We Study Billionaires - The Investor’s Podcast Network - TIP526: Quality Investing: Lessons from Terry Smith

Starting point is 00:00:00 You're listening to TIP. Welcome to the Investors Podcast. I'm your host, Clay Fink, and on today's episode, I'm going to be diving in to discuss the investment philosophy and framework of Terry Smith, who is the founder and CEO of Fund Smith, and also known as the Warren Buffett of Great Britain. He started his fund in 2010, and ever since has outperformed the market, as he's returned 478% to his investors versus his benchmark returning 256%. He did this by continuing to do three things really well, buying good companies, ensuring that he doesn't overpay and doing nothing.

Starting point is 00:00:39 I really enjoyed researching Terry Smith because I love his writing style of being a straight shooter and telling it how it is. He's not afraid of calling people out when he sees wrongdoing and sticking to his strategy of buying and holding quality companies. I'm always on the hunt for the next great company to add to my own portfolio. And understanding Terry Smith's approach help me take the next step of better understanding what to look for. And at the end of the episode, I took a look at Terry's portfolio today, as well as as as more recent purchases. So be sure to stick around until the end of the episode. With that, let's dive right in. You are listening to The Investors Podcast, where we study the financial markets and read the

Starting point is 00:01:22 books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. To get this episode kicked off, many of you are probably like me in that you didn't know who Terry Smith was prior to checking out this episode. And you're in for a treat today because, in my mind, this guy really gets it and he understands what it takes to outperform the market. To help illustrate why I say that, I wanted to share a short clip here of him chatting with Morningstar Europe all the way back in 2014. Here it is. The Fund Smith Equity fund is now four years old. I think it's as marked by what's not allowed in the fund as what is allowed in the fund. So perhaps you could talk me through the screening process you do for stocks.

Starting point is 00:02:12 Yeah, sure. What we're screening for is to get rid of bad companies. We think there are very few good companies in the world, companies that consistently make a return on their capital above their cost of capital right across their business and economic cycle that you can rely on not to destroy any value for you while you're holding them. Now, most fund managers will hold all kinds of companies, good and bad. And there's more than one way of investing. I'm not saying this is the only way of doing it, but one of the problems of owning the bad companies in life is, whilst you're waiting for those companies, the sort of steel companies and the chemical companies and the airlines of the banks of this world, to have an event, which is what people are really waiting for,

Starting point is 00:02:45 a change of management, take over, the business cycle to turn up, they basically destroy value just the same as it would destroy value for you personally, if you took in money at a cost of 10% and you invested it at 5. That's what they're doing. The companies we own take in money at a cost of, let's call it 10%, and they make 30%. You can rely on the fact that we may get the share price right or wrong when we buy them. Whilst they're sitting there in that portfolio, they consistently create value. So that's what our screening process is about. It's about looking for companies that right across the business and economic cycle

Starting point is 00:03:15 have fundamentals that actually create value by making a high return on capital in cash. One of the things that some value fund managers say is the way they're able to make returns for you is by buying significantly cheaper stocks and way to. for that re-rating. Is there a risk then with your strategy that you're paying over the odds, that these stocks are expensive? Yeah, you're right. That's how some value fund managers seek to do it. I have to say, looking at the average results of the industry, not very many of them seem to manage to achieve outperformance with that. And one of the problems with that strategy is this, if you buy your poor company, apart from the fact that it does destroy value whilst you

Starting point is 00:03:51 wait, if you get your timing roughly right, yeah, it will make some value for you. It'll create and performance for you. The problem is then you have to go find another one. Whereas with our companies, if we select them right, we never have to go and find a new company. We can sit there, not deal, and as a result, cut down the costs of running the portfolio. Are they too expensive? One of the things that we're really bad at as investors is judging the outcome of differential rates of compounding. If you have a thousand pounds that you invest for 30 years, so an investment lifetime, I would say, roughly, and you invested at 10%, you'd have 17,000 pounds at the end. If you invested at just two and a half percent more, 12 and a half percent, you'd have 34,000 pounds at twice as much. If you invested at 15

Starting point is 00:04:32 percent, only 5 percent more, have 68,000 pounds, four times as much. The secret to the companies we have, if there is a secret, is that they actually compound in value more consistently in the market as a whole over long periods of time, not because they grow faster, but because they don't really have a downturn. And that's what makes them relatively inexpensive over time, because people find that hard to figure out. So we did some work on 30 years of investment, looking at baskets of companies of the sort we invest in and said, well, on average, what could you pay for those companies in terms of a P.E. versus the market and still break even over that 30 years versus the market. And you know, on average, you could pay nearly four times the market P.

Starting point is 00:05:08 And still break even now. If my funder was sitting here today on twice the market P, which it isn't, I think you'd say it's too expensive. Your value investors would say that. I'd probably say that. But the reality is, it might not be if you take a long term view. So there you can probably tell that Terry Smith is someone who's very confident. confident in himself and also really confident in his investment strategy, which I will be talking all about during this episode. In researching Terry Smith, I picked up this book called Investing for Growth, which compiles all of Terry Smith's letters and writings from 2010 through 2020.

