On the eve of the launch of Smithson investment trust, Fundsmith founder Terry Smith tells Andrew Pitts about unearthed opportunities.
Timing the market is a notoriously difficult way to make money. You have to be ‘all in’ to win – or stay out of the game if you can’t take the pressure. This is pretty much the view of Terry Smith, founder and chief investment officer of fund management group Fundsmith. He has some stats ready to back up his point, in response to the question of whether this is an auspicious time for the group to be launching a new investment trust focusing on global small and medium-sized companies.
After all, I suggest, the US stock market is experiencing its longest bull run in history, so surely a change for the worse is more likely than the market climbing higher up the ‘wall of worry’? Smith responds that investors must simply ask themselves which asset classes other than equities offer the prospect of decent gains, and whips out the charts: a £10,000 investment in the US S&P 500 index 15 years ago, left to grow with dividends reinvested, would be worth £41,333 today. That tidy sum represents a 313 per cent increase.
But then comes the killer stat: had you not been invested for the best 10 days in the market during that 15-year period, you would have missed out on profits of £20,460, and gained a more pedestrian 109 per cent. Miss the best 20 days and that £10,000 falls to just £13,629. The 30 best days out of the market see you making a loss of 6 per cent over 15 years. And that’s before inflation.
‘We don’t worry about things we can’t control’
Smith makes this point for good reason. ‘We don’t spend much time worrying about things we can’t control,’ he says. ‘We invest in companies, not markets.’ His pedigree in this respect is up there with the best: since launching Fundsmith Equity in November 2010, he has steered the global large company-focused fund to a 305 per cent gain, double that of the benchmark MSCI World index (in sterling, to 10 September).
Fundsmith Equity has become a leviathan: at more than £17 billion, it now ranks as one of Europe’s top 10 largest actively managed funds. Which begs the question, why is the group seeking only £250 million for the launch of Smithson Investment Trust? It seems small beer in comparison.
The answer is in the trust’s name. Smithson will target companies that are simply too small for the ‘Smith senior’ fund to invest in: those with a market capitalisation of between £500 million and £15 billion, and an average of £7 billion. To some, that might not seem very small, but as Smith says, the average market capitalisation of the 27 companies in Fundsmith Equity is around £100 billion.
Besides, ‘perceptions of what constitutes a small or large company have changed over the years’, he says, citing the example of Sage Group, the well-known UK financial software company which had a market capitalisation of close to £8 billion at the start of the year. Even for a company of this size, liquidity in the shares is very thin.
Company size and share liquidity are two of the reasons that the closed-ended investment trust format suits Smithson’s target range of companies. But just as important, if not more, is the size of the trust’s ‘investable universe’. For Smithson, this comprises just 83 global companies that exhibit the same strong financial and business fundamentals as those populating the Fundsmith Equity portfolio.
The trust envisages investing in between 25 and 40 such companies at outset, which explains why the trust has a relatively small £250 million target. It’s easier for a £250 million trust to invest in companies of this size and still get a meaningful stake.
Just as good, but smaller and probably better
Conversations between Fundsmith and its institutional clients were the touchpaper behind the decision to launch the trust. They were telling Smith that although the majority of holdings in Fundsmith Equity have performed well, many smaller companies that are not in the fund’s investable universe have done far better. ‘Some of them are growing at twice the rate of the larger companies in Fundsmith Equity,’ Smith reckons.
The size of companies may be different, but there are strong correlations between the type of businesses that Smithson is looking for and those in the larger fund.
Spanish travel and tourism giant Amadeus, Fundsmith Equity’s second-largest holding by assets, has a smaller US equivalent in Sabre, Smith reveals. In food and beverages, holdings such as Diageo and PepsiCo could be mirrored by the likes of the UK’s Fever-Tree Drinks and Wingstop Restaurants, a US chicken wing specialist whose diners are decorated in a 1930s and 40s ‘pre-jet aviation’ theme.
