Fundsmith’s Terry Smith gives fund industry a bloody nose

Terry-Smith-Fundsmith-500x320.jpgWhen Terry Smith first launched his Fundsmith Equity fund the portfolio looked to many a bit dull, and in places barely digestible. Domino’s pizzas, anyone? Not quite Google, is it? Yet the share price of Dominos has not only beaten Google – but with lashings of extra toppings. 

In November 2010, when Fundsmith Equity was launched, Dominos was trading at $15 (£9.60) a share, and Smith made it one of his biggest holdings. This week it was on an extraordinary $115, making Smith around seven times his initial investment. But back in 2010, Dominos was not without a fair amount of debt and the appetite for fast food stocks like McDonalds was waning. 

“It had been IPO’d and came with a lot of debt because it had been owned by private equity,” says Smith. “But its cashflow is perfectly predictable, and while people look at McDonald’s and the problems it has had, Domino’s has not had difficulty growing sales at double digit levels – around 14 per cent per annum.” 

“I’ve made over seven times my money on it. It’s a franchise business and the great thing about franchises is that they use other people’s money to grow their businesses.” 

“As a long-term investor you need to be prepared to sit and ignore what is going on outside if you want to obtain good performance.” 

Not every stock in Fundsmith’s highly concentrated portfolio has soared like Dominos – Unilever and Diageo have disappointed – but he has done what he promised at the outset – to give the fund management industry a bloody nose. 

Over three years Fundsmith Equity is ranked 13th out of 233 funds in the global sector and has had a storming past year, up 24 per cent compared to the sector average gain of 8 per cent. 

The trick is not to trade. “Last year on dealing we spent £98,000 on commission on a £3.5bn portfolio. That works out at 0.005 per cent. The average UK fund manager is spending around 1 per cent to 1.5 per cent a year,” says Smith. 

He’s almost the definition of a long-term investor. “To paraphrase Charlie Munger, if you are a long-term investor, then what will determine your returns is the return on capital, not the price that you buy or sell it at.” 

Munger is vice chairman of Berkshire Hathaway and Terry Smith fancies himself as a Brit-version of Warren Buffet. No investor is going to quibble about his iron self-confidence with the returns this fund is generating.

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When other fund managers are promising to find you tomorrow’s company today, Smith is pretty good at finding yesterday’s company – and making a packet out of it. Not that he thinks they are yesterday’s company, just misunderstood by markets chasing the latest fad. 

Take one stock in Smiths’s portfolio. From 2006 to 2012 it grew its sales from $44bn to $74bn, with cashflow jumping from $14bn to $32bn, almost in a straight line bar a blip in 2009. 

Who was it? Step forward Microsoft, the forgotten tech giant that you thought had been eclipsed by Google, Amazon and Facebook. Its share price has gone from around $25 to $50 over the past five years. 

So, what is Smith looking for in companies before he invests? His favourite figures are return on capital employed, gross margins, cash generation and debt to equity. And, boy, can Smith reel off the figures. The companies in his portfolio make an average of 28 per cent return on average capital employed, versus 18 per cent for the FTSE, gross margins of 61 per cent versus 39 per cent, interest cover of 15 versus 9 on the FTSE. Ask him for the same numbers on the S&P and he’ll reel them out too. 

Profile: Terry Smith established the Fundsmith business in 2010. He manages the Fundsmith Equity fund, which was also launched in 2010, and the Emerging Equities Trust, which was launched last year. At the end of last year Fundsmith had £3.3bn in global equity assets. Smith was also chief executive of Tullett Prebon until September 2014, when he stood down to focus on Fundsmith. He graduated in History from University College Cardiff in 1974.

Once you have a portfolio of companies with these characteristics, you just sit back and order in the pizza. Just because the stock has risen seven times in price, there’s no reason to sell, he says. “As a long-term investor you need to be prepared to sit and ignore what is going on outside if you want to obtain good performance.” 

Over the life of the fund, he has only really added one new ingredient to the consumer stocks he so values. “We have found more opportunity in software companies that have installed bases of software and recurring revenues such as Sage. That’s been about the biggest development in the portfolio since we started.” 

Does this lack of activity mean that Smith picks the portfolio, then lets it look after itself while he runs his many other businesses? Far from it, he insists. “I spend the vast majority of my time on the fund. But the very small amount of trading and dealing I do does not reflect the amount of research time I put in.” 

Since launching Equity, he has also launched an emerging markets trust. Last week it was described as “stuttering” in one analysis – from a year-high of 1,125p per share it is now around 966p – but Smith brushes off the criticism. He has never been a fan of China-listed stocks, holding just one in the fund. Most of the money he took at launch has yet to be invested, and none of it has gone into the boom-bust stocks in Shenzhen. 

“We only own one company in China. We own noodles, soy sauce, that sort of thing – they are hardly likely to be companies that share in a major ramp-up in the market.” 

Around £60m is flowing into the fund every month, but will today’s investors have any hope of enjoying the same returns earned by his early backers? “I haven’t got a clue what will happen in the next five years. At least I don’t say that I have got a clue. The rest do,” he says. “We own good companies. That is the only certainty. I simply don’t know if it is going to be a good economy.” 

When pushed, he will give a view of the macroeconomic situation, and it’s not good. “It has been apparent that there is a very weak economic recovery even after the major stimulus of 0 per cent interest rates for eight years and QE still in operation in the Eurozone and Japan. 

“And we have deflation. There have been falling prices in Europe for three years. Chinese devaluation is another brick in the wall of deflation.”

So, it is not the best time to buy then? Ah, adds Smith: “In a world where it will be difficult to get growth, our companies represent great value.” 

Kay takeaway: Terry Smith takes a very long-term view with his equity fund, trading minimally and saving costs in the process. He argues that this does not mean he is hands-off with the portfolio. His emerging markets trust has faced criticism recently, but he is brushing off concerns.