Investing for Growth
Investing for Growth

Investing for Growth

In November 2011, one year after launching Fundsmith, Terry Smith asked me whether the Financial Times would consider publishing his obituary-commentary on the death of Smokin’ Joe Frazier, the former heavyweight boxing champion with the murderous left hook. (Location 162)

‘We would all do well to remember that we are defined by those with whom we compete – be they boxer, banker or politician.’ (Location 169)

He has reserved a special place for those who, in his eyes, are guilty of incompetence, obfuscation or misleading investors via sophisticated marketing or creative accounting. (Location 175)

He built up Tullett Prebon as a pre-eminent inter-dealer broker and then walked away to launch Fundsmith, where his commitment to invest in sound businesses has proved a winning, if still somewhat unfashionable, formula. Or as he puts it, succinctly: (Location 179)

In the following years, Fundsmith would come to thrive and challenge many of the (lazy) assumptions about the fund management industry. (Location 185)

Myth number one: algorithms have taken over the world and there is no serious alternative to passive investing, exemplified by the rise of exchange-traded funds (ETFs). These funds have indeed grown exponentially, ostensibly offering far more reliable returns compared to so-called “active” investing. But Fundsmith has demonstrated that there is a profitable niche in the market alongside the titans of BlackRock, Fidelity and Vanguard. (Location 186)

Myth number two: so-called value investing has run its course. Chief witness for the prosecution is Neil Woodford, long hailed as Britain’s Golden Boy. Woodford certainly had his moments at Invesco; but after striking out on his own in 2014, his record looks more similar to that of another golden boy: Billy Walker, the British heavyweight from Stepney, known as “the Blond Bomber” who eventually gave up his gloves for a brief career in movies. In fact, Woodford’s demise owes more to hubris and an unhealthy reliance on illiquid stocks. It does not spell the end of the savvy stock picker. (Location 190)

Myth number three: asset allocation trumps all considerations and, almost by implication, the addition of a small/mid-cap element to a portfolio constitutes an unacceptable level of risk. In fact, as Terry argued in a myth-busting FT column in August 2018, ‘there is no doubt that adding a small/mid-cap element to a portfolio can achieve the seemingly impossible feat of generating additional return while reducing risk.’ No doubt Terry had half an eye on the launch of Smithson, his small-to-mid-cap fund; but once again the subsequent performance of the fund speaks for itself. (Location 195)

Myth number four: blue-chip companies deserve a measure of respect which makes them impregnable or untouchable. Terry has shown time and again a willingness to challenge conventional wisdom. He has taken on national champions such as IBM in the US and Tesco in the UK, relentlessly probing their underlying performance and profitability. In retrospect, his critical analysis has proven remarkably prescient. (Location 200)

a certain correlation between Terry’s “without fear and without favour” approach to stock-picking and my own approach to journalism. (Location 204)

At the outset Fundsmith believed that direct communication with our investors was important because it gave us the best chance of explaining our investment strategy, how we were performing and what we are doing, without the intervention of intermediaries. (Location 225)

To this end we not only publish an annual letter to investors, we also hold an annual meeting at which investors can pose questions and see us answer them live and in public. (Location 228)

You may encounter certain buzzwords like “bond proxies” – the stocks we invest in reliably produced profits and cash flows like bonds. (Location 239)

There was much talk in the early years of Fundsmith’s existence about our strategy being all about consumer staples even though these stocks were never much more than half the portfolio at their peak. (Location 241)

Some of these naysayers are protagonists in the ongoing debate about so-called value investing, which they contrast with growth or quality investing. (Location 246)

For Ben Graham, and Buffett in his early years, value investing meant buying a stock below its intrinsic value as the most important investment consideration, and then waiting for the two to converge – hopefully by means of the share price rising rather than the intrinsic value declining. (Location 248)

Latterly, in the hands of other practitioners, it has morphed into a simplistic approach of investing in stocks with low valuations, which is not the same thing – hence my use of the term “so-called”. (Location 250)

Buying such a stock is not a recipe for investment success. Nor is growth or quality investing (I believe the latter is a more accurate descriptor for Fundsmith’s approach) best done irrespective of valuation. (Location 252)

The fact, as Warren Buffett has acknowledged, is that growth is a component of valuation. (Location 261)

But when a company has superior returns on capital employed, and a source of growth which enables it to reinvest a substantial portion of those returns, the result is compound growth in its value and share price (Location 263)

It is important to realise that this is over the long term. In any given period, stocks of the sort which Fundsmith invests in may underperform those lowly rated stocks which we shun, which are in heavily cyclical sectors, are highly leveraged, have flawed or outdated business models and/or which consequently have poor profitability, returns and cash generation. (Location 264)