Stryker, a US medical technology firm that also manufactures surgical implants, has an equivalent for Smithson in Fisher & Paykel Healthcare. Renowned throughout Australasia for its washing machines and other white goods, the New Zealand-based company split its healthcare and appliances divisions in 2001.
There will be no emerging market exposure in the trust, as this requires a totally different mindset in terms of dealing with country-specific issues, says Smith. Investors who want the Fundsmith approach in developing markets have a ready-made vehicle in Fundsmith Emerging Equities trust.
It is well-known that over time, small and mid-sized companies tend to better-reward their shareholders than larger companies. But contrary to perceived wisdom, Fundsmith’s research shows that adding a small and midsized company portfolio to a large company portfolio raises expected returns without increasing risk.
What is more impressive is the neat little table that Smith produces, showing how the trust’s 83-strong investable universe has performed in two major market downturns. In the first, between 30 December 1999 and 7 March 2003, Smithson’s universe declined by 1.8 per cent, a far less bitter pill to swallow than those tracking market indices: the MSCI World SMID index fell by 31.2 per cent and the broader MSCI World index plummeted 45.5 per cent.
In the more recent downturn, during the global financial crisis from 7 December 2007 to 9 March 2009, the MSCI indices fell by 36.3 and 38.5 per cent respectively, compared with a 14.7 per cent drop for the Smithson universe.
The growing popularity of index-tracking strategies is heaping pressure on active fund managers to justify and reduce the fees they charge. Smith reckons 0.9 per cent is fair. Like other Fundsmith-managed products, there are no extra ‘performance’ fees for investors to worry about. Smith also calculates that by bearing the costs of the trust’s launch, the group is forgoing at least two years of fee income for managing the trust.
Either way, it’s reassuring to know that the management team also have their financial interests on the line. Smith is investing £25 million in Smithson before the public offer and placing periods close on 12 and 16 October respectively.
The past performance of the investable universe bodes well for Smithson and backs up Smith’s simple three-pronged strategy: buy good companies; don’t overpay; do nothing. Although wider markets may be riding for a fall, Smithson-backers should be better-cushioned and better-placed for a quick and profitable recovery.
This son of Smith could turn out to be a fast developer.
Disciples of the Fundsmith orthodoxy: to run Smithson
Terry Smith’s role with regards to Smithson will be less hands-on and more éminence grise. However, as chief investment officer, Smith will fully participate in outright buying and selling decisions, mirroring the collegiate approach that is taken across other Fundsmith-managed products.
Simon Barnard, who joined the firm in September 2017, will be lead manager, assisted by Will Morgan, who joined Fundsmith earlier last year. Both were colleagues at Goldman Sachs, where Barnard ended up running the firm’s Global Millennials fund and Morgan spent 17 years climbing up the sector analyst ranks.
The duo have been identifying Smithson’s investable universe from small and medium-sized companies that are members of the MSCI World SMID Cap index.
Many active investment managers place faith in meeting corporate management teams regularly and getting to see the whites of their eyes. For Barnard, this is not an overriding requirement. Top managers didn’t get where they are today by being poor talkers, he says, and investors can be too easily swayed by a compelling presentation.
Barnard and Morgan prefer to place their faith in ‘the financials’. The numbers don’t lie, Barnard says, particularly free cash flow yield, a crucial measure by which the Fundsmith team determines the credentials of a company, coupled with return on capital employed.
As the table shows, backtesting the investable universe of 83 stocks that Fundsmith has identified shows compelling outperformance (net of anticipated 1.1 per cent fees) compared with a range of benchmark indices and representative global smaller company funds, over various time periods.
By investing in what the managers determine to be the best of those companies, expectations will be for outperformance in the future to be even stronger.
The author was editor of Money Observer from 1998 to 2015.
Great to chat about main fund and Smithson but why no analysis of how FEET has done and what difference is there between FEET and Smithson or are they overlapping in choice of stocks to invest in. Do they use same methodology etc