Periodic investment plus good asset allocation is the secret to grow wealth, and Fundsmith Equity Fund is one of the funds to have allocated savings in the last years. £1,000 invested in its inception (November 2010) plus a £100 monthly investment would be more than £22,000. That is, with £10,200 invested along the years, your wealth would be more than twice that amount. The total annualised return since inception is 19.3% (MSCI World Index £ Net: 12.3%) (as of June 2018) with assets under management currently equal to £15.6bn. On top of beating the market in the long term, the fund has overperformed the MSCI World Index in every single complete year since inception, with 4 years of double-digit excess return.
Terry Smith, the fund manager, has been in the industry since 1974 when he graduated in History. But it was in 2010 when he decided to set up Fundsmith LLP to manage his own and third parties’ funds. The company, on top of Fundsmith Equity Fund, manages a sustainable fund and an emerging markets investment trust.
The fund is concentrated, with 27 holdings as of June 2018. The top 10 holdings have a weight of 47.3% in the portfolio, with the top 3 weighing 16.38%. The main investment is PayPal Holdings, followed by Amadeus and Microsoft. As we can see, the fund invests in large-cap stocks, being the average market capitalisation of the holdings £97.5bn. Additionally, the fund invests in high-quality companies, with high returns on capital and substantial competitive advantages. According to Morningstar’s Style Box, the fund is biased towards large and growth stocks.
The portfolio is biased towards the U.S. market (62.9%), being the second market by exposure the U.K. (18.7%). Regarding the sector diversification, the main industry is technology (36%), followed by healthcare (25.2%) and consumer staples (23.8%).
However, when it comes to fund analysis, the most important part is not historical performance or the portfolio, although they help to understand its nature. For a long-term investor, what is even more important is the management philosophy, as past performance is not indicative of future results and the portfolio could easily change.
In regards to the underlying principles of the fund, Fundsmith provides in the webpage a document called Owners Manual, which I personally recommend as an investment guide, in which they show the main characteristics of the fund in regards to the investment strategy and some insights on the investment industry.
It is well known that most of the managers do not beat the market in the long term. The reason? Their portfolios are like the indexes, which, after taxes, implies an underperformance by definition (index minus fees is less than the index). But, why would a manager have a portfolio similar to the index? First, managers do not want to face reputational risk; second, managers hold many stocks. However, Fundsmith managers “want to diverge from the benchmarks” by applying a different approach to investment.
Additionally, the investment industry is marketing-oriented, instead of return-oriented, meaning that asset managers try to maximize assets under management creating lots of funds (growth, income, large and small caps, etc.) to achieve a larger number of investors. Fundsmith’s objective, however, is just to generate high returns by investing in good businesses. As an example of this, Fundsmith rejected naming itself Income Fund despite knowing that funds including Income in their names outsell other funds.
The first key principle is the long-term approach, with a clear bias towards the buy-and-hold strategy, which is in line with the idea of investing in stocks that can compound capital over the years. Additionally, buying and holding minimises frictional costs and helps the management to focus in few stocks.
The second principle consists of investing only in high-quality businesses, defined as “one which can sustain a high return on operating capital employed. In cash”. Therefore, the key metric for Fundsmith is the return on capital employed (ROCE) and cash conversion, with growth in earnings per share as a not-so-relevant measure. As an illustrative example, the average ROCE of the portfolio since inception is around 29% and cash conversion is above 100%. On top of that, a good company needs to have reinvestment opportunities to generate growth. The verb “sustain” is key in this definition, as having a high ROCE is not enough. A high-quality business needs to be able to maintain or even increase the return on capital over the years, and the way to assure that a company will manage to achieve that objective, Smith invests in companies whose assets are intangible and difficult to replicate.
Companies with intangible assets “break the rule of mean reversion that states returns must revert to the average as new capital is attracted to business activities earning super-normal returns.” Hence, intangibles such as brands, patents, distribution networks, or client relationships are crucial elements in every investment for Fundsmith.
In one sentence, “since stock markets typically value companies on the not unreasonable assumption that their returns will regress to the mean, businesses whose returns do not do this can become undervalued.”
Another part of the investment philosophy, and the reason why Fundsmith can be said to be a value fund, according to what I understand by value investing, is that they invest only if the valuation is attractive, meaning that the free cash flow yield is relatively attractive in comparison with the long-term interest rates and other stock candidates in the market.
The last main part of the whole philosophy is that the portfolio is concentrated in 20-30 global companies. That is, concentration is not seen as a risk and there are no restrictions in terms of geographical scope.
In addition to these principles, Fundsmith does not invest based on the “Greater Fool Theory” and does not like companies that need leverage to generate high returns such as banks or real estate companies. Moreover, they do not try to predict the market and, hence, market timing is not part of the investment strategy.
The investment philosophy can be summarised, as per their presentations, as: first, only invest in good companies; second, do not overpay; and third, do nothing.