Terry Smith joined Barclays (BARC) as a freshly-minted history graduate in 1974 following an interview milkround with household names from Unilever (ULVR) to Marks and Spencer (MKS). Not one to shy away from a challenge, Smith chose Barclays because they gave him the toughest interview, and he liked that. He became prominent as the UK’s top-rated banking analyst throughout the 1980s and in 1992 published the blockbuster 'Accounting for Growth' which exposed accounting malpractices and frauds of the time - and also cost him his job at UBS (called UBS Phillips & Drew at the time).
Smith is now best known for his hugely successful career as a fund manager, having set up Fundsmith and managed its flagship Fundsmith Equity Fund (GB00B41YBW71) since its inception in November 2010. The fund has become the most popular open-ended actively managed fund based in the UK, with assets of £27.9bn on 30 November, according to data from FE Analytics.
The fund has delivered an annualised return of 18.4 per cent between inception and the end of November 2021 - far outstripping the MSCI World index which has a comparative annualised return of 12.8 per cent. In a recent Investors’ Chronicle podcast, which can be found on our website and all major podcast channels, Smith to shared some of the secrets of his success.
Read annual accounts
While Smith believes that much accounting malpractice has been cleaned up over the past three decades, the problem today is that people don’t read the accounts. “If I could find an adjudicator, I will bet you a large sum of money that the average so-called investor, whether professional or amateur, in whatever capacity, doesn't read the report and accounts,” he says, adding that too many people rely on slides put forward by company management teams.
Smith says where his team has had to call up a company because they found gaps or mistakes in its accounts. He gives the example of IBM (US:IBM) where he discovered a $1.9bn (£1.43bn) hole in the cash flow around 10 years ago when he was setting up the fund. “If you think that people are reading the accounts, you would need to explain to me how things like Wirecard (GER:WDI) and Patisserie Valerie happened,” he says, referring to once popular stocks which collapsed into administration in recent years following accounting frauds.
While some investors think investing is an art, Smith believes it's the numbers that count. “If something’s a good company, it will be there in the numbers,” he says, adding that he doesn’t need to meet the management to tell him that a company is a wonderful business.
However, he says that once you are happy that the numbers look good over a long period of time, it’s important to be comfortable with exactly what the company does and that it is sustainable. “By what means does it fend off the inevitable competition, and is the management good at reinvesting the capital?” he says, adding that you also need to assess if the management is capable of continued success. “You have got to be very careful about managements who have brilliant new ideas outside their main area of competence,” he cautions.
Smith also says that the rise of intangibles has had an impact on how he reads accounts and assesses companies, something which he believes is underappreciated by much of the industry. Companies which have a large physical asset base will record the majority of their assets on their balance sheets, whereas companies with high intangible assets - such as a software or drugs business - will put much of their spending through their income statements. This depresses profitability and bumps up the price to earnings ratio.
“You can't just sit there as many people do, particularly when they're talking about the debate between value and quality or growth stocks and go oh, these guys have got a higher P/E,” he says, adding that you are likely comparing “apples with pears”. He notes that with S&P 500 index companies, more money has gone into intangible assets than tangible ones since the 1990s. He thinks that a reason why investors “don’t focus on it nearly enough” is down to the difficulty of trying to work out the cost of capital.
Investment process and outlook
Part of the beauty of the Fundsmith Equity fund’s investment process is its simplicity, which has been boiled down to 'buy good companies, don’t overpay, do nothing'. Smith's preferred methodology is to look at the free cash flow yield, which is the cash a company generates after paying for everything except the dividend divided by the market capitalisation. He says the team then compares that yield with a number of things: other companies in the portfolio, other companies they would be prepared to own, the market more broadly and bonds. They then try to see whether what they’re buying is at least reasonable on that basis. They also try to guess what the free cash flow yield might be on a five-year basis. In simple terms, the higher the company's growth rate, the lower the current cash flow yield they might be prepared to accept.
