Post: Review of Fundsmith Equity Fund

Review of Fundsmith Equity Fund

This is not a recommendation. If you want financial advice tailored to your circumstances seek independent financial advice. We are independent and receive no payment from Fundsmith or any other fund manager for writing this review.

Why I don't invest in active funds

An active fund should outperform its benchmark index. That is why we pay the fund manager considerably more than we would pay a passive fund to track the same benchmark. Unfortunately there is strong evidence that fund managers consistently fail to beat their benchmark once we subtract their fee. Those that do outperform their peers fail to do so consistently suggesting that this outperformance is due to luck rather than skill.

A study by S&P in the US showed that less than 1% of funds in the top quarter of performance tables managed to remain in the top quarter after 5 years.

So today's winners will not remain so for very long making finding truly skilled outperformers, if they exist, exceptionally difficult to find. However you have to pay a percentage of the amount invested every year whether the fund manager succeeds in their job or not!

Fundsmith Equity: An exception?

The Fundsmith Equity Fund, managed by Terry Smith and his team, is a fund that has an impressive track-record of beating its benchmark index, which is the MSCI World index. This is its performance since inception in November 2010 versus its MSCI benchmark.

Fundsmith vs Benchmark Cumulative

Over the lifetime of the fund, which is just under seven years, the fund has returned 18.7% versus 10.4% for the MSCI World benchmark. This is just long enough to trigger the usual cascade of events:

  1. Fund outperforms its benchmark and its peers for X years (X=6.7 for Fundsmith)
  2. Media pick up on the outperformance and talk about it, pops up in performance league tables.​
  3. Money pours into the fund as investors expect the fund's outperformance is due to manager skill and will persist in future. Current assets under management for Fundsmith Equity is £11.4 billion (according to Fundsmith's website as of June 30, 2017).

The fee you pay for the fund depends on which of the three share classes that you buy. The fees are designed to nudge investors toward regular investments. Unless you are willing to invest at least £5 million you will have to pay 50% more in management fees to avoid regular investments:

  • T Class: 1.0% Annual Management Charge, minimum initial investment £1000, minimum monthly investment £100
  • R Class: 1.5% Annual Management Charge, minimum initial investment £1000, no minimum monthly investment
  • I Class:​ 0.9% Annual Management Charge, minimum investment £5 million

For comparison, a passive fund that tracks the MSCI World benchmark costs ten times less than Fundsmith's R class shares (this is the HSBC MSCI World ETF, ticker HMWO with an ongoing charge of 0.15% per year).

Why Has Fundsmith Outperformed?

It's hard not to like Terry Smith. You can see him in action at the Fundsmith annual meeting on YouTube (link here). The fund has values which they post on their website. They have a no-nonsense and straightforward approach, and seem to genuinely promote transparency in fees and their investment approach. The annual investor meeting and its YouTube video are a testament to that transparency. Here are their top holdings and their values:

Fundsmith Top 10 Holdings and Values

How have they beaten MSCI World so soundly for seven years? The only way to increase return is to increase risk in some way. Riskless return is impossible. So where is the additional risk? The answer is concentration. The fund invests in around 20 to 30 stocks. For comparison its benchmark the MSCI World index contains 1656 stocks across 23 countries.

Fundsmith Equity vs MSCI Sector Composition

The tree maps above show the percentage of the MSCI World Index and Fundsmith's equity fund that are invested in each stock sector. While the MSCI World is split across many sectors the Fundsmith allocation is heavily concentrated in just three sectors:

  • Consumer Staples (stuff you have to buy e.g. food, household goods)
  • Healthcare (pharmaceutical and medical supply companies)
  • Technology (IT, smartphones, software)

Concentration helps return if the sector choices match the macroeconomic environment and the stock selection picks winners. Since the Global Financial Crisis in 2008/9 we have essentially been in the same environment. This was a period of ultra-low interest rates as central banks tried to avoid deflation and stimulate job growth. Stocks rallied after the crash but, oddly for a bull market, defensives fared very well. Usually defensives do well in a downturn, but this time, perhaps because people were still cautious after a 50% stock market crash, defensives enjoyed the rally too. The three dominant sectors and stocks chosen by Fundsmith have thrived in this environment.

This concentration risk does not show up if we consider standard risk measures like volatility, which is the typical annual percentage price move, either up or down. The volatility of the Fundsmith Equity fund is 12.0% which is lower than its benchmark MSCI World index which has a slightly higher volatility of 14.4%. This is because Fundsmith's approach is to find high quality, large companies with strong balance sheets and these so-called "defensive" stocks tend to have low volatility.

Fundsmith's Approach to Investing

These criteria are taken from Fundsmith's website and merit a little bit of explanation. The order is important. Everyone has access to the same information as Fundsmith and working through this checklist does filter for high quality companies. However the amount you pay for these companies is high as a result. Notice that valuation comes last. Terry Smith talks about this in his 2017 investors meeting video and makes it clear that he would rather pay more and own a high quality company long-term than pay less and own a lower quality company.

