This book gives insights into one of the largest UK equity managers, Terry Smith, whose Fundsmith Equity Fund has outperformed the broader market by close to 6% per annum since inception. The book combines his historical letters to shareholders, along with opinion pieces he has published over the years, which range from attacks on aggressive accounting to the investment opportunities present in emerging markets.
His investment philosophy is simple
While this sounds like an oversimplification, Smith uses data to annually back up his funds record on all three. On the first point, Smith provides an annual weighted “look-through” analysis of the quality of his portfolio versus broader market indexes. Smith uses metrics such as ROCE (return on capital employed), margins (gross and operating), cash conversion and interest cover to do so. In this way, Smith points to his holding companies possessing superior fundamental business characteristics than the combined quality of the average in the respective market indexes (S&P 500 and FTSE 100).
“The companies in our portfolio have consistently had significantly higher returns on capital and better profit margins than the average for the indices. They convert more of their profits into cash and achieve this with a much lower level of borrowing than the average company.”
2017, Annual Letter, Fundsmith.
As noted in Chris Mayer's book ‘100 Baggers’, strong underlying (ROCE) returns does not translate automatically into good shareholder returns, as Mayers references that this was the case with Microsoft for many years due to an overly optimistic market capitalisation relative to its earnings. Hence Smiths second point, don’t overpay.
Once again Smith seeks to compare what his portfolio yields versus the closest comparable option for prospective investors, the S&P 500 and the FTSE 100 (which he does on a free-cash-flow yield). Crucially, he examines the actual FCF growth of the underlying portfolio companies and whether certain companies expanded FCF yield (say 15%), is an indication of cheapness or poor quality (and the inverse for low yielding companies).
The final point, do nothing, focuses on reducing, to the absolute minimum, portfolio-turnover related costs and voluntary dealing. This, if not watched, can be an unseen handbrake on performance, bleeding a fund’s assets if it is jumping in and out of positions. Smith actually makes the point that often the vast bulk of his turnover is derived from involuntary transactions (takeovers).
This book is well worth the read, ultimately explaining how owning some of the worlds most well-known companies (Amazon, Nike, L’Oreal, Paypal, Visa), hiding in plain sight, can still render a market-beating result.
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