Starting point is 00:05:41 What I really like about this guy is that he's very willing to speak his mind and call companies out if they're doing things like using deceptive accounting practices, or what Buffett calls giving into the institutional imperative. Because of his competitive nature, he cares more about winning, and he gets pretty upset when companies do wrong by their shareholders, so he's really willing to call them out when he thinks they're acting irrationally. On the front page of his book, you can see it's titled, Investing for Growth, How to Make Money by Only Buying the Best Companies in the World. And then when I look at his portfolio in his most recent 13F filing for his fund called Fundsmith, I see that it's full of quality companies, companies like Microsoft, Google, Amazon, PepsiCo, S.A. Lodder, Adobe, Nike,

Starting point is 00:06:29 among others. So when I see Terry Smith's portfolio, this can be used as a resource for me for getting ideas for quality companies I want to add to my own portfolio. Or I may see opportunities in the market if I see he's heavily purchasing a particular company as he updates his holdings each quarter through his 13F. And this guy manages over $21 billion in his fund, so he's no small manager, which is surprising because I hadn't learned about him until just recently. Before I dive into the writings in his book here, I wanted to comment on some things I found from his most recently published annual report for 2022. In the report, he shows the performance for 2022, his fund did minus 13.8% for the Fund Smith Fund, and then his benchmark with dividends,

Starting point is 00:07:16 reinvested returned minus 7.8%. He says that, quote, while a period of underperformance against the index is never welcome, it is nonetheless inevitable. We have consistently warned that no investment strategy will outperform in every reporting period, in every type of market condition. So as much as we may not like it, we can expect some periods of underperformance, end quote. So while Terry Smith, like many investors underperformed the market in 2022, he's able to show that historically, he's actually beaten the market and certain years of underperformance are to be expected. The reason that most active managers are bound to have underperformed in 2022 is because the only sector in the S&P 500 that was up was energy.

Starting point is 00:08:01 He shows that energy was up 59% on the year, while every other sector in the S&P 500 was down. Utilities were only down 1%, consumer staples were down 3%, and then down the line, real estate was down 28% and communication services were down 40%. He says that, quote, in 2022, unless you restricted your equity investments to the energy sector, you were almost certain to have experienced a drop in value. Why has this happened? We have exited a long period of easy money, a period of large fiscal deficits, where the government spending exceeds revenues and low interest rates. Attempts to suppress volatility

Starting point is 00:08:42 will only exacerbate it in the long term. If you count the current events, we have now had three economic and financial crises this century, and it is still in its first quarter. This would seem to illustrate that attempts to expunge volatility from the financial system are actually producing the opposite of the desired effect. They breached the rule for what you should do if you find yourself in a hole." He actually talks a lot about these issues that easy money has created, such as asset bubbles, people buying homes as an investment rather than something to live in, and the misallocation of capital by investors and businesses. Since the era of easy money is over for the time being, tech companies are now forced to be much more deliberate with

Starting point is 00:09:28 their spending, and really all companies in general. The market now values cash flows today much more than they did in the past couple of years with interest rates rising. So companies are more incentivized to think harder about how they should be investing in future growth. And anything that doesn't show much promise should be cut as the allocation of capital really matters now more than it has in the past. He notes that his holdings in Alphabet, Amazon, and Meta are all cutting some of that blow in their businesses, such as Alphabet trimming their unprofitable divisions and meta cutting some of their spend on the Metaverse, which now is a lost leader funded by their core advertising business. He then says that we continue to apply a simple three-step investment strategy, buy good

Starting point is 00:10:13 companies, don't overpay and do nothing. Then he shows this really interesting table that shows his portfolio relative to the S&P 500 in a way, I don't know if I've ever seen before. He shows the return on capital employed for his portfolio, the gross margin, the operating margin, and then a number of other metrics. And then he compares these metrics to the S&P 500. So he takes his fund and takes the average of all of these metrics, and then he's comparing it to the average for the S&P 500. So instead of looking at one individual company and how it's performing, he's looking at his whole fund as a whole. So for the return on capital employed, his portfolio's metric was 32% while the S&P 500 was 18%. So on average, his portfolio earned a

Starting point is 00:11:00 returns on capital employed at 32%, and then the S&P 500 on average is 18%. This is his way of showing fundamentally that the FundSmith portfolio is invested in better companies that are able to reinvest at higher rates of return. The gross and operating margins are significantly better as well than the S&P 500, and the interest coverage ratio is double that of the S&P 500. So not only are the companies he owns earning higher returns, but they're also doing so with less leverage, which makes his portfolio more robust and better able to handle downturns when credit conditions are tight. He stated that, quote, consistently high returns on capital are one sign we look for when seeking companies to invest in. Another is a source of growth. High returns are not much use

Starting point is 00:11:51 if the business is not able to grow and deploy capital at these high rates. So how did our companies fair in that respect in 2022. The weighted average free cash flow grew by 1% in 2022. This is the lowest growth rate we have recorded to date in our portfolio and probably says far more about the leveling off and demand in some sectors post the pandemic surge and the macroeconomic conditions than it does about the long-term growth potential of the businesses themselves. You may recall that the free cash flow for our companies surge 20% in 2021, significantly above the more more normal 9% growth in 2019 and 8% in 2020. Moreover, the free cash flow of the S&P 500 fell by 4% last year. Frankly, we are pleasantly surprised that there was any growth at all in our

