Get to know: Terry Smith
Terry Smith has been referred to as “the English Warren Buffet” for achieving superior results with his robust investment strategy. Once UK’s top-rated banking analyst during the 1980s, today bestselling author, founder, and CEO of the investment-company Fundsmith. With an annualized return of 18.4 percent since 2010, you may wonder: what makes him and his investments so successful?
Terrance, or simply Terry Smith, was born in 1953 in London, England. He is a notable fund manager and the main founder and CEO of Fundsmith, the London-based investment management company, where he has managed its flagship Fundsmith Equity Fund since its inception in 2010. Formerly, Smith was the CEO of Tullett Prebon and Collins Stewart and is today not only a legendary fund manager but also a bestselling author and regular media commentator on investment issues.
After attending Stratford Grammar School and reading history at University College Cardiff in 1974, Smith started working at Barclays Bank, where he initially managed the Pall Mall branch before transferring to the bank’s finance department. The Barclays finance department is what sparked his stock analysis interest.
His newly found interest in stocks made him obtain a master's of business administration (MBA) from Henley Management College in 1979. After working as a research analyst at W Greenwell & Co, and other positions within Barclays, he became prominent as the UK’s top-rated banking analyst throughout the 1980s. He later became Head of UK Company Research at UBS Phillips & Drew in 1990. However, his tenure at UBS was not long-lived, as he was dismissed in 1992 after publishing the controversial report "Accounting for Growth," which later became his best-selling book with the same name.
In 1990, several major FTSE 100 (100 largest companies by market cap on the London Stock exchange) public companies went bankrupt, for example, Polly Pec and British and Commonwealth. Being Head of UK Company Research at UBS Phillips & Drew, Smith’s clients were eager to know why these firms failed, despite earning healthy profits. This led Smith to write a report showcasing that these firms had run into problems regarding cash flow, not profitability and that deliberately misleading accounting techniques had been used.
The growth that characterized the British industry in the early 1990s wasn’t always caused by improved efficiency but was often generated from manipulated profits and arguable accounting techniques.
Accounting for Growth
In the report, Smith examines twelve of these accounting techniques developed during the 1980s to make reporting continuous growth in earnings per share (profit) possible. This gave an entirely false picture of the company's health. Smith urges investors to switch focus to the balance sheet movement, dividend potential, and above all, cash levels to evaluate how the companies are performing.
When first released in 1992, the report caused a big stir in London and beyond, as creative accounting practices were put under the microscope. Although Smith was fired for publishing this report, he has continued encouraging investors to understand how and why companies' accountants can increase their profits by using different questionable methods.
In 2010, Smith founded Fundsmith, the London-based fund management company. With a focus on delivering superior investment performance at reasonable prices. In line with Sir John Templeton’s axiom, “If you want to have better performance than the crowd, you must do things differently from the crowd,” the fund was established to be different from its peers to achieve superior results.
The fund is structured not to be reliant on any single person, Smith included. All firm partners have invested significant amounts of money in their funds, clearly aligning their interests.
The Fundsmith team mainly focuses on investment analysis, portfolio management, and customer care. Hence, other inferior activities are outsourced to some of the world’s leading providers.
As of 31st December 2021, the fund managed 43 billion pounds. The customers are mainly some of the world’s largest and most sophisticated wealth managers and private banks, as well as prominent families, charities, donations, and of course, the individuals invested in their fund range.
Investing lessons from Tour de France
What similarities are there between investing and the multiple-stage bicycle race, “Tour de France”? Smith makes this analogy in his book, Investing For Growth. He means that it’s meaningless to expect an investment strategy or fund manager to perform well in all various market conditions. Equally, it’s almost impossible to find a cyclist who can win every stage of the Tour De France, as it has never been done.
As investors tend to examine their portfolios way too often, often daily, Smith suggests that “to assess an investment strategy or fund, you need to see its results across a full economic cycle with both bull and bear markets“. Similar to the race, what distinguishes the winners from the losers, is endurance, and the ones that find a good strategy or fund and can stick to it, become winners in the long run.
“Investors are their own worst enemy,” “there are only two types of investors: those who can’t time the market, and those who don’t know they can’t time the market.” Terry Smith.
Returning to this old saying, much evidence points at the shortcomings of switching and changing investment strategies.
Fundsmith’s investment strategy
Buy and hold: The aim is to be long-term investors; they seek to own stocks that will compound over the years. They believe, like Warren Buffett, that you should treat your investment career as if you had a punch card with 20 available punches, representing all investments you get to make in a lifetime. “Under those rules, you'd really think carefully about what you did, and you’d be forced to load up on what you’d really thought about.”
High-quality businesses: Businesses that can sustain high returns on operating capital employed. In cash. They critique the talking about earnings per share, as it doesn’t take capital employed to generate those earnings or the return earned on it.
They’re not only looking for high rates of return but also favor repeat business - they rather invest in companies that sell many small items daily than cyclical and “lumpy” ones, as the former is better able to earn more consistent returns over time.
Companies they might like are most often sellers direct to consumers, with consistent demand for food and toiletries. Or business service and capital goods companies with repeat business, for example, servicing their already installed base of equipment and thus earning profits.
Intangible assets that are difficult to replicate: Companies with their most important assets not being physical, and instead intangible assets which can be very difficult to replicate, no matter how much capital a competitor is willing to spend.
