He’s given up on prophecies, but is still delivering profits. Jonathan Davis talks to Terry Smith.
Terry Smith gave up making public comments on economics and politics a few months ago because, he says, it was fruitless – nobody in government or central banking paid the slightest attention. That doesn’t mean Smith has stopped thinking they are making a mess of monetary and fiscal policy.
Last week, in an interview to mark the third anniversary of Fundsmith, the fund-management business he set up in 2010, Smith was still hyperventilating on the subject of quantitative easing (QE) and the recovery – or, to be precise, on the folly of the former and the lack of the latter.
“Nick Clegg says the UK economy is ‘blooming’,” says Smith. “Can we just pause for a moment? We’ve still got the biggest monetary stimulus ever given out there at the moment. It’s ongoing in the US as we speak, and certainly not being reversed over here.”
Yet despite this, when he looks at the growth of the companies in his portfolio, “you know what? They’ve struggled.”
Unilever’s disappointing results are one example, but Smith also cites Church & Dwight, a budget provider of consumer goods in the US. “It’s run by a really down-to-earth guy called Jim Craigie, whom we love – he’s so straight-up. What he says to us is: ‘What recovery?!’”
If growth were appearing, you’d expect people to trade up from his budget products to the more expensive brands owned by rivals such as Proctor & Gamble. But it’s not happening.
Says Smith: “I find it hard to believe that there’s a genuine recovery if people are not brushing their teeth more, or willing to pay a bit more… These things should be trickling down. Yet everyone is finding it difficult.”
He sees other grounds for concern too. “I’m unconvinced that the Chinese problem [of excessive credit expansion] has been cured in just two quarters.” That in turn will hurt its trading partners, particularly in South America and Australia.
Against this background, the idea that the Federal Reserve is about to withdraw its $85bn-a-month programme of QE is laughable. “I think what we’re going to see now is QE 99. I don’t think there’s any chance of the foot coming off the pedal.” In effect, we are heading towards outright monetary financing of government deficits, albeit by stealth.
Meanwhile, the stock market is already getting frothy, I suggest to Smith, with record amounts of margin debt, a surge in initial public offerings, and other signs of incipient excess. He agrees: “We are seeing the return of all those wonderful things we learnt about during the crisis, such as CDOs and CLOs – it’s all started again.”
But despite that gloomy prognosis, Smith has reason to be happy with his fund’s progress. For a single fund to go from nothing to £1.5bn under management in just three years, with only a modest marketing spend, is no mean feat.
His profile and reputation have played a part, but what investors have really warmed to, Smith thinks, is the fund’s uncomplicated Warren Buffett-style philosophy – a focused portfolio of 25-30 global stocks with high returns on capital, large competitive moats, and little need for debt – and its simple, transparent fee structure.
Performance to date has been solid and consistent, just as he hoped when it launched: a total return of 54%, against 36% for the MSCI World index.
But aren’t the kind of global defensive stocks that Smith likes to buy and hold becoming too richly valued? I ask. Smith concedes their value is not as good as it had been. The average free cash-flow yield on the stocks in his portfolio was close to 7% when he set up the fund three years ago. Now it is a little over 5%.
“There is no doubt that this strategy has become more popular, and the stocks have become more expensive, and that’s not the ideal way to deliver performance.” Future returns, inevitably, will be lower, but he argues there is no reason to change course.
There is a hierarchy of ways to achieve performance in the kind of portfolio he holds, he says. “The absolute best way” is for companies to grow sales. Second-best, if they can’t grow volume, is to have the pricing power to keep revenues growing even if sales are flat. Third-best is being able to cut costs.
And at the bottom, is to use surplus cash flow to buy back stock and pay dividends. “If the world is going to be stagnant, it’s better to have companies who can do all that, including the last, than those who can’t.”
The other point, he notes, is that the very best companies, the kind of ironclads that continue to churn out cash flows for years, can often be worth paying more for than you would expect.
Before they started the fund, Smith and his colleagues conducted a study of stock market heavyweights over the past 30-year period to see what multiples investors could have been justified in paying back in 1979.
Some of the figures were startling: you could have paid 34 times earnings for Colgate and 38 times for Coca-Cola back then, and still beaten the S&P 500 over the next 30 years, even though the index was on a multiple of just ten at the time. For Wal-Mart the figure was 277 times earnings!
“The reason”, says Smith, “is that the average growth rate for those companies, excluding Wal-Mart, was about 16% per annum over the next 30 years, whereas for the market it was 11%. That differential of 5% causes an amazing difference when compounded over 30 years.” Investors who “have an attack of the vapours” when the price/earnings ratios of their stocks get to 20 should take note.
As Buffett said when he paid up for Coca-Cola in the 1980s, valuations of genuine long-term growth stocks might leave his mentor Ben Graham, the father of deep-value investing, spinning in his grave, but they can confound the sceptics if you can pick the ones that can deliver that kind of sustained performance. The only pity, we agree, is that there aren’t more of them around.
• An extended version of this interview is available at Jonathan’s website, www.independent-investor.com.
Are Fundsmith’s fees too high?
The Fundsmith Equity Fund charges 0.9% for those investing over £5m, and a flat 1% for anyone else. How does Smith react to criticism that, following the banning of trail commission, the management charge is now higher than that of many other active equity funds?
First, he says, he only invests in businesses with high returns on capital, and he needs to make a similar return as a reward for taking the risk in setting up Fundsmith. The business lost money in its first two years and has only recently moved into profit.
“The right time” to have a conversation about fees, therefore, is “not today, but maybe in two years’ time”, when the business is more entrenched. Secondly, what investors should focus on is not the annual fee but the all-in costs, including the add-ons that go into a fund’s total expense ratio (Smith’s come to around 0.13% a year), and also dealing costs.
His fund’s dealing costs came to just four basis points (0.04%) last year, of which three were attributable to fund inflows investments. That compares with the 1.0%-1.25% dealing costs incurred by the average active fund. Add all those up and the Fundsmith Equity Fund has an all-in cost of around 1.2% a year, against 2.25% for the average open-ended fund.
“Even net of fees, we’ve outperformed the market by a compound 4% per annum since inception, which would suggest that net, you’re OK – in fact, you’re a bit more than OK, given how valuable compounding of those returns can be.”