Fund in focus: Fundsmith Equity

Posted by Liz Rees in Fund and industry updates category on 26 Jun 19


The proposition

Fundsmith Equity aims to produce capital growth from a concentrated portfolio of companies, typically well-known names with a global reach and which are listed in developed markets. The fund manager, Terry Smith, takes a long term view and has not tended to engage in short term trading, hence turnover has been very low.

The team

Terry Smith founded Fundsmith, of which he is CEO, in 2010 following a high profile career in the City during which he held a number of senior roles. As an advisor to pension funds, he developed the successful investment strategy which has been employed by Fundsmith Equity.

Smith made his name as a top-rated banking analyst and has always expressed strong views, famously issuing a sell recommendation on Barclays when employed by its stockbroking subsidiary. He has worked with his head of research, Julian Robins, for 33 years and they have assembled a team of highly experienced sector analysts to support them.

Research from Fundsmith’s emerging markets team is also drawn on to help them understand the growth opportunities for multi-national companies in the developing world.

Investment philosophy & process

The philosophy is simple, clear and easy to understand. Smith sums it up as ‘only invest in good companies, don’t overpay and do nothing.’ He believes that in-depth financial analysis of businesses results in superior stock selection and contributes more to returns than worrying about asset allocation and trying to time the market.

The team ‘live and breathe’ company accounts and Smith considers their scrutiny to be of greater importance than external research or meetings with management. However, they do invite respected external analysts, with the most bullish and bearish stances, to present to them. This helps validate their own investment thesis.

The process is designed to uncover opportunities with valuable intangible assets such as enduring brands, defendable patents and extensive distribution capacity. Companies must demonstrate strong cash flow generation which can be reinvested to produce high, and sustainable, returns on capital.

Other essential characteristics are low borrowings, dependable growth attributes, strong and defendable market positions and resilience to disruption. Finally, an attractive valuation at the time of purchase is important.

These stringent criteria reduce a vast investment universe down to a shortlist of around 100 companies. From this they build a portfolio of only 20-30 shares which are held for long periods and will only be sold if the investment case no longer stands, the valuation is excessive, a better opportunity is identified or if a company is taken over.

Performance & Costs

The fund has produced strong and consistent out performance since inception, on 1 November 2010. The total return to the end of May 2019 is 341% compared with 154% for the MSCI World Index and 107% for the IA Global Sector(FE data). It has been in the first quartile of its peer group since launch.

The Annual Management Charge (AMC) is above the peer group average but additional expenses, notably trading costs, have been relatively low. Fundsmith absorbs any external research cost, although in practice, this is rarely used.

Current outlook

Smith makes a point of ignoring the short term economic and political noise since his portfolio is constructed for the very long term. He believes that the focus on companies with defensive qualities, in industries that are experiencing structural growth, will deliver good returns over the long term.

Current positioning

The focused and research-driven approach means the portfolio looks very different to the MCSI World Index.

By country of domicile, the fund has a big US weighting (65% at 31/05/2019, source: fund factsheet) but by origin of sales it is much more diversified. Indeed many household brands it invests in are benefiting from growth in Emerging Markets, for example, Reckitt Benckiser and PepsiCo.

There is concentration in certain sectors, notably technology, consumer goods and healthcare which meet the strict investment criteria. Weightings in these sectors accounted for around 31%, 28% and 24% of the fund respectively. Conversely, the fund does not have exposure to more cyclical sectors such as financials and commodities.

The high conviction approach means weightings of 4% plus are common. However, the emphasis is on large, liquid stocks which can be traded easily. The top three positions at the end of April, were Paypal, Microsoft and Facebook.

Smith has recently expressed confidence that Facebook has built an effective competitive moat and should now be viewed as an advertising, rather than social media, business. Cosmetics brands L’Oréal and Estée Lauder are other long term favourites.

Our view

This strategy has an impressive track record of excellent stock selection over a lengthy period, although this is not a guide to future outcomes. Indeed, it should be acknowledged that market conditions have favoured robust, defensive businesses and should market sentiment experience a swing towards value stocks, the fund could lag more economically sensitive funds.

Not surprisingly, quality companies often trade at a premium to the market and this is presently the situation more than ever. However, the fund has experienced relatively low drawdown (peak to trough falls) due to the defensive nature of many of its investments.

There are a few other facts that new investors should bear in mind. The fund is now £17.5 bn in size which could reduce its flexibility. Also, global funds do expose UK domiciled investors to currency risk although in this fund it is spread across a number of countries which can help to even out any movements over time.

Finally, by investing in this fund, investors are backing the personal reputations of Mr Smith and Mr Robins, who hold large stakes in the management company. Morningstar have expressed high conviction in the duo, awarding the fund a coveted gold analyst rating.

Important information: Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Nothing in this article is intended to or should be construed as advice. This document is not a recommendation to sell or purchase any investment.

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