The Fundsmith Equity Fund’s Investment Strategy
On Wednesday night I was invited to a presentation on the Fundsmith Equity Fund, delivered by the founder and CEO Terry Smith at their 33 Cavendish Square office to a small group of attendees selected from Fundsmith’s own proprietary database (still not sure how i got on the list!). I was happy to turn up and find out more, particularly as I’ve followed Terry’s business career and also read his blog for a while.
Fundsmith, although not revolutionary, is a different type of fund management company, whereby the partnership of nine members own the whole business, there are no outside interests and Terry himself invests his own money through the fund – as they say in the tech community, he “eats his own dog food”. The fund was set up in 2010 and already has over £600 million under management.
The genesis for Fundsmith came following Terry and Collins Stewart’s takeover of Tullett Prebon in 2003 when they inherited a poorly performing pension fund and then from 2004 to 2011 massively grew the scheme’s assets and outperformed the market through making the right investments, on a long ‘buy and hold’ only basis, in a portfolio of just 20 carefully selected companies.
Terry and his team believe that most other funds have become closet index trackers, are too diversified, trade too much and charge performance fees and initial fees that punish investors. Despite popular perception, the payment of performance fees doesn’t mean that the interests of the asset manager and the investors are aligned, principally because the fund manager never has any liability for losses. Such an absence of accountability incentivises wild risk taking and has the net effect of poor performance.
In 2011 apparently 81% of active large cap equity managers underperformed the S&P 500 market. Terry cites that he sees the main reason for this being the frequent trading carried out by most funds where information can’t be properly analysed in such short spaces of time, leading to weak decisions being made. Terry likens this to the invisible gorilla concept whereby humans are overloaded with inputs and a person’s attention can’t be focused on everything such that they suffer from ‘inattentional blindness’ as a result.
The Fundsmith strategy is therefore very simple, at any one time the fund only holds shares in between twenty and thirty well established and durable companies on a buy and hold basis, they charge just an annual 1% management fee, have no performance fees and align the interests of the fund managers with their clients. They look for companies which produce high returns on operating capital, whose shares are liquid and traded frequently, whose growth is derived from the reinvestment of their own cash flows at high rates of return after covering fixed charges, that have no significant leverage, that are priced sensibly, that are resilient to change and disruptive technological innovation (patents like Gillette’s ones for razor blades are good) and are focused on products (particularly consumer ones) that are not negatively impacted by economic downturns. A good example is pet food – last year Americans bought $10 billion worth of diet pet food alone and people will feed their pets before their children!
Fundsmith like to invest in companies operating in sectors with intangible advantages like brands, established distribution networks, installed base and franchise business models (where capital is supplied by the franchisees, great for investors in the franchisor). The fund also sees the regular payment of dividends as a significant part of the return, in addition to capital gains, expected from the companies in their portfolio. In addition, Fundsmith will not hedge anything, will not short anything, will not react when the markets fall or go in for the latest investment fad and will not invest in some sectors at all (such as banks, real estate, insurance, people businesses, utilities and airlines). They invest in carefully selected companies then do nothing, no tinkering, just sit on their hands (sounds like a pretty good job to have!).
Finally, Terry describes Fundsmith as the ‘Groucho Marx of the investment world’ in that like Groucho Marx’s saying that he would never join a club that would have him as a member, Fundsmith would never invest in a company that needs the fund’s money.