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 the 4th quarter of 2018 and the Covid-19 (Fundsmith outperformed both periods).
This is the first article about Fundsmith and starts with the letter of 2010, the first year of operation:
(I have compiled all the best quotes from Terry Smith’s annual letters 2010 – 2020 in an article called takeaways from Fundsmith’s annual letters (Terry Smith). )
Benchmarks are useful for measuring performance, provided a long enough time scale is used. Problems arise when fund managers start to use them for portfolio construction. At Fundsmith we do not endeavour to track any index or to minimise our “tracking error” versus any index (even the use of the expression tracking “error” tells you that an active fund manager has the wrong mindset).
Pet food is typical of the sort of product we seek to invest in. It is a small ticket, consumer, non-durable. As a small ticket purchase, no credit is required to buy it. The consumer has no opportunity to bargain on price -the price the supermarket or pet store displays is the price you pay. Consumers are typically brand loyal, and once it has been consumed there must be a replenishment purchase-there is no opportunity to defer this by prolonging the life or ownership of the product as there is with a consumer durable, like a car. Moreover, research clearly shows that if times are hard, consumers will reduce their spending on food for themselves or their children rather than cut back on their pets’ food.
Whilst it would be churlish to suggest that we do not like receiving a premium for our investments in cash, such events are not without their downside as we have to find an equivalent investment for our cash. The fact is we really want to own our stakes in the companies in our portfolio and benefit from the good cash returns on capital which they generate. We are not simply hoping to on-sell the investment at a higher price. This changes perspectives on events such as takeovers.
The historic dividend yield on the Fund at year end was 2.47%. This dividend was covered over 2.5 times by earnings. Only one stock in the fund does not currently pay a dividend. This is significant: dividends have historically provided a significant portion of the total return on equities.
The average company in our portfolio was founded in 1883. We are investing in businesses which have shown great resilience over a long period of time-in most cases surviving two world wars and the Great Depression.
What we can say with a high degree of certainty is that our portfolio has a FCF yield higher than the average for the market. Yet it is inconceivable in our view that it is not of higher than average quality in terms of longevity, resilience, predictability, profit margins, return on operating capital and the conversion of profits into cash. Put simply this means that we own shares in businesses which are higher quality than the market on a valuation lower than the average for the market. Whilst that is not a total solution to successful investing, it strikes us as at least a good start.
We regard an equity holding as a claim on a share of the cash flow produced by a business. In the Fund we seek to own companies which produce high cash returns on capital and distribute part of those returns as dividends and re-invest the remainder at similar rates of return. And we want to own those companies shares at prices which at best under-value their returns and at worst value them fairly.
This year’s rant is a warning about the misunderstanding and misuse of Exchange Traded Funds (“ETFs”)…… So what’s the problem? I suspect that the average investor regards all ETFs as just another form of index fund, and indeed many of them are. But many aren’t and therein lies the potential for misunderstanding. Or worse……Some ETFs do indeed replicate the performance of an index by purchasing a weighted package of all or most of its constituent securities. But many so-called synthetic ETFs do not do so and instead use so-called swap agreements with counterparties who agree to provide a monetary return which matches the underlying asset class or the index the ETF is seeking to track. Anyone who has studied the events of the Credit Crisis should be able to spot a potential problem here: what if the counterparty supplying the swaps defaults? This risk may once have been considered theoretical, but after the collapse of Lehman and the need to rescue AIG in order to prevent the contagion from a default it surely no longer is. True the ETF should be holding collateral against such a failure, but collateral is an imperfect science even where it is held which isnot in all cases. Moreover, in some cases the sole counterparty. Moreover, synthetic ETFs are often used at access markets which are not directly accessible to retail investors such as the Chinese A-share market or where liquidity in the underlying investments is poor such as equities in some emerging markets. The opportunity for the performance of the ETF to diverge from the performance of the underlying assets and therefore from the investors’ expectations in these cases seems obvious. The idea that a counterparty will provide you with a contract which matches the returns from underlying illiquid assets which you cannot directly own should give pause for thought-not least about how the counterparty will fulfil those obligations, for example in the case of extreme market movement and a liquidity crisis-a not unlikely combination. I would bet that a large proportion of ETF investors do not realisethat leveraged and inverse ETFs can produce these apparently perverse results. The moral of this is that these sort of ETFs are really day trading tools. If they are held for more than one day, they will begin to diverge from the performance of the underlying index or asset class. However, it would not be surprising if in many cases they were being used inappropriately as if they are index funds.
…….Investors in ETFs may be quite logical in avoiding most active management, but many of their ETFs are not as inactive as they think.
Finally, returning to our own active fund, we look forward to the year ahead. ……it is because we enjoy running The Fundsmith Equity Fund. Robson Walton, the Chairman of Wal-Mart and son of its founder Sam Walton said, “My dad did not set out to make Walmart the world’s largest retailer. His goal was simply to make Walmart better every day, and he thought constantly about how to do just that……..Please be assured we are doing the same with Fundsmith.
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 21st of August 2020.)