Starting point is 00:12:41 portfolio companies. And if 1% growth worries you, it may be wise not to read next year's letter, end quote. Then he goes on to talk about valuation. The second leg of our strategy is about valuation. The weighted average free cash flow yield of the portfolio at the outside of the year was 2.7% and ended the year at 3.2%. The year-end median free cash flow yield on the S&P 500 was 3.4%, roughly in line with our portfolio. So not only does Terry Smith invest in higher quality companies than the S&P 500, but the companies he owns are trading at roughly the same free cash flow yield as at S&P 500 as well. So he's owning higher quality businesses that are roughly the same price as your typical business in the market, which is no surprise given that he's managed to outperform the market

Starting point is 00:13:30 since his fund's inception. Now, the valuations and free cash flow yields really stand out to me here as well. As I mentioned, he stated in 2022, the free cash flow yield on the S&P 500 is around 3.4%. Then when I go back to his very first shareholder letter back in 2010, he says that the free cash flow cash flow yield on the S&P was 7%. And just for reference, the 10-year treasury was pretty comparable at the end of 2022 relative to 2010. It was 3.9% in 2022 and then 3.7% for the 10-year treasury in 2010. Despite the similar U.S. Treasury yields, based on the free cash flow yields, the S&P 500 was roughly 50% cheaper in 2010 than it was in 2022, which is quite surprising just to see how much valuations have grown over the years. And then the third leg of Terry Smith strategy

Starting point is 00:14:24 is doing nothing. His fund in 2022 had a turnover of 7% in assets, which he says is slightly higher than usual. Out of his 46 holdings, he has held on to five of them since his fund's inception in 2010. Then he goes on to share his concerns on Unilever and PayPal, both of which are long-term holdings of his, and despite having a substantial position in these companies, he hardly hears from the management team when he shares his concerns about the businesses. So I really like how he will put these companies on public display, and it makes me think of the Buffett quote of praising by name and criticizing by category. Smith does not take that approach at all because he wants to see change at these companies, and he's giving them a chance to improve and make

Starting point is 00:15:10 better decisions than they did in the past because he believes these companies have unrealized earnings potential. And I'm really glad that Smith also touched on the importance of understanding stock-based compensation. When you look at a company's gap, net income, or free cash flow amounts, they haven't factored in stock-based compensation, which is a real expense for the company. This is an expense that is most commonly used by technology companies to try and attract top talent. Smith says that share-based compensation, has become an increasingly prominent part of some companies' expenses in recent years, especially among companies in the technology sector.

Starting point is 00:15:49 If we take, for example, the 75 companies in the S&P Dow Jones Technology Sector Index, share-based compensation expense expressed as a percentage of revenue has gone from an average of 2.2% in 2011 to 4.1% in 2021. This may not seem like much of an increase, but keep in mind that during that period, revenue for this set of companies had almost quintupled on average. There is nothing wrong per se with compensating employees with shares. In fact, there is a legitimate reason for doing so. It may help to align interest some employees with those of shareholders.

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Starting point is 00:20:27 That's Shopify. All right, back to the show. I want to focus on how share-based compensation is accounted for, or more accurately, how it is not accounted for in companies non-gap earnings figures. Among the 75 companies in the technology select sector, 45 of them remove share-based compensation from non-gap versions of their earnings per share, operating income, or both. In plain English, they remove the amount for share-based compensation which boosts their profits. And you'll find it as no surprise that all of the companies in the index whose share-based comp

Starting point is 00:21:06 represents greater than 5% of revenue remove share-based compensation from non-gap measures, end quote. There's a case to be made that excluding stock-based compensation from gap earnings does make sense. For example, you need to put a value on the options, which can be very volatile from month to month, or because this is a non-cash expense, but nonetheless, it should be accounted for when you're determining how much cash a company produces for valuation purposes. Smith showcases the example of Microsoft and Intuit to show what he means by how important this really is. When looking at the PE ratios of the two companies, at the time of the writing, Microsoft traded at a PE of 25 and Intuit traded at a PE of 28, representing a 14% premium for Intuit. However, Intuit does not factor in stock

Starting point is 00:21:59 based comp in their earnings, while Microsoft does, which leads to pretty deceiving results for investors who are trying to compare the two companies and their valuations. If you're bullish on Intuit, then you may believe that Intuit is pretty cheap relative to Microsoft. But after you subtract out that stock-based comp from their earnings figure, you'll find out that Intuit is actually trading at a PE of 43, which instead of it being a 14% premium, it's actually a 73% premium, so it's not near as cheap as it looks. For the case of Intuit, this adjustment decreases their free cash flow yield from 3.5% to 2.2%. The bottom line is that when you're using the free cash flow amount to come up with your normalized earnings, you'll need to factor in the stock-based compensation

Starting point is 00:22:48 because this is a real expense for the company. For some companies, may be a really small expense relative to their free cash flows, and for many tech companies, this expense can be pretty significant and affect your calculation of the free cash flows to a pretty large degree. That's not to say that you shouldn't invest in companies just because they pay a lot of stock-based comp. You'll just want to take that into consideration when calculating your earnings figures. To round out the letter, Smith says that we should consider the potential of the Fed's monetary policy being too lax in the past, and eventually turning and becoming too tight leading to a recession.

