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Terry Smith: Choose Quality Stocks Over Value Investing

Fund manager Terry Smith hates new technology, and thinks value investing loses cash, preferring to invest in 100 year old companies which offer slow but steady growth

Emma Wall 14 August, 2014 | 9:48AM

 
 
 

Emma Wall: Hello and welcome to the Morningstar series 'Why Should I Invest with You?' I am Emma Wall and here with me today is Terry Smith, chief executive of Fundsmith. Hello Terry.

Terry Smith: Hi.

Wall: So, the Fundsmith Equity fund is now four years old. I think it is marked by what's not allowed in the fund as what is allowed in the fund. So perhaps you could talk me through the screening process you do for stocks?

Smith: Sure. What we are screening for is to get rid of bad companies. We think there are very few good companies in the world; companies that consistently make a return on their capital above their cost of capital right across their business and economic cycle. You can rely on not to destroy any value for you while you are holding them.

Now most fund managers will hold, all kinds of companies good and bad and there is more than one way of investing, I'm not saying it's the only way of doing it, but one of the problems of owning the bad companies in life is, whilst you are waiting for those companies is sort of steel companies and the chemical companies and the airlines or the banks of this world to have an event. Which is what people are really waiting for change of management, a takeover, the business cycle to turn up. They basically destroy value just the same as it would destroy value for you personally if you took in money at a cost of 10% and you invested it at 5%, that’s what they are doing.

The companies we own taking money at cost of let's call it 10% and then make 30%. You can rely on the fact that we may get the share price right or wrong when we buy them not whilst they are sitting there in that portfolio they consistently create value. So that’s what our screening process is about. It's about looking for companies that right across the business and economic cycle have fundamentals that actually create value by making a high return on capital in cash.

Wall: One of the things, that some value fund managers say is the way they are able to make returns for you is by buying significantly cheaper stocks and waiting for that re-rating. Is there a risk then with your strategy that you are paying over the odds that these stocks are expensive?

Smith: You are right, that’s how some value fund managers seek to do it. And I have to say looking at the average results in the industry not very many of them seem to manage to achieve outperformance with that and while the problems with that strategy is this. If you buy your poor company apart from the fact that it does destroy value will actually wait. If you get your timing roughly right, yeah it will make some value for you. It will create some performance for you. The problem is then you have to go find another one.

Whereas with our companies if we select them right we never have to go and find a new company. We can sit there, not deal and as a result cut down the cost of running the portfolio. And are they too expensive? One of the things that we are really bad at as investors is judging the outcome of differential rates of compounding.

If you have £1,000 that you invest for 30 years. So an investment life time, I would say, roughly. And you invest it at 10%, you'd have £17,000 at the end. If you invested at just 2.5% more 12.5% you'd have £34,000 twice as much. If you invest it at 15% only 5% more have £68,000 four times as much. The secret to the companies we own if there is a secret is that they are actually compounding value more consistently than market over long periods of time. Not because they grow faster because they don’t really have a downturn. And that’s what makes them relatively inexpensive over time, because people find that hard to figure out.

So we did some work on 30 years of investment looking at baskets of companies at the sort we invest in and said well on average what could you pay for those companies in terms of P/E versus market and still breakeven over that 30 years versus the market?

And you know on average you could pay nearly four times the market P/E and still breakeven. Now if my fund was sitting here today on twice the market P/E which it isn’t I think you'd say it was too expensive your value investors would say that, I'd probably say that. But the reality is it might not be if you take a long term view.

Wall: Looking then at that screening process and that attitude you've just explained it sounds like you've got your companies in mind, the companies that are in the fund now are the ones you are going to buy and hold forever. Does this sort of sometimes mean you are blinkered to new investments or are you still keeping a lookout for new opportunities?

Smith: Well we kick the tyres pretty regularly on companies to try and find new companies to come into what we call our investable universe which currently consists of 65 companies that we would be prepared to invest in if the price was right. It's a continuous search for that. And yet we do look on the sort of the frontiers of things to see in terms of medical devices and in terms of installed bases of software and payment systems for what's emerging. So it's not just the case that we look at companies that have been around for 100 years. Although on average they have been around for 100 years.

On the whole though we are really suspicious of new technology, it's really difficult to evaluate and I think most of us are bad at it. So for example if I had owned Sony (SNE) when Sony dominated mobile music through the walkman would I have spotted the rise of the MP3 player and the iPod I don’t think I would have got it. If I'd have owned Yahoo! (YHOO) when they were the kings of search would I have spotted that Google (GOOGL) will come along and destroy their business effectively. I don’t think I would have got it.

So we really like old line of technology and the stuff that doesn’t change very much over time for example we like elevator and escalator companies and the safety elevator was patented by Mr. Otis in about 1850 and you know what it has changed significantly since. I don’t think we are suddenly going to be startled by coming in one morning and finding people have got new way of moving people up and down high buildings. So that’s the sort of thing that makes our pulse quicken is that kind of old line technology.

Wall: Terry, thank you very much. This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Alphabet Inc A1,333.54 USD0.00
Altaba Inc  
Fundsmith Equity R Acc4.33 GBP-0.21
Sony Corp ADR62.06 USD0.00

About Author

Emma Wall  is former Senior International Editor for Morningstar

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