Takeaways From Terry Smith’s (Fundsmith) Annual Letter Of 2011

Terry Smith, the CEO/CIO of Fundsmith, writes an interesting annual report that is well worth reading. He goes one step further than most money managers by delving into a range wide of subjects, usually with the intelligent British humor. The letters are not so long, but for my own personal reference I like to quote what I consider the most interesting (and sometimes funny) parts of the letters. Mr. Smith lets his mind speak freely, especially about the fund managing business.

Fundsmith has an exceptional CAGR since the start in 2010: 18%. The fund has yet to experience any true bear market, except for the short downturn in 4th quarter of 2018 and the Covid-19 (Fundsmith outperformed both periods).

Below are the main takeaways from the 2011 letter:

Turnover in the Fund in 2011 was 15%. This was higher than we would ideally like although still significantly lower than most funds…..Excluding dealing in Del Monte and Clorox (takeovers), the turnover was 4% which is much closer to the level we seek (zero ideally).

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We prefer to judge our investments by what is happening in their financial statements than by the share price.

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Share Buybacks-Friend or Foe?……..in which we concluded that buybacks were rarely accompanied by any reasoned justification; that they had become almost universally regarded as a good thing and contributing to shareholder value irrespective of the price paid or the valuation implied, which simply cannot be true; and in many cases their timing was poor.

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During the year we wrote to the management of those companies within our portfolio which have engaged in share buybacks to ask for some insight into their rationale. The responses ranged from prompt, personalized (by the CEO) and well reasoned to being completely ignored. We regard the greatest risk for our investors after the obvious potential for us to buy the wrong shares or pay too much for shares in the right companies, as being reinvestment risk: we seek to buy companies which deliver high returns on capital in cash. What the management then does with these cash returns is one of the major factors affecting future returns on the portfolio.

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So, for example, having determined to return a portion of earnings to shareholders, how does a management decide between a dividend and a buyback? In many cases we do not know as the management does not give any detailed rationale and we suspect that the answer is with the “benefit” of advice from their investment bankers who get fees, commissions, bid-offer spreads and maybe proprietary trading profits for advising companies to pursue buybacks but get nothing when a dividend is used. No prizes for guessing which way the advice is slanted.

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I have long and publically maintained that the best equity investment for most investors most of the time is an index fund because of its low cost and outperformance of most active fund managers

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ETFs are almost certainly being mis-sold…..Synthetic ETFs do not hold underlying securities of the sector or market they are supposed to replicate….SyntheticETFs are of particular concern….ETFs are represented as low cost investments. Yet research published during the year demonstrated that ETFs were amongst the largest profit generators for some banks. This seems counter intuitive: how does a low cost product become a major profit contributor? The answer of course is that synthetic ETFs in particular provide banks with innumerable ways to “clip the ticket” of the ETF……My advice on this matter is simple. A broadly-based index fund is often the best investment you can make in the equity markets. But if you decide this is correct, buy precisely that, an index fund, not an ETF…….The only people who want to deal more frequently than daily are hedge funds, high frequency traders, algorithmic traders and idiots (these terms are not mutually exclusive). Why join them? If you don’t want active management, and mostly you shouldn’t, buy an index fund.

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We are often asked by investors whether we hedge currencies. The answer is a firm ‘No’. How would we do so? Should we base it on the currency of the country in which the companies are listed? This obviously would not work.

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However, in contrast the Credit Default Swaps of Nestle have been less expensive than the cost of insuring against default on the debt of European governments and the US Treasury for some time. We are far from believers that the market is always right, but this does suggest that holding shares in major, conservatively financed companies which make their profits from a large number of small, everyday, predictable events is a relatively safe place to be if you have the patience, fortitude andliquidity to ride out the share price volatility which is likely to occur in such circumstances. And that’s exactly where and how our Fund is invested.

 

Disclosure: I am long Fundsmith T Class Acc. I am not a financial advisor. Please do your own due diligence and investment research or consult a financial professional. All articles are my opinion – they are not suggestions to buy or sell any securities.  

(This article was published on the 15th of September 2020.)

 

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