Terry Smith is one of the UK’s most popular fund managers. His Money Observer Rated Fund Fundsmith Equity has topped the table of most-bought funds on Interactive Investor for the last twelve months and it returned 32.7per cent over one year and 98.4 per cent over three years.
His second, more recent venture – Fundsmith Emerging Equities Trust (FEET) – has gained 16.2 per cent over one year in comparison.
While such gains are not to be sniffed at, investors in a passive index tracker could have done better. The MSCI Emerging Markets index is slight ahead of FEET, with 17.2 per cent returns over the year.
At a recent investor meeting, Smith asked investors for patience, and explained why the principles he is applying to his Fundsmith Equity fund will pay off for FEET in the long run.
What makes a good company? According to Smith what characterises a good company is the following four qualities: high returns on capital employed; growth driven from reinvestment of cash flows at a high rate of return; an ability to protect its market position against the competition by having advantages that are difficult for rivals to replicate; and finally the business makes money from a large number of everyday, small-ticket, repeated and predictable transactions. These are features of companies he aims to hold in both of his funds.
‘I would suggest to you that the secret to success to investing is a combination of factors,’ says Smith, ‘it’s looking for a company with a high return on capital employed and looking for a company that has got growth – it’s no good looking for one without the other.’
Smith emphasised that both growth and high returns are equally important. ‘There is no point having a company with good growth but without returns,’ he said. ‘Believe it or not I could run a successful business that grows a lot with very poor returns – if you’re giving stuff away for free you can usually grow quite rapidly. So we need to have both these things.’
He continued: ‘By the way, there’s no point having high returns without growth either; then you basically have a high yield bond on yours hands. You need some source of growth into which the company can deploy their capital in order to create compounding of value for you.’
Smith is seeking to profit from the emerging market consumption story, evidenced by the fact FEET has the vast majority of its holdings at 88 per cent in consumer goods such as food and beverages, as well as household and personal care products.
Explaining the investment case Smith made the point that once people have 10 dollars a day of disposable income they become consumers. ‘This increased prosperity usually happens as a result of an industrialisation process. Once people have a job, like we do, they can’t spend the majority of their time sourcing food and preparing it, as people might do in a non-industrialised economy. They have a job to go to, so they need the convenience of consumption.’
He adds: ‘There will be 18 trillion dollars in new consumption created in emerging markets over the next 15 years versus 8 trillion dollars in the developed world. Clearly, one grows much more rapidly than the other.’
One of the main striking differences between FEET and the MSCI emerging market and frontier market indices is the weighting to China, which dominates the index at 25 per cent. In comparison, the country only takes up 4.6 per cent of the FEET portfolio. Smith explained the lack of exposure to the country is because he is worried about ownership rights and corporate governance.
‘The biggest repository of the kinds of companies we like are in India,’ says Smith, and points out that the country takes up 34.8 per cent of the portfolio.
All of the companies he likes to invest in are characterised by a high return on the capital employed. And if his investment story plays out the way Smith predicts it might, his bet will pay off in the long run – investors simply need to be patient.
Smith says that the big inflows into emerging market ETFs are both good and bad for active managers. ‘We’re most likely to outperformed passive investments when markets are falling,’ says Smith.
And besides, he adds, it should be ‘every active manager’s dream to be the last one left in the world,’ because that would mean being ‘the last one to have a mandate to think’.