Key Insights From This Market-Beating Fund’s Semi-Annual Letter

Terry Smith, who’s the portfolio manager of Fundsmith Equity Fund, is an investor I follow closely. I got to know about Terry Smith through my good friend, Chong Ser Jing, who runs The Good Investors blog together with another friend of mine, Jeremy Chia.

Since its inception in November 2010, the Fundsmith Equity Fund has produced an annualised total return of 15.8%, handsomely beating the MSCI World Index by 4.6 percentage points during the same time frame.

Fundsmith Equity Fund invests in global equities with a long-term focus. It has strict criteria for picking stocks, and this ensures that the fund only buys:

  • high-quality businesses that can sustain a high return on operating capital employed (ROCE);
  • businesses whose advantages are difficult to replicate;
  • businesses that do not need large amounts of leverage to generate returns;
  • businesses with a high degree of certainty of growth from reinvestment of their cash flow at high rates of return;
  • businesses that are resilient to change, especially technological changes;
  • businesses with an attractive valuation.

As of June 2022, Fundsmith Equity Fund’s top 10 holdings were:

  • Microsoft
  • Novo Nordisk
  • Philip Morris
  • L’Oréal
  • Estée Lauder
  • IDEXX
  • McCormick
  • Stryker
  • Pepsico
  • Waters

With that, let’s explore four quotes from Fundsmith Equity Fund’s letter for the first half of 2022 that stood out for me.

Current Inflation Worries

If a recession ensues but inflation persists we will not have seen conditions of this sort since the 1970s when the term ‘stagflation’ was coined. My first full year in work was 1974 when inflation in the UK, as measured by the CPI, was 24.24%. In an example of history not repeating itself but rhyming, as Mark Twain observed, the 1970s inflation was boosted by the Arab oil embargo which followed the Yom Kippur War. On this occasion we have a similar effect from the Russian invasion of Ukraine.

I have no insight into how severe or persistent the rise in interest rates will need to be to quell inflation, but I am not optimistic. Interest rates as a tool to combat inflation are a blunt instrument at the best of times and I suspect more so in this instance where the inflation has not been caused by demand exceeding supply during an economic boom.

Best Protection Against Inflation

Inflation causes an increase in the cost of the ingredients, components and other inputs which constitute companies’ Cost of Goods Sold (‘COGS’). The best defence against this inflation is a high gross margin — the difference between sales revenues and COGS. On average last year the companies in our portfolio had a gross margin of 60% compared with about 40% for the average large, listed company. Our companies make things for £4 and sell them for £10 whereas the average company makes things for £6 and sells them for £10. A 10% rise in the COGS clearly has much less effect on the profitability of the companies in our portfolio than the average. Moreover, if they want to compensate for say a 10% rise in COGS, our portfolio companies can achieve this with a much smaller price rise than the average company. The effect on COGS is not the only effect of inflation but it is clear that the high and sustainable gross profit margins of our companies provide a robust first line of defence.

Missing Out on Value?

Did we miss out by not owning more lowly-rated ‘value’ stocks during this period? Not much. The much talked about ‘rotation’ from ‘growth’ to ‘value’ stocks during the first half of 2022 was rather underwhelming from the perspective of the latter. In the US, the S&P Value Index did indeed significantly outperform its S&P Growth counterpart and the NASDAQ but this outperformance took the form of a 12% fall for the S&P Value Index versus a 28% decline for the S&P Growth Index and a 30% decline in the NASDAQ. Falling less than others when times are tough has obvious merit but still isn’t a sufficient payback for the long preceding wait during which value stocks underperformed massively.

On Meta Platforms

The title for the lowest-rated belongs to Meta Platforms. Meta’s stock now trades on a FCF yield of 8.7%. At this level it is either cheap or a so-called value trap. We will let you know which when we find out, but we are inclined to believe it is the former.

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Disclaimer: This information provided in this article is purely based on my opinions and is not intended to be personalised investment advice. The ideas discussed here are not recommendations to buy/sell any stock.

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