125: Is Active Management Worth Paying For? With Terry Smith (CEO, CIO & Founder of Fundsmith)
Jan 25, 2024
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Terry Smith, referred to as 'the English Warren Buffett', discusses his investing style and success. He explains the genesis of Fundsmith, its mission, and what he looks for in companies. He also discusses the decline of research standards, the problem with management presentations, and his passion for military history.
High return on capital is crucial for assessing a company's performance and creating long-term value.
Thoroughly analyze company accounts instead of relying on management presentations and guidance.
Focusing on quality companies with high returns on capital, growth potential, and defensible competitive advantages leads to consistent long-term risk-adjusted returns.
Deep dives
The Importance of Companies' Return on Capital
A key aspect of good companies is their ability to generate a high return on capital. This measure, often overlooked, is crucial in assessing a company's performance and creating long-term value. Companies with high returns on capital can compound their value over time, making them a desirable investment. Additionally, companies should have a source of growth, such as consumerization in developing countries or secular trends in healthcare and aging. Furthermore, it is important for companies to have a means of fending off competition, such as strong brands, control of distribution networks, or patents.
The Pitfalls of Ignoring Accounting and Management Presentations
Many investors today rely on management presentations and adjusted numbers rather than delving into the details of company accounts. This can lead to a superficial understanding of a company's financials and potential misrepresentations by management. It is imperative to read and analyze company accounts thoroughly, looking beyond the management's narrative. Moreover, relying heavily on company guidance can be misleading, as companies may not accurately predict their future performance. It is important to recognize the value of scrutinizing financial statements and not solely relying on management's presentations or guidance.
The Focus on Companies Rather Than Macro Factors
Fundsmith's investment process centers around analyzing individual companies rather than macroeconomic factors. While they consider macro trends, it does not significantly impact their investment decisions. Instead, Fundsmith pays attention to company data, such as payment processing statistics, to gain insights into the economy. They believe that focusing on quality companies with high returns on capital, growth potential, and defensible competitive advantages is key to achieving consistent long-term risk-adjusted returns. Fundsmith's goal is to continue delivering exceptional performance and ensuring the long-term success of the business.
The Importance of Price in Investment
One important factor to consider when evaluating a company as an investment is its price. A great company may not necessarily be a great investment if its stock is overpriced. Even if you buy a highly valued company at a low price, if it has low returns on capital, it may not yield a good investment return over the long term. It's crucial to understand that price and value are not always directly related, and investors should not solely rely on valuation metrics when making investment decisions.
The Significance of Management in Investment
Another reason why a great company may not become a great investment is poor management. When investing in a company, investors essentially subcontract the management's role of generating returns. It is crucial for management to effectively reinvest capital and make sensible decisions that generate incremental returns on investments. Deviation from a company's core competency, investing in areas outside their expertise, can be a red flag for potential investment issues. Assessing management's ability to provide good stewardship is essential in determining whether a great company will translate into a successful investment.
Our guest today has been referred to as "the English Warren Buffett" for his style and success in investing. His book, published in 1992, Accounting for Growth, and its ensuing controversy helped propel it to the top of the bestsellers chart, displacing Stephen Hawking's ’A Brief History of Time’ from the No.1 spot.
He’s been head of research, CEO of a public company, a former top banks analyst (who won’t own a bank in his fund), and is now highly respected Founder and CIO at the global equity fund manager, Fundsmith.
Terry details his progress through finance, including how he examines inconsistencies and checks cash flows. He explains why he believes you cannot be successful in investing unless you break out from the crowd.
He then describes the genesis of Fundsmith, its mission “to run the best fund ever; by which we mean the one with the highest return over the long term adjusted for risk.”
He then details what he looks for in the companies he selects, red lines, distrusting management gloss and why he believes that equities beat bonds over the long term. Lots to learn!