Starting point is 00:23:25 He says that this holds few fears for us. Our companies should demonstrate a relatively resilient fundamental performance in such circumstances and the only type of market which ends in a recession is a bare market. What we are clear about is that we continue to own a portfolio of good companies, where the end of the easy money era has exposed any doubts, and there are always doubts, We have acted upon them and or aired them in this letter. Our companies are more lowly rated than they were a year ago. Now, being rated roughly in line with the market, this does not make them cheap, and there's

Starting point is 00:24:01 no guarantee that they will not become more lowly rated. But our focus is on their fundamental performance, as it should be, because in the long term, that will determine the outcome for us as investors. I will leave you this year with a quote from Winston Churchill. If you are going through hell, keep going. at FunSmith, we intend to, end quote. Now, transitioning to the book Investing for Growth, in the forward written by Lionel Barber, he writes that those that have come to appreciate Terry Smith know that he is a man who is

Starting point is 00:24:30 fiercely competitive, whether cycling uphill in the French Alps, kickboxing on a beach patio, or squaring up against his rival brokers and fund managers. What sets him apart is not his formidable winning streak, but the principles on which he has chosen to stand. He is the unabashed champion of quality, which he argues is synonymous with true value, end quote. Then he states that Terry Smith has challenged many lazy assumptions or myths about the fund management industry, including the belief that there is no alternative to passive investing. That value investing was dead and had run its course, that small and midcaps offer unacceptable risk, and that the largest companies are untouchable, as he time and time again

Starting point is 00:25:13 challenged conventional wisdom, such as when he questioned the strength of IBM in the U.S. and Tesco in the UK. To open up the book, Terry Smith makes the case for what he calls quality investing. To illustrate the power of it, he took the returns of certain companies from 1973 all the way to 2019. When you look at his benchmark over that period, his benchmark had an annual return of 6.2 percent, and then he takes a number of quality companies and says what price to earnings multiple he would have to pay for this quality company in 1973 in order to still beat the market and achieve, say, a 7% return. Well, for a company like L'Oreal, you could have paid a 281 times a multiple and still

Starting point is 00:25:57 beaten the index. You could have paid 63 times the multiple for Coca-Cola and 126 for Colgate. Clearly, if you would have bought any of these companies at an extremely high multiple, it wouldn't have been considered value investing at the time, which is generally associated with buying low PE stocks that look to be really cheap. It's much easier to argue that a company is cheap if it's trading out a PE of 5 rather than a PE of 50 or more. So this quality approach requires a few things in the company in order for it to be a quality purchase and a successful investment. First, the company must have high returns on capital invested. Dollar General, for example,

Starting point is 00:26:37 which I've talked about in the past, with each new store they build, they target a 20% annual return or else they won't build the store. That's a high return on invested capital. Second, the company needs to have the opportunities to make these types of investments, or in other words, it needs to have a long runway for growth. And third is that as investors, we need to hold that company for a long period of time. If you pay what looks to be an expensive looking price, it's going to take time for those earnings to march upward. And then when you're you look back in, say, five or 10 years, you're going to realize how good of a price is that you paid because the earnings have increased so much when you implement a quality investing strategy

Starting point is 00:27:17 correctly. It reminds me of Francois Rochon on William Green's podcast. He mentioned that he's looking for the middle of the road stocks, not the low PE, low quality stocks, and not the super high PE, more speculative stocks. It's somewhere in the middle, oftentimes a PE somewhere between 15 and 35 if I had to put a range of numbers on it. that are high quality, but still reasonably priced for long-term investors. The difficult part of this is to find the companies that are likely to continue to grow their earnings for a really long period of time. How does Terry Smith do such a thing?

Starting point is 00:27:52 He says, quote, the short answer is carefully. Very few companies make it through our filtering system as potential investments and even fewer make it into our portfolio. The longer answer is that while we see companies who have superior financial performance, that should be an outcome of the operations, not their primary objective. We are seeking companies that offer superior financial products or services to customers, which enables them to generate impressive financial returns and prevent competition from eroding them, end quote. The secret that quality companies have is that they're able to compound capital at higher rates of return,

Starting point is 00:28:30 meaning that they have higher than average returns on invested capital, and they're able to maintain those returns over long periods of time. Investors in these companies may need to pay up slightly for them and understand the power of compounding when you hold these for that long period of time. For example, when you compound capital for one fund at, say, 10% over 30 years and another percent at 12.5% over 30 years, you end up with double the amount of money at the end of the period for the second fund. So it ends up being well worth it to pay up for quality. It reminds me of the wonderful quote that time is the friend of a wonderful business and the enemy of a terrible business. Wonderful businesses continue to

Starting point is 00:29:11 improve and increase their intrinsic value day in and day out, and terrible businesses fall in value over time. Now, quality companies in a way defy the laws of investment. There's this economic theory of mean reversion, which suggests that companies that generate high returns on capital should attract competition, which will eventually reduce those returns to the average or worse than average. Our millennial investing host, Rebecca Hotsko, wrote a great article on Mean Reversion if you're interested in learning more about that. Terry Smith says that the very small group of companies that manage to avoid this economic law of gravity have some kind of defense, which enables them to fend off the competition.