The relative success of quality investing over value investing cannot be solely or mainly attributed to the factors which I listed earlier – low interest rates, QE, bond proxies, consumer or tech stocks. (Location 278)

lowly rated does not equal good value highly rated doesn’t not equal expensive. (Location 343)

In some cases it seems that the inability of forecasters to achieve any accuracy is caused by a degree of role confusion. (Location 356)

To return to J. K. Galbraith: ‘We have two classes of forecasters. Those who don’t know – and those who don’t know they don’t know.’ We are in the former camp, and so long as many other investors rely upon people in the latter camp this gives us an advantage. (Location 368)

Given that we acknowledge that the future is unknowable – we regard the phrase “foreseeable future” as an oxymoron – how do we manage to select companies to invest in which will perform well in future and better than our benchmarks? (Location 372)

The longer answer is that, whilst we seek companies which have superior financial performance, that should be an outcome of their operations – not their primary objective. (Location 375)

I can’t think of a company which was mainly focused on driving financial results, and especially those that have obsessed about quarterly earnings in comparison with “the Street’s” expectations, which has blossomed into a great company and investment. (Location 378)

If you look back to the “How growth became value but value didn’t” table earlier it suggests that the reason why “value” investors fell into the trap of owning some of those stocks is because they felt that the low valuation and share price was the most important piece of information. (Location 382)

They were right, albeit not in the way they intended given that we have made nearly ten times our money on our first purchases of Microsoft. The moral here, I suspect, is not just that you need to ignore the noise and look at the facts but that some people are actually a useful negative indicator. (Location 388)

One of the lessons this illustrates is that you may only get to invest in really good businesses at a cheap rating when they have a problem. (Location 393)

Our job is to determine whether such problems are a temporary glitch that presents an opportunity for us as investors or an existential threat. (Location 395)

Spotting the problems isn’t difficult. An assessment of the company’s products, services, management, competitive positioning and prospects should lead you to determine what share price you might be willing to pay for it, not the other way around. (Location 411)

I know ten years (120 months) would be a long time to wait for this, but if your time horizon is shorter than this I would suggest you shouldn’t be invested in the equity market. You certainly shouldn’t be invested with Fundsmith. (Location 418)

We prefer the refreshing candour of the CEO of Stryker, the medical equipment and devices company in which we have been invested since the inception of Fundsmith, who remarked during the Covid lockdown ‘the reason we’re not giving guidance, right, is because we just don’t know what’s going to happen in the future’. (Location 425)

We have learnt to be wary of companies that make lots of adjustments when reporting their figures. (Location 429)

The only way to focus your fund manager on performance without gifting him or her most of your returns is to ensure he or she invests a major portion of their net worth alongside you in the fund and on exactly the same terms. (Location 479)

Fundsmith opened for business on 1 November 2010, and we are critical of attempts to measure investment performance over short periods of time. (Location 494)

Eighteen days after the fund opened and we purchased our initial holding in Del Monte it was bid for by private equity firm KKR at a significant premium to the price we had paid. (Location 531)

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. (Location 552)

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. (Location 563)

We launched an active equity fund at the end of a decade in which a) equities have performed badly; and b) the average active fund manager has again underperformed the index and so made a bad performance by the asset class worse. (Location 573)

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. (Location 581)

Moreover, synthetic ETFs are often used to 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). (Location 587)

One of the most important facts that is continually overlooked is share buybacks only create value if the shares repurchased are trading below intrinsic value and there is no better use for the cash which would generate a higher return. (Location 679)

Most share buybacks destroy value for remaining shareholders, and management is able to get away with this as the current accounting for share buybacks conceals their true effect. So what needs to change? Management should be required to justify share buybacks by reference to the price paid and the implied return and compare this with alternative uses for the cash. Investors and commentators should analyse share buybacks on exactly the same basis as they would if the company bought shares in another company. Investors and commentators should use return on equity to analyse the effect of share buybacks rather than movements in earnings per share. Share buybacks need to be viewed with more than average scepticism when done by companies whose management are incentivised by growth in EPS. Accounting for share buybacks should be changed so that the shares remain as part of shareholders’ funds and as an equity accounted asset on the balance sheet in calculating returns. (Location 681)

One is that the underlying clients for many of those “institutions” are individual investors – do they really understand the risks their private wealth manager is running with ETFs? (Location 713)

The net result is that across the entire ETF asset class a portion of the funds which ETF purchasers think has been invested in ETFs, via the creation of new shares, has in effect been lent to hedge funds. The ETF holdings are not all backed by assets of the sort investors expect, even if they understand what the ETF is meant to do. (Location 740)

Moreover, in the case of some ETFs such as PEK, it is difficult to fathom what the short interest in PEK really represents as it is illegal to short China A shares. (Location 744)

To date this year Citigroup reckons that in the US market there have been 26 accelerated share repurchases (ASRs) totalling $8.5bn. (Location 756)

