority of the time since launch. The NAV has only risen 11 per cent over the same period.

FEET struggling to stand up

Source: FE Analytics, as at 08/10/2018

And although Smithson is modelled on Fundsmith Equity, investors should note that it will not actually be run by Mr Smith, although he will oversee its operation as the firm’s chief investment officer. The managers, Mr Barnard and Mr Morgan, both joined from Goldman Sachs Asset Management in 2017. Mr Barnard, the lead manager, has experience in running a concentrated global equity fund, but this only launched in 2016. Prior to this he was running a multi-asset income fund.

His assistant manager, Mr Morgan, since 2011 has specialised in analysing and managing portfolios of auto companies, industrials, construction and building materials stocks – not exactly the prime sectors for Smithson. You might have faith in Mr Smith’s ability to pick managers as well as stocks, but they still have to prove themselves at the coal face.

Is it different?

In comparison to other global small-cap investment trusts available, Smithson offers something relatively different. Major players in the space include Edinburgh Worldwide Investment Trust (EWI) and F&C Global Smaller Companies (FCS), however the companies in their portfolios have average market caps of between £2.5bn and £1.5bn, respectively, significantly smaller than the £7bn targeted by Smithson. In terms of sector composition, EWI and Smithson are likely to be similar, with the Baillie Gifford-run investment trust currently holding 31 per cent in healthcare and 34 per cent in technology, but only 15 per cent in consumer companies. The F&C trust is slightly different in that it allocates 20 per cent to industrials and 15 per cent to financial services, but also has 24 per cent in consumer stocks.

Smithson's charging structure is also different. The annual management charge of 0.9 per cent will be levied against its market capitalisation instead of the usual NAV, which Fundsmith says will better align the investment manager’s interest with shareholders'. The estimated ongoing charge is 1.1 per cent. This compares with FCS’s 0.83 per cent and EWI’s 0.87 per cent, making Smithson very much a premium product.

Mr Smith is putting £25m of his own money into the trust, which is looking likely to raise £600m at IPO on 19 October, most of which will be invested within a week. Other Fundsmith partners and managers will be investing £5m.

Despite the concerns, the logic behind the Smithson strategy is compelling. Mr Smith’s large-cap buy-and-hold strategy has done wonders for his investors across the decades he has run it and, given the right timeline for investing, there is a significant chance it can do so again.

This article has been amended to correct the potential holding to Sabre (NSQ:SABR) and not London-listed Sabre Insurance Group (SBRE)