Fundsmith Equity turns in chart-topping gains

Investors in Fundsmith Equity, managed by the forthright Terry Smith, have plenty of reasons to be cheerful. On 1 November 2013, its third anniversary, the global equities fund had powered to a total return of 61.2 per cent, placing it fourth among 244 funds in the Global growth sector, and beating the MSCI World index by nearly 20 percentage points.

And Smith can feel more than pleased about how that performance has boosted his own net worth: for having invested £25 million of his own money in Fundsmith Equity that not inconsiderable pot has swelled to £41 million.

Even investors who were late to the party can feel the expanding width of their wallets. On an annualised basis the fund has delivered a 17.3 per cent compound return. Granting Money Observer an exclusive interview before the results were announced, Smith put the performance in context: 'We said what we were going to do when we launched the fund, and that's something we'll continue to do.'

Smith is more than happy to share the secret of Fundsmith Equity's success - indeed the fundamental tenets of how he invests are spelt out in the fund's 'Owner's Manual'. In a nutshell it boils down to one over-riding principle: invest for the long term. 'We only ever invest in good companies that we would be happy to own indefinitely'.

That's born out in the portfolio turnover figures. Of the 22 global stocks Fundsmith Equity started out with, 16 remain the same. Of the six that exited, two were due to takeover offers, and four were sold on valuation grounds. The fund now boasts 25 holdings. 

Like the size of the fund, now some £1.5 billion, Smith's investable universe of global companies has grown over the period – to 64, with four removed and 15 added.So why doesn't he invest in all of them? 'The others are on my watchlist and I'm waiting for valuations to improve before buying them - I've got them on my computer screen as we speak,' he says.

For example, they include several global drinks companies, including Pernod Ricard, but they do not yet meet Smith's six fundamental rules for investment. These are: high returns on operating capital employed; businesses whose advantages are difficult to replicate; no significant leverage to generate returns; growth driven from reinvestment of cash flows at a high rate of return; resilience to change; and a high cash flow yield.

Smith wasn't the only fund manager who was attracted to these sorts of stocks when he started out three years ago - safe, household names with strong brands such as Unilever, Colgate, Johnson & Johnson and Domino's Pizza - but he says, 'more investors have begun rotating their portfolios into recovery stocks over the past six months or so.'

Does that go some way to explaining why performance over the past quarter has been, dare I mention it, lacklustre? 'Apart from observing that a quarter is a rather short and artificial time period to measure anything, I would say that's exactly what has caused it,' Smith retorts. 'The sectors which have performed well are the ones we would never own and which are sensitive to economic recovery - consumer discretionary, industrials, IT, finance, energy and materials. If there is a genuine recovery then I would expect those sectors to do better than consumer staples and medical equipment stocks, which are the bedrock of our portfolio.

Why doesn't Smith feel as confident as some his peers, when it appears that the global economy is getting back on track? First, the sorts of shares they are investing in don't meet Fundsmith Equity's demanding critieria - they rule out most businesses that don't sell directly to consumers or which make goods that are not consumed at short, regular intervals.

In the Fundsmith Equity portfolio that translates into companies that generating an average return on capital of 34 per cent - roughly three times the market average, a dividend yield of 2.6 per cent and a free cash flow yield of 4.7 per cent, which Smith reckons is forecast to grow by 7 per cent a year.

Second, and more worryingly, Smith suspects that the global economy is not as resilient as many of his peers believe. 'The fundamental problems of 2007-08 have not been resolved; if anything they are worse, because leverage in the financial system is higher than in 2008. The problems are bigger as a result of the actions taken so far by policymakers. There is a danger that they have lost control of the situation and in terms of policy response, the armoury is empty.'

Smith laughingly recites what Lord Adair Turner, ex head of the Financial Services Authority and the Confederation of British Industry, recently had to say on the crisis. 'We had one hell of a party and one really bad hangover - which is best resolved with several stiff drinks.'

Indeed Smith reckons that the global policy response to the financial crisis, if anything, has worsened the problem. The health of the global economy remains reliant on unsustainable foundations, he says. These include massive deficit spending in the US, the UK, the eurozone and Japan; continued high expectations for the state to finance health and longevity; quantitative easing of epic proportions, particularly in Japan and the US; and a renewal of credit expansion in China after an all-to-brief pause.

“Despite this colossal and continuing stimulus, the recovery is creating very few jobs and even fewer quality jobs - highly paid, full time or even on normal employment contracts,' he says.

As a result he doesn't disagree with the assertion that the developed world at some stage needs to make the sorts of painful adjustments that countries in the eurozone periphery are going through today. 'The difference is that it was forced upon them,' he adds.

But what Smith finds a bit odd is that even the solid, non-cyclical companies he follows are reporting slower revenue growth. 'I can understand why cyclical companies would outperform staples in an upturn but why are the staples companies growing revenues more slowly? People don't use less toiletries, cosmetics, eat or wash less, or clean their houses less in a recovery. The only things which people seem to be buying more of are goods they can buy using credit - namely cars and houses. Here we go again…'

Nevertheless, as much as Smith dislikes discussing short-term performance numbers, there are signs that global investors may be questioning whether they have backed the wrong horse, economically speaking. 'This reality may have begun to dawn on investors - as Fundsmith Equity had a 4.6 per cent gain in October.'

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