The investment bank(s) makes a short sale to the company and borrows the stock it delivers to the company. (Location 759)

After all, share buybacks can generate share price rises at least in the short term and indeed part of the raison d’être for ASRs is to trigger a bigger short-term boost to share prices. (Location 762)

One of the rules that I have found in business life is that when management is doing something they really don’t want examined they use polite euphemisms to camouflage the reality of the situation. (Location 768)

Add to that the fact an ASR gives investment banks even more ways to take money from the unfortunate shareholders of these companies. (Location 778)

The announcement of an increased share buyback at News Corporation is clearly meant as a sop to shareholders who might justifiably be querying whether Murdoch family control is really in their best interests. (Location 786)

The main criteria which determine whether a share buyback creates value for remaining shareholders are a) the shares should be trading below intrinsic value; and b) there should be no better alternative use for the cash that would deliver superior returns than the buyback. (Location 789)

So far his clan’s control has produced a mediocre 10% return on capital employed over the past five years, and a share price which has underperformed the S&P 500 Index for the past 15 years. (Location 798)

bias. I suggested to her that, as the CEO of a public company, I think the shareholders would have had me fired if I had indulged in the following: paid $580m (£360m) for MySpace and then sold it for $35m (£22m) paid $5.7bn (£3.5bn) for Dow Jones and written off $2.8bn (£1.7bn) paid $615m (£382m) for my daughter’s business in an example of what has been described as ‘blatant nepotism’ seen my company’s shares underperform the S&P 500 Index for 15 years; and been in charge when several of my staff had engaged in criminal phone-hacking and bribing police officers, activities which had been covered up by my management. (Location 810)

The answer, of course, is that nobody can fire Rupert Murdoch because the Murdochs control News Corp through differential voting rights. (Location 819)

My responses about the Murdoch situation were clearly not what the Sky interviewer was expecting, or wanted to hear. She mounted a defence of Rupert Murdoch’s achievements in building a ‘big empire’. I reminded her that to qualify as a business empire, News Corp would need to generate, for example, a decent return on capital – something which it has failed to do. (Location 826)

Return on capital employed is one of the most important measures of corporate performance – it is the profit return which the management earns on the capital shareholders provide. News Corp has managed a decidedly poor return on capital employed of just 10% a year in the past five years. (Location 829)

ETFs are regarded by many investors as the same as index funds. (Location 850)

Some ETFs do not hold physical assets of the sort they seek to track. They are “synthetic” and hold derivatives. (Location 851)

This gives rise to a counterparty risk, and as we saw with the UBS incident, some interesting risks within the counterparties supplying the basket of derivatives. (Location 852)

ETFs do not always match the underlying in the way people expect. Because of daily rebalancing and compounding, you can own a leveraged long ETF and lose money over a period when the market goes up but during which there are some sharp falls. (Location 856)

I would strongly suggest that people would not expect to be leveraged long and lose money if the market goes up or short and lose it when it goes down. (Location 859)

some market participants are short ten times the amount of the ETF. (Location 863)

If the ETF is in an illiquid sector, can you really rely upon creating the units as you may not be able to buy (or sell) the underlying assets in a sector with limited liquidity? (Location 863)

The answer, I suspect, is that the short sellers cannot create the units because the ETF operates in an area with limited liquidity (the Russell 2000 is the US small-cap stock index). (Location 869)

Although ETFs are billed as low cost, they are also the most profitable asset management product for a number of providers. (Location 874)

There are also the hidden costs in the synthetic and derivative trades which the provider undertakes for the ETF. (Location 876)

is. Like so many boxers before him, Frazier died penniless, living above a boxing gym in the Philadelphia ghetto. (Location 904)

Even a calendar year is too short for this purpose – it is the time it takes the earth to go around the sun and has no natural link to the investment or business cycle. (Location 932)

This strikes us as a good performance. It was achieved against the background of a year in which it gradually dawned on many people that the financial crisis of 2008–09 had not been solved but had rather been transformed into a sovereign debt crisis: (Location 952)

So, for example, having determined to return a portion of earnings to shareholders, how does a management decide between a dividend and a buyback? (Location 990)

Practitioners within the ETF sector reacted with a fury which can only be generated by two factors: 1. the criticism was accurate and/or hit a nerve; and 2. it was in danger of derailing a large gravy train. (Location 1013)

not. Synthetic ETFs do not hold underlying securities of the sector or market they are supposed to replicate. (Location 1024)

Inverse ETFs can lose money even when the market sector they track has gone down, and leveraged long ETFs can lose money when their market or sector has gone up. (Location 1025)

Synthetic ETFs are of particular concern. If a fund which is described by the words “synthetic”, “derivative”, “swap” and “counterparty” does not cause you obvious concerns, I suggest you may need to study the events of the Credit Crisis of the past four years more carefully. (Location 1027)