Brand names, dominant market share, patents, distribution networks, installed bases, and client relationships are intangible assets favored by Fundsmith.
Greater Fool Theory: Fundsmith doesn’t own companies in the hope that someone more gullible will come along and value them even higher. They only invest in reasonably priced companies with attractive business models - all with the assumption that there is no greater fool than themselves.
Avoid companies that need leverage: Companies that can earn high returns on their capital without the need for leverage. For Fundsmith, it's totally acceptable for the companies to use leverage, but they shouldn’t be reliant on it.
For example, banks, investment banks, leasing companies, and real estate companies typically earn low unleveraged returns on their capital, meaning they have to employ leverage to earn an adequate return on equity.
Growth potential: Growth potential in terms of the company being able to earn high unleveraged rates of return, with the possibility to reinvest some of their excess cash flow into the business at attractive rates of return on the reinvested capital. Over time, this should compound shareholders’ wealth by generating more than one pound of stock market value for each pound reinvested.
Rapid growth can be both good and bad news, depending on how much capital is needed to generate that growth. You shouldn’t rejoice in the fact that if you double your capital invested, you will get twice as much interest. Because that is not what growth is. Companies with physical growth in the merchandise or service sold are favored over companies only relying on pricing power.
Resilient businesses: Companies with timeless products and services are, by definition, more resilient over time. Fundsmith seeks to avoid industries with rapidly changing technology, as it’s hard to time when the innovation actually produces value for the investor.
Big, innovative, and exciting new developments that change the world, are not necessarily good long-term investments. Fundsmith accepts that they don’t have the capability of spotting new innovations and don't try to ride the wave of initial enthusiasm for the short term. They simply seek to invest in and benefit from product development from long-established products and industries.
Attractive valuation: There is more to investing than only buying quality companies. The valuation is key, and in order to not underperform, you can’t overpay for your investments.
Fundsmith estimates the free cash flow of every company after tax and interest but before dividends and other distributions and adds back any discretionary capital expenditure which is not needed to maintain the business. To not penalize companies that invest to grow.
The investments are made only when free cash flow per share as a percentage of the company’s share price (the FCF-yield) is high, relative to long-term interest rates, and when compared to other potential investments.
Don't time the market: Fundsmith doesn’t claim to have the skill of timing the market. According to studies, the most successful fund managers avoid market timing decisions, as the consequences of trying it often are severe. For example, if you invested in a UK index fund during the years 1980-2009, you would have achieved a return of roughly 700 percent, or eight times your initial investment. If you had missed the 20 best days, however, that return would have been reduced to only 240 percent.
Don’t over-focus on benchmarks: Over the short term, Fundsmith means that there is no value in comparing movements in different asset prices or indices. Even a year is a short period of time, and in fact, nothing more than the time it takes the earth to go around the sun. Hence, astronomists have more use in studying years than investors.
Invest globally: Fundsmith doesn’t geographically restrict their investments. Why should the most attractive investments be listed in the stock market of a country that ranks fifth in the world by economic size and is located on a small island off the coast of Europe?
By being global investors, the ability to contrast and compare growth rates and valuation levels across all geographies is made possible.
Don’t over-diversify: As their investment criteria are strict, the number of companies that they can keep track of inevitably shrinks. Therefore a portfolio of 20-30 companies has proven to be a winning concept.
Buffett once said, “Wide diversification is only required when investors do not understand what they are doing,” and diversifying the portfolio with less attractive investments is often a bad idea.
Don’t hedge currency exposure: Fundsmith doesn’t pretend to be currency traders. You simply can’t know what any individual company’s currency exposure is without knowing what hedging the company has in their own treasury operations.
As many of the companies in which they are invested generate revenues and incur most of their costs in the same currency, their exposure to currency fluctuations are, therefore, a matter of translation of their profits.
Management vs. numbers: Fundsmith are more keen on analyzing the company's actual numbers than meeting their managers. Their process includes screening financial results in the search for high-returning, cash-generative, and consistently performing businesses.
Since most companies are cyclical, require leverage to get adequate returns, sell to businesses instead of directly to consumers, and make capital goods or other durable items, Fundsmith excludes most companies from consideration already when looking at what they do or the sector they operate in.
However, management is undoubtedly an important factor, and Fundsmith prefers managers who invest adequately to maintain and grow a company’s brands and franchise value at favorable returns. They are aware of their limited insight into human nature and expect management words to be reflected by the figures in the reports and accounts.
Liquid investments: Companies with large market capitalizations without shareholders owning major blocks are more easily tradeable. Additionally, The Fundsmith Equity Fund is an open-ended fund, meaning it’s a diversified portfolio of pooled investor money that can issue an unlimited number of shares that can be bought or sold anytime. This means that investors that want to redeem their investments, won’t have any issues with the liquidity in the shares of the fund itself, which can be the case with close-ended funds.
“The English Buffett,” or why not only “Smith”
With his great success as a fund manager, founder, and author, Smith has undoubtedly made a name for himself and maybe shouldn’t be compared to Buffett. By following his principles which are reflected in Fundsmith’s investment strategy, individual investors can draw huge benefits. His timeless lessons guide investors to act rationally without letting emotions interfere. He means, as frequently mentioned by heavy hitters in the investing field, that the best course of action often is to just “sit on your hands” and let time take its toll.