Starting point is 00:29:52 This is the often quoted concept of the moat, popularized by Buffett. When Terry Smith first started his fund, he was pretty criticized for purchasing Microsoft as many deemed the company too expensive. The company today is a 10-bagger for the fund. One lesson Smith learned over the years is that every company has some sort of problem. If I look at one of my higher conviction plays, which is Alphabet, the problem with Alphabet is that the advertising market is somewhat cyclical. And when we're in a recessionary period, the first thing that many companies cut is their

Starting point is 00:30:25 advertising spending, which is obviously bad news for Google. But 10 years from now, I expect the digital advertising space to be much larger. and for Google to continue to have a very large share of that spend, which means they will be a much larger company. So it's very unlikely you're going to find a company that doesn't have any issues or any problems, but what you want to try and find is a company with very little competition or other threats such as regulatory overwatch. Since I mentioned Microsoft, I figured I'd tell the story of how this one became such a big win for him. He wrote a piece titled just the facts when weighing investments. And he laid out the revenue and operating cash flows for

Starting point is 00:31:07 just a random company from 2006 to 2012. The revenues grew from 44 to 73, and operating cash flow grew from 14 to 31 over that period from 2006 to 2012. So revenues grew by around 9% with a slight downturn in 2009 because of the crisis, and operating cash flow did even better growing by 14% annually, plus the company's margins were exceptional. So when looking at the numbers for this faceless company, you can clearly see that this is a really good business, and just based on the numbers, and you'd probably assume that the company was trading at an expensive price, but the reality is that this company traded at a free cash flow yield of over 8% and a PE ratio of only 12.

Starting point is 00:31:56 Well, this was a reality for Microsoft during that time. You just need to add a dollar sign in front of those numbers I mentioned and then add the word billions after those figures. The story people were telling themselves back then was that Apple had won the mobile device market and Google had won the online search and mobile operating systems market. This was back in January of 2014, Smith writes, I do not profess to know anything about technology investments, nor do I have any insight into who will take over from Steve Ballmer as chief executive, but I do know something about financial analysis, which often seems to be ignored,

Starting point is 00:32:32 as it has been by many commentators on Microsoft. Worse, much of the quote-unquote research and commentary about Microsoft is not about whether it's going to do well or do badly, it's more about the biases of the commentators, who often seem to feel that because Microsoft is not hip or fashionable and doesn't have the design sense of Apple, it doesn't deserve to succeed. The facts suggest otherwise. Just stick to the facts. So my big takeaway from this is that people can quickly become enamored by some narrative about a company. And people tend to attach a story to a company based on how the stock price has performed as of late, rather than how the actual business fundamentals have changed

Starting point is 00:33:14 over time. Now, Smith, when starting up his fund, obviously needed to determine his fee structure. And I thought I would mention this in case listeners weren't aware of the detrimental impact to the long-term returns that too high of fees can have. The standard in the hedge fund industry is the 2 and 20 model, which is 2% of assets per year plus 20% of profits are taken out as fees. Now, this is practically highway robbery, in my opinion. If you don't believe me, consider the stats that Smith mentions in his early reports in 2010. He says that had someone invested $1,000 with Warren Buffett over the past 45 years, they would have ended up with $4.3 million, which is up 4,000 times their money.

Starting point is 00:33:58 How do you charge them a 2 and 20 fee? They would only have ended up with $300,000, with the other $4 million belonging to the manager. Also, consider that no fund managers are ever going to do as well as Buffett did. And the tricky thing about this is that they're slowly taking their money away from you. so the fees can be deceiving because it really compounds over time. It's not until you run the math and see how those fees really compound can you see the true impact of those fees. I suspect most of our listeners are well aware of this, but some might not be.

Starting point is 00:34:33 If I'm buying into a passive fund, I generally want their fees to be less than 0.5% as just a general rule of thumb. In Smith's 2012 annual report, he discussed the entry into a low interest rate, environment and how investors are venturing into riskier assets in search for a yield. He cautions against solely buying a dividend stock with a high yield only because of that high yield the dividend stock offers. Many of these types of companies may end up being value traps as the business fundamentals deteriorate and the company is forced to eventually cut their dividend, which has been the case with AT&T over the past couple of years as they offered a very high dividend, which was recently cut in half.

Starting point is 00:35:16 One disadvantage of dividend investing is that dividends are not a tax-efficient investment strategy, as the money is taxed twice, once when the company is taxed on their earnings, and a second time when you receive your dividend check, which is taxed as income. Smith believes that investors should not focus on the dividend yield a company has, but rather the total return a company provides. As I was reading Smith's letters, I really couldn't help but be surprised by how critical he is of central bankers policies. Most letters from fund managers that I've read often times ignore the Fed policy, but he is not shy to say that QE and other policies that attempt to stimulate the

Starting point is 00:35:57 economy will do more harm than good over the long run. He says that the inevitable consequence of these policies is inflation and currency depreciation, which I believe he was absolutely spot on about. But he rounds out his 2012 letter by stating that, quote, while we wait to see If or when this scenario comes to pass, the good news is that macro views and developments have no bearing on our strategy. Increasingly, desperate attempts to stimulate the economy are far more likely to stimulate the valuation of our portfolio, not that we like to make money that way, and our stocks are likely to be a relatively good hedge against a resurrection of inflation. In his next annual letter, he says that, although we have an interest in the subject,

Starting point is 00:36:43 These market shenanigans have no bearing on the manner in which our portfolio is invested. People often ask us what we think the outlook is for the economy or the markets. Apart from prefacing any response with the phrase, we don't know, we usually point out that whatever the outlook is will not alter our methodology of investment. Whatever our view of the economy, the Fundsmith Equity Fund will always be fully invested in high-quality companies, which satisfy our criteria on financial performance. and have done so for many decades. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:40:19 distribution rate as of 1231, 2025. Carefully consider the investment material before investing, including objectives, risks, charges, and expenses. This and other information can be found in the income fund fund fund's prospectus at fundrise.com slash income. This is a paid advertisement. All right, back to the show. In 2013, Terry Smith wrote an article called Return Free Risk, Why Boring is Best. He then went on to explain how the efficient market hypothesis states that in order to achieve higher returns, you must take on more risk. But in practice and when looking at the data, Smith found that this is not necessarily true.