Given the free cash flow yield has fallen on the fund over the past decade, we asked if it is probable that returns might be lower over the next decade, to which Smith responded: “I haven’t got a clue, and neither does anybody else.” He makes the point that few people would have predicted in 2010 how successful the fund would be over the course of its first 11 years and, citing Harold Macmillan’s famous quip about ‘events’, he says: “I don’t spend an awful lot of time from an investment standpoint puzzling about the macro.”
However, as a historian by training, he believes the events which most closely foreshadowed the credit crisis of 2008-09 are not the great depression, which people often cite, but the long depression of 1873 to 1896. “If we are following a parallel to that, we might not even be halfway through [the current cycle]. In which case, the next 10 years could look very similar to the last 10 years”.
In terms of trends Smith thinks look most attractive, he says “almost anything to do with pets is good,” from pet food to veterinary practices as pets are a “full family member” and pet ownership has grown over lockdowns. Smith also likes other areas that have been turbocharged by the pandemic, including e-commerce, payment processing, various forms of telemedicine and companies that facilitate remote working.
Why the time was right for Amazon
Smith opened his first position in Amazon.com (US:AMZN) this summer, having previously been put off by the low profitability of its retail businesses. “There were a couple of things that got me over the line with Amazon,” he says, one being that the return on capital has grown notably from under 5 per cent in 2015 to27 per cent in 2020 which is “clearly a significant improvement”.
He adds that there’s “nothing not to like” about the Amazon Web Services business, which is pretty similar to the Azure business of Microsoft. On Amazon’s retail business, he says the ‘third party business’, which sells things for other people, has now become more than half of the retail business, which is preferable to selling their own goods as they don’t carry the inventory. “The returns are basically much better”, he says.
Smith adds that the merging of other business lines has helped, such as Amazon Prime and advertising. “We’ve obviously had a bit of bumpiness recently, in terms of the outlook for companies like Facebook (US:FB) and Alphabet (US:GOOG) in terms of advertising, because of the change in the iOS 14 operating system, which has just been put through by Apple, which allows people to opt out of the ability for advertisers to trace the data needed to show the efficiency of the advertising, which is problematic for them,” he says.
“But Amazon does not suffer from that problem. It is not picking up the data on advertising, and your shopping habits from your phone, it is picking them up from itself,” he says.
Fund size
Fundsmith is by far the largest open-ended actively managed fund in the UK with £27.9bn in assets under management. While Scottish Mortgage Investment Trust (SMT) is the largest investment trust (closed-ended fund) with a market cap of £21.5bn on 29 November, according to FE data, the second largest UK-domiciled open-ended fund is Baillie Gifford Managed Fund (GB0006010168), which had £9.2bn in assets under management.
This means that the minimum market capitalisation of a company Smith can now invest in is much larger than it was a decade ago. Smith says that fund size “definitely is a challenge” going forward, but one of the things people need to appreciate but often miss is that the world doesn’t stand still. The overall market capitalisation of the S&P 500 is now significantly larger than it was a decade ago.
Smith says that they can’t have much below £500m as an individual holding size in the fund and they don’t want to own more than 5 to 8 per cent of a company “so we’re probably looking at the $8bn to $10bn bracket” in terms of market capitalisation of potential investee companies."
Size-wise, this would include nearly all of the companies in the S&P 500, which currently has 16 companies with a market capitalisation under $8bn. Smith notes that the recent sale of InterContinental Hotels (IHG) was not because its market capitalisation of £8.4bn had made it too small for the fund, but because of the possibility of business travel not recovering to previous levels post pandemic.
Talking to Investors’ Chronicle from the sunny climes of Mauritius, Smith says living away from the hustle and bustle of the city is "definitely advantageous," adding that "most of the day-to-day noise that you get from the broking industry is aimed at promoting activity - it’s not aimed at creating higher returns for people".
