Terry Smith: Hero or evil genius?

Patrick Collinson 160 byline

In 2010, Terry Smith made an extraordinary claim as I quizzed him about the launch of his Fundsmith Equity business. He promised it would be “the best fund ever”. It was a typically bold statement from one of the City’s most combative figures, and surely one that would haunt him later.

Infuriatingly for his critics, Fundsmith Equity is proving to be, well, one of the best funds since its launch in November 2010. Since inception it is up nearly 30 per cent, or twice the gain of the MSCI World index over the same period. Even though 2012 was less stellar than 2011, it is still top decile over 12 months, ranked 7th out of 290 funds in the IMA Global Sector. Terry Smith has the swagger of John Duffield’s New Star, but none of the bluff.

Investors love him. Without paying a penny in commission to financial advisers, the fund has raked in £1.1bn already. One investor even tried to put £400,000 into the fund directly using the debit card payment facility on the website. Smith has had to overhaul the site a few times to keep up with individuals who want to pour money in.

A one-time analyst at UBS Phillips & Drew, Smith has built one of the world’s biggest money broking businesses, Tullet Prebon, where he remains chief executive and a major shareholder. In truth, he’s only a part-time fund manager, splitting his working week two-thirds to Tullet Prebon and one-third to Fundsmith. So how does a part-time manager beat so many of the full-timers?

It’s all disarmingly simple. “I don’t try to find winners. I place money with the people who have already won,” he says. Other fund managers seek out hidden gems and ‘ten baggers’ to dazzle investors. But all they are getting is return-free risk. “The fact is that for much of the time you get better returns from investing in predictable high quality companies than in smaller, riskier, more obscure company shares. But there appears to be a human desire to indulge in excitement and back the 100-1 shot rather than the favourite,” says Smith.

Earlier this month he issued his 4,000 words of wisdom to investors. It’s a great read – he’s a wordSmith as well – but it’s striking how there’s not a mention of P/Es anywhere. Smith, one of the sharpest analysts in the business, thinks they tell you nothing. “It takes no account of the amount of capital employed and how much cash you are generating.”

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Free cash flow is what interests Smith, but only what is generated across the business cycle. He cites car companies as appearing to be selling vehicles for much above their cost, but which then have to spend vast amounts a few years later developing the next model. It completely wipes out the cash generated in the earlier years.

Given this thinking, it’s no surprise Fundsmith Equity’s portfolio is heavy with consumer staple stocks, such as Dr Pepper, Unilever, Domino’s and Reckitt Benckiser. Many trade on high P/E multiples but on a free cash flow basis are a little bit cheaper than the market overall.

There is not a bank in the fund, and with that audacity he’s famous for, he says there never will be. Never?

Here’s a man who has made his fortune in the City, whose main business is facilitating the trading activity of commercial and investment banks. Yet as stocks, he detests them. The malaise in the banking system runs so deep, both structurally and culturally, that he can’t see himself ever buying them. They are propped up by quantitative easing and without the support of central banks many would be bust. He traces the demise of Britain’s banks to ‘big bang’ in the 1980s. He accepts the stockbroking cartel needed reform, but combining brokers with jobbers was a “school boy error”. Regarding today’s reforms to the banking sector, he says “no ringfence will work”. The banks will have to broken up. After all, as he archly points out, the Mirror Group Pension Fund was completely ringfenced from Bob Maxwell.

Smith often prompts comparison with Warren Buffet. Maybe it’s the folksy wisdom, the annual letter to investors, the long-term view and the portfolio of high quality, businesses. But the person he really wants to emulate is John Bogle.

Bogle set up Vanguard, which has recently toppled Fidelity to become the world’s biggest fund manager. In 2012 it smashed all records by taking $141bn into its low-cost funds, and it now has an astonishing $2trn under management.

“I want to be the John Bogle of active management,” says Smith, and as he rails against excessive charges and fees he sounds comfortingly like a personal finance hack. Turnover in the fund was just 0.48 per cent in 2012. During the year, the fund paid £231,000 in commission, and stripping out the commission on trades caused by inflows, it added up to just 1bp of the average funds under management. That compares with the typical 1 per cent a year spent by the average fund manager. If he maintains his outperformance, these figures will be more grist to us hacks, and an ever greater thorn in the side of conventional managers.

What is amusing, though, is that Smith takes 1 per cent as an annual management fee, or considerably more than other asset managers bring in after the 1.5 per cent traditional AMC is carved up with advisers and platform providers. It’s why some will continue to see Smith as an evil genius, while others regard him as the small investor’s hero.

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Patrick Collinson is the Guardian’s personal finance editor