Starting point is 00:40:58 He references a study that found that with higher cash returned on cash invested, which I read as return on investing capital, these companies tend to to have higher stock returns. Thus, better companies made better investments. Or said another way, companies that are able to consistently have higher than average return on invested capital tend to outperform the market. He believes that the reason for this is because of investor psychology. The efficient market hypothesis states that markets are efficient and all investors are rational. But the reality is that investors aren't rational and they can be very, very emotional. When presented with a riskier investment like stocks versus a safer investment like

Starting point is 00:41:39 bonds, many people will opt for bonds because of the higher certainty of receiving a positive return. Even if they're investing for 10, 20, 30 years, it's very likely that they'll get a higher investment return in stocks, but some people just want that certainty and will opt for bonds. He believes that because many investors put an emphasis on certainty, this leads to many quality and boring stocks to be underappreciated by the market. This allows investors like him to buy those companies that are underappreciated and end up outperforming the market over the long run. Then he wrote another letter titled The Ten Golden Rules of Investment. He says that in theory, individual private investors have plenty of advantages compared to managers of big retail and pension funds.

Starting point is 00:42:26 They don't have to write quarterly reports to investors justifying their fees. They don't have to worry about beating benchmarks all the time, and they're not constrained by rules about liquidity or limits on portfolio constituents. But many investors fail to fully capitalize on these advantages because they make basic mistakes, such as buying the wrong companies, trading too often, and paying charges that are too high. My rules are designed to help investors avoid such pitfalls. Then he lists his 10 golden rules of investment. If you don't fully understand it, don't invest. Don't try to time the market, minimize fees, minimize trading and friction, don't over-diversify, never invests just to avoid tax.

Starting point is 00:43:08 He's not referring to retirement accounts here. He's more so talking about funds or projects such as renewable energy that allow companies to do tax write-offs, never invest in poor companies, buy shares in a business that can be run by an idiot. Don't engage in the greater fool theory. If you don't like what's happening to your shares, turn off. the screen, essentially what he's saying here is that Mr. Market can be irrational. And just because the stock price is falling doesn't mean the fundamentals are deteriorating. I think most of our

Starting point is 00:43:39 listeners are pretty familiar with these lessons, especially if you've tuned in in my previous episodes, so I won't dive too much into these. Earlier, I mentioned the focus that Terry Smith puts on the return on invested capital. And this is one of the most important lessons I've learned personally as a value investor. When I first got into investing, It was so easy to just look at a company and believe that if the company's revenues and their earnings are going up at a really fast pace, then the company must be doing something right. But what I've come to learn and discover is that it's possible for a company to grow its earnings per share while destroying shareholder value.

Starting point is 00:44:18 As Smith says, my definition of value creation is when a company delivers returns that are above the cost of capital it used to generate them. are in essence just like us. If you borrow money at a cost of 10% per year and invest it at 5%, you will become poorer. If you invest at a return of 20%, you will become richer. Similarly, companies which consistently make returns above their cost of capital become more valuable and vice versa. A company that can sustain a return on capital above its cost of capital creates value for its shareholders who should want it to retain at least part of its profits to reinvest it at these attractive rates of return rather than handing them over as dividends

Starting point is 00:45:03 or to be used for share buybacks. The slight problem with this approach is that the cost of capital is not straightforward to define or compute, which is why many investors just look at the growth in their earnings per share over time. However, Smith notes that EPS and PE ratios suffer serious flaws because they don't take into account the amount of capital invested in the returns that the capital makes. Terry Smith's three-step process is to invest in good companies, don't overpay, and do nothing. And good companies are those that are able to earn high returns on capital relative to their cost of capital consistently over time. To a large degree, Terry Smith's investment approach aligns with Warren Buffett, who says that it's far better to buy

Starting point is 00:45:47 a wonderful company at a fair price than a fair company at a fair company at a wonderful price. But what I really admire, in particular, about Terry Smith, is his willingness to stand out and go against even some of the smartest money managers if he believes they're wrong. He analyzed IBM around the same time Buffett bought it, and he publicly announced that he was passing on the company and then watched the share price underperform over time after Buffett had taken a position in it. However, in his letters, he does give Buffett a ton of credit to all of his contributions to the value investing community, as Buffett has referenced many times throughout his letters. Smith also recognizes the wisdom of Charlie Munger as well. And one of my very

Starting point is 00:46:28 favorite quotes from Munger is that, over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years, and you hold it for 40 years, you're not going to make much different than a 6% return, even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with one hell of a result. To illustrate this, Smith lays out an example of a company that earns 20% on capital versus a business that earns 10% on capital. And if these returns maintain these levels over long periods of time, then the returns of a stock tend to trend towards the returns