High quality businesses that can sustain a high return on operating capital employed

Return on capital employed is a used to find how efficiently a company uses the capital it possesses to generate earnings (profits). This is the heart of capitalism, and is the reason why a company exists and so this ratio is extremely important. Two numbers go into the calculation:

  • Capital employed is the capital raised in the form of shares and bonds. It can be easily worked out by taking the value of a company's assets minus any short-term funding in the form of cash, supplier credit or tax credit
  • EBIT which stands for Earnings (profits) Before Interest and Tax

Return on Capital Employed = EBIT / Average Capital employed.

​Shareholders want a large ROCE through a combination of high profits relative to capital employed.

In the case of the tobacco company Philip Morris, which is in the top ten holdings for Fundsmith Equity, EBIT is $11.4 billion, capital employed is $23.6 billion and so the ROCE ratio is 48.4%​. This means that for every dollar of capital employed the company generates about 50 cents of profit, some of which can be paid back to shareholders as dividend and some of which can be ploughed back into the business to generate more revenue in future.

Businesses whose advantages are difficult to replicate

One way to ensure that other companies don't copy your business model is to have a swathe of patents that protect your intellectual property. This is particularly important for technology companies where ideas, once implemented in software and services, lead directly to revenue. Microsoft is one of the companies in which Fundsmith invests, and it has been granted around 30,000 patents. In 2016 Microsoft was granted over 2000 patents in the US.

Businesses which do not require significant leverage to generate returns

Leverage is how much money a company borrows, usually measured against the amount of share capital on the company's balance sheet. We are emerging from a decade of ultra-low interest rates during which borrowing has been very easy and the cost of borrowing has been very low. Some companies have used this as an opportunity to increase returns through more borrowing, but this comes with a greater risk of bankruptcy if profit rises more slowly than debt payments. It shows foresight to be wary of this, given that rates are already starting to rise.

As a visual example comparing the amount of leverage on a company's ​balance sheet here are Google and Microsoft's liabilities. This is how they have funded their business. Microsoft's liabilities are 37% equity, whereas Google has a much higher percentage of funding from shareholders: 83%. Microsoft depends more on debt for its funding, long-term borrowing makes up 32% of its liabilities, whereas Google's long-term debt is just 6% of its funding. The more equity on the liability side of the balance sheet the lower the leverage, hence Microsoft is more levered than Google. As equity absorbs any losses, companies with more equity have a lower probability of becoming bankrupt because their shock-absorbing buffer is larger, hence they have a lower credit risk. All else being equal Fundsmith prefers companies with low leverage and low credit risk. 

Liabilities For Microsoft and Google

Businesses with a high degree of certainty of growth from reinvestment of their cash flows at high rates of return

Once a company generates cash profits can it reinvest that cash into its own business to grow future profits? This is more difficult than it sounds because scaling up a business may reduce the return on capital if the increased capital fails to deliver. For example if we have an ice cream company we could continue ploughing profits back into investments in more ice cream factories. However, if demand for our products fails to match our increased production then the return on our investment will start to fall. This is why, over the long-term, companies with high Return on Capital Employed tend to revert down to industry averages. Fundsmith tries to find companies for which this will not happen.

Businesses that are resilient to change, particularly technological innovation

News headlines about jobs being replaced by AI are commonplace, but are just one example of technology changing the face of entire industries. Fundsmith is sensitive to these changes, with a good example being the sale of its holding in Swedish Match in 2014, as described in Fundsmith's Short Form Report from December 2014:

"We took the view that the e-cigarette development, whilst not necessarily harmful to the cigarette companies, was a potentially disruptive change which could adversely impact its Snus smokeless product. We are sensitive to the possibility of permanent loss of value which disruptive change can cause and on the whole we seek to avoid investing in companies which could be affected by it.​"

If you watch the 2017 shareholder meeting you will see (54 minutes and six seconds into the presentation) the following "worry table" showing how disruption could affect some of the companies in which the fund invests. For example Pepsi's profits may be affected by the cultural move towards consumption of healthy and organic food and drink. No company is safe, but it is clear, and reassuring, that the Fundsmith fund managers obsess and monitor potential dangers.

Fundsmith Disruptive Change

Businesses whose valuation is considered by the Company to be attractive

This is bottom of the list for a reason. In his 2017 investor meeting Terry Smith said the following (6 minutes and 50 seconds into the YouTube video):

Our investment strategy... we need to use an acronym, because you always need to use a three-letter acronym, it's "ODD".
  1. Only invest in good companies.
  2. Don't overpay
  3. Do nothing.
The D for don't overpay, that is second for a reason. It is less important if you are a long-term investor to look at the valuation of a company than it is to look at whether it is a good company. That's not a statement of opinion it is a statement of fact. If you go back and look at a statement which Charlie Munger, Warren Buffett's business partner made in about 1995, he talked about the returns that a company makes in its business and that over the long term the share price must gravitate to that. And he's absolutely right... Of course bear in mind if you're a long-term investor. If you're not a long-term investor you shouldn't be in the fund... If you are long-term investors then having a good company is more important than the valuation you buy it on.​