Starting point is 00:47:11 of the underlying business, which illustrates Buffett's point that it's better for long-term investors to own wonderful businesses bought at fair prices, than fair businesses bought at wonderful prices. The ability of a company being able to reinvest back into the business gives equities a unique advantage over other asset classes such as bonds or real estate. The average company pays out about half of its earnings as dividends, meaning that the other half is invested back into the business. If you own bonds, you receive your coupon payments, and for real estate, you receive your rental income. But neither of these assets inherently reinvest those earnings back into themselves on their own, as is the case with equities. Towards the end of 2015, Smith shared the lessons he learned

Starting point is 00:47:54 after running his fund for five years. And some of these lessons really struck a chord with me and resonated with me, so I'll share a few of them here. The first lesson was to invest in something good. He says, what has continued to amaze me throughout the past five years is not just this largely pointless obsession with factors which are unknowable, largely irrelevant, or both, but how infrequently I hear fund managers or investors talk about investing in something which is good, like a good company with good products or services, strong market share, good profitability, cash flow, and product development. Then later he states, another obsession I have been surprised about is that the quote unquote cheap shares. I've been asked whether a share is cheap many more times than I've

Starting point is 00:48:39 been asked whether a company is a good business. If you're a long-term investor, owning shares in a good company is a much larger determinant of your investment performance than whether the shares were cheap when you bought them. The second lesson is to ignore the siren song. Rather than being constantly swayed by public opinion, you want to have a set of principles that you can adhere to to ensure that you're consistent with your investment approach over time. If Smith had listened to public opinion, then he would have never bought Microsoft when it was trading at a PE of 12 and the business was performing really well. Another lesson was to not sell a good company. As selling a steak in a good company for him was almost always a mistake. It's funny

Starting point is 00:49:21 that he mentions this as a lesson because in 2015, he went ahead and disregarded this lesson by selling his steak in Domino's Pizza. They loved the business and they were pretty hesitant to sell it, and he said he was very reluctant to sell the shares in an excellent company simply for valuation purposes. After he had sold it, the very next year in 2016, they watched shares of dominoes increased by 45% from $111% to $159. And now in 2023, shares of dominoes trade at $352 per share. Now, what I like most about this lesson is that Smith isn't afraid to point out his mistake of selling dominoes, very similar to what Buffett does in his letters. Now, he did make the mistake selling Domino's, but he did not also make this mistake with Microsoft, as to my knowledge,

Starting point is 00:50:12 he has never sold his stake in the company, and today it makes up over 10% of his U.S. equity holdings at $2.1 billion. And at the end of this particular letter, he shares his insights from his best performing stock from that year, which was Domino's Pizza. People often assume that for an investment to make a high return, it must be esoteric, obscure, difficult to understand, and undiscovered by investors. On the contrary, the best investments are often the most obvious. He's talking about Domino's here again. Run your winners. Too often investors talk about taking a profit. If you have a good profit on an investment, it might be an indication that you own a share in a business, which is worth holding on to. Conversely, we're all

Starting point is 00:50:56 prone to run our losers, hoping that they will get back to what we paid for them. Gardner's nurture flowers and pull weeds, not the other way around. Domino's is a franchiser. If you regard a high return on capital as the most important sign of a business, few are better than businesses which operate through franchises. As most of the capital is supplied by them, the franchiser gets a royalty from revenues generated by other people's capital. Domino's has been focused on the most important item for success in its sector, the food. This is in sharp contrast to other fast food providers like McDonald's, which are struggling.

Starting point is 00:51:35 is mostly a delivery business. This means that it can operate from cheaper premises in secondary locations and so cut the capital required to operate compared with fast food operators who have higher costs for their restaurants. Throughout many of his letters, Smith also discusses the mistakes of many other value investors. In his 2019 letter, Smith showed that his fund vastly outperformed all of the other large active equity funds in the UK. So we probably watches closely what other managers are doing and why they aren't doing as well as him. He states, value investing has its flaws as a strategy. Markets are not perfect, but they are not totally inefficient either. In most of the stocks that have valuations, which attract value investors,

Starting point is 00:52:21 have those evaluations for good reason. They are not good businesses. This means that the value investor who buys one of these companies, which are lowly rated, but rarely or never make an adequate it return is facing a headwind. The intrinsic value of the company does not grow, or it even erodes over time, while the value investor is waiting for the low valuation to be recognized, and the share price to rise to reflect this. Additionally, even when the value investor gets it right and this happens, they then need to sell the stock, which has achieved this and find another undervalued stock again and again, which leads to frictional costs. This type of value investing is not something which can be pursued with a buy and hold strategy. In investment, you become what you

Starting point is 00:53:07 eat. Insofar as, over the long term, the returns on any portfolio which has such an approach will gravitate to the returns of the companies themselves. So again, he's hyper-focused on the return that the underlying business earns rather than trying to find something that is trading at a below-average multiple. Next, I'd like to transition to take a look at Terry Smith's portfolio today and get a grasp of what companies he owns in his fund and what moves he's made recently. Just as a reminder, his public 13F filing only shows as U.S. listed holdings, so we aren't able to see his international holdings. His top 10 U.S. holdings make up 60% of his portfolio shown in his 13F, which is a lot more concentrated than most funds. Microsoft tops the list at a 10%