Specialisation: A Warning From Giant Pandas

Three million years ago, during a period when the climate on Earth was relatively warm and wet, bamboo forests flourished in Southeast China, Myanmar and Vietnam. A carnivorous mammal, the pygmy panda, turned vegetarian and exploited this rich food resource by becoming a specialized eater of bamboo. Things were great for pygmy pandas until 700,000 years ago when two glaciation events affected China. The population declined and the species was on the verge of extinction 300,000 years ago, but managed to evolve into the larger baconi panda that was better suited to the new environment. When the glaciations passed the Earth witnessed Peak Panda around 30,000 to 50,000 years ago. Numbers decreased dramatically again over the last few centuries thanks to loss of habitat, and it is only through conservation programmes that the wild population of Giant Pandas has been rebuilt.

Giant Panda Eating Bamboo

The moral from Giant Pandas is that specialisation is risky. You can thrive while conditions suit you, but long-term the only way to survive is to evolve. The questions investors have to ask themselves is: Can Fundsmith evolve as the economic environment changes?

Will Outperformance Continue?


Perhaps I should qualify that. Firstly the baseline odds of any fund outperforming long-term are extremely low. The S&P Persistence Scorecard is based on US Mutual Funds and shows that being in the top 25% of funds in a given year almost guarantees, with 99% certainty, that the fund won't be in the top 25% of funds five years later. This means long-term outperformance cannot be predicted by outperformance today. In turn that suggests that outperformance is due to luck, not skill. I'm not ruling out the possibility that Fundsmith is the one in a hundred fund that outperforms over decades, but this is extremely unlikely. Given baseline odds of 99% I'm happy to stand by my "No" over a five year horizon.

S&P Persistence Table

The second reason is that we are about to experience a regime change. I'm talking about a change of macroeconomic regime rather than political regime. That's because the Federal Reserve is now well into its rate hiking cycle and other central banks such as the Bank of England and the ECB will follow. In such an environment we are almost certain to see a rotation in sector performance. Perhaps Fundsmith will alter its sectors to match the new regime, but given the dogmatic tone of communications from the company this seems unlikely.

Smith has responded to this criticism, as his fund underperformed during a cyclical rally in the last six months of 2016, as follows:

​"I remain amazed... by the number of commentators, analysts, fund managers and investors who seem to be obsessed with trying to predict macro events on which to base their investment decisions... I have no way of knowing whether this "rotation" will continue but then again neither do any of the analysts or commentators who are involved in opining on the matter."

Of course he is correct, neither he nor anyone else can forecast whether one sector or another will rally in future. But what we can forecast is that the sectors where he is overweight will not rally forever and as the global economic picture changes his fund's concentrated bet will underperform. The only unknowns are when this shift will occur and how long it will last.

The fund platform Hargreaves Lansdown maintains a list of 150 funds that they consider to be exceptional, but they have not included Fundsmith on the list, as their analyst Heather Ferguson explained in February 2016:

The Wealth 150 is reserved for managers we feel are exceptional. We feel the Fundsmith Equity Fund could deliver good returns for investors while defensive sectors continue to perform well. However, we have concerns over how performance may be affected when these areas begin to lag. Terry Smith's track record is relatively short and he is as yet untested in an environment of prolonged falling share prices.​

Perhaps it seems unfair to say that seven years is a short track record, but remember that a business cycle is usually a decade. Although Terry Smith says that his fund should weather falling equity markets well given its defensive sector stance there are funds which have existed longer than one business cycle whose performance is a matter of record. Hargreaves also points to the relative inflexibility of the Fundsmith approach and mentions alternative funds that they prefer based on their longer performance history and greater flexibility.

The third reason why Fundsmith is unlikely to continue it success long-term is size. The "investible universe" of stocks that meet the fund's strict criteria consists of only 70 companies. The fund size at the time of writing is £11.4 billion. Warren Buffett's Berkshire Hathaway fund ran into this problem a while ago, and feels it more keenly given its size which is $162 billion or £125 billion (in its May 2017 SEC filing), about ten times the size of Fundsmith. However if Fundsmith is wedded to the idea of holding just 29 stocks then if this is split equally one 29th is £393 million. For small companies on their list such as Choice Hotels the market capitalisation is just $3.6 billion or £2.8 billion so Fundsmith would own around 10% of the company. If they want to sell this holding it will be difficult to find enough buyers, particularly in a crisis (this discussion occurs 1 hour 10 minutes 46 seconds into the 2017 investor meeting on YouTube). Smaller companies have the greatest growth so excluding them from their investible universe will be a drag on return.

I'm Not a Believer

Ultimately the choice comes down to whether you believe this group of experts will continue to be better than all the other active fund managers out there. For the reasons above I don't believe this will be the case. Having said that, I love Fundsmith's rigorous investment approach, their transparency and openness, and really enjoyed watching their investor meeting. It was entertaining, informative and, remarkably for such events, amusing.

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