Starting point is 00:53:54 holding, which we all know is just a fantastic company. The return on invested capital over the past five years, it's been 25%, which is exceptional. Microsoft's EV to EBIT was quite low during the 2010s when Terry Smith was first purchasing it. It was trading at a multiple below 10, and today there are multiples around 20. So we've seen some multiple expansion in Microsoft, but also it's been a really strong performer through the growth of the business. Not only is Microsoft an example of the power of buying a long-term compounder, but it's also a great example of what can happen if you vastly overpay for a company. During the 1999 tech bubble, Microsoft got up to a PE of 75. And by 2005, it reached a PE of 20. In 2011, it reached a PE of 11 before the market

Starting point is 00:54:44 started to appreciate the stock again. It wasn't until 2016 that Microsoft stock price hit the ridiculous price that it did during the 1999 tech bubble. Terry Smith's next largest holding is Philip Morris, ticker PM. This is a taboo. tobacco company, and it's a 6% waiting for him. A tobacco company is probably one of the last types of companies I would like to own personally, so I'll just briefly touch on it here. Their EV to EBIT is around 14. Revenues and earnings are much more stable and steady relative to a company like Microsoft, and the stock's price today is the same as it was back in 2016, so I'm somewhat surprised to see this one as one of their top holdings. The third largest

Starting point is 00:55:27 holding is Estee Lauder, ticker E.L. This is a company that sells beauty products such as skincare, makeup, and fragrances, and they're a leader in their industry as they sell products in over 150 countries. This seems like much more of a company that I would expect Terry Smith to own. The stock's performance has been really good and consistent over the past decade. Their return on capital has averaged 17% over the past five years. And their EV to EBIT multiple is 27, which is pretty high based on historical standards for this company. It was typically around or below 20 until 2015 until we saw this multiple consistently elevated. Now, when looking for companies to potentially add to my own portfolio,

Starting point is 00:56:11 it may be a bit more helpful to look at his more recent purchases rather than his top holdings because his top holdings are likely there because they've appreciated their way to become his top holding. So if you were to buy a company today, oftentimes it won't be his largest holdings because these stocks have appreciated and they may be a little bit more expensive. So let's see what some of his more recent purchases are. His biggest addition in Q3 of 2022 was Otis Worldwide Corporation, which went from nothing to nearly a 2% position for him at an average price of $63, and the stock is now at 81. This is a company I've never heard of. They are an elevator in escalator manufacturing, installation, and service company. This company started trading on the Newark

Starting point is 00:56:58 Stock Exchange in the first half of 2020 as it was spun off from another company. They have a $34 billion market cap and the limited data I can see, their revenues and earnings are fairly stable. Terry Smith must have some interesting insights on this company as I see that their revenue and earnings for the most recent quarter are down from the previous year. And they have good return on capital at around 20%, but because of that lack of growth, I'm personally not really interested in this particular pick. One of the other bigger moves they made in 2022 was adding Adobe in the first quarter, which ended up being pretty bad timing as the stock got hammered in September of 2022 after Adobe announced that they would be acquiring Figma.

Starting point is 00:57:41 I recently watched Bill Nygren go on CNBC to discuss Adobe in how he was recently purchasing shares in the company. He said that the stock dropped on the acquisition announcement and the stock ended up trading at the same multiple as the market based on the following year's expected earnings, which he believed was really too cheap for a company this high quality. This is definitely a company that I'd be more interested in relative to many of the others I've mentioned. I actually did a deeper dive in an intrinsic value analysis back on episode 501 if you're interested in learning more about Adobe. Their EV to EBIT is around 27 at the time of this recording, which is much lower than it's been in years past. And this is for a company that's still growing very rapidly.

Starting point is 00:58:25 They have really high margins, high return on invested capital. It's in the 20% range. So it definitely checks all of the boxes for me when looking for a quality compounder. Over the past couple of years, Terry Smith has also added sizable positions to Amazon and Alphabet. Both companies I hold myself. In 2020 and 2021, he started to make Church and Dwight a core holding. This is a household product manufacturer, which has been around for over 175 years. That's another thing I've noticed with a lot of Terry Smith's holdings is that oftentimes these companies have been around for a hundred years or more. They've just been dinosaurs and are just core staples of the American and the global economy. So I find that quite interesting as well. And you know with many of these

Starting point is 00:59:09 companies that have been around forever and they just continue to have high returns on capital. These are companies that have really strong moats. All right, that wraps up today's episode covering the investment philosophy and framework of Terry Smith. This was definitely one of my favorite episodes today as I personally aligned pretty closely with how he invests and put a lot more focus on buying quality companies. So much focus on the quality of a company, the moats, and the return on capital. If you enjoyed this episode, I'd appreciate it if you shared it on your performance. social media channel. If that channel is Twitter, feel free to tag me so I can see what you

Starting point is 00:59:44 thought of the episode. My username is at Clay underscore Fink, C-L-A-Y-U-N-C-K. Also, if you don't already, please be sure to click follow on the podcast app you're on so you can get notified of all of our future episodes coming out. And if you don't already subscribe to our daily newsletter, We Study Markets, be sure to get signed up at The Investorspodcast.com slash we study markets. With that, thank you so much for tuning in, and I hope to see you again next time. Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by the Investors Podcast Network and learn how to achieve financial independence.

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We Study Billionaires - The Investor’s Podcast Network - TIP526: Quality Investing: Lessons from Terry Smith

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