Money Makers

Terry Smith is not lacking in self-confidence, to put it mildly, but I think even he must be agreeably surprised by quite how successful his Fundsmith global equity fund has become. I am not talking about the performance of the fund, which has been exceptional, although not a surprise, given the inherent soundness of his investment philosophy. It is the weight of the money that he has been able to attract which is the real eye-opener.

Speaking to him last week after the AGM of his other investment management venture, the Fundsmith emerging markets investment trust, it seems that the main fund took in something like £400m in new flows last month alone. The fund now has £5.8 billion in assets, all the more remarkable since the Fundsmith fund has never found its way onto the buy list of the country’s largest fund broker, Hargreaves Lansdown, whose endorsement (or lack of it) can make or break the fortunes of lesser mortals in the fund business.

Despite this lack of support, but no doubt reflecting his talent for PR, Terry’s fund regularly occupies one of the top five spots in the list of most popular funds on the HL platform. When he launched the fund in 2011 I remember him telling me that his ambition was centred on reaching £200m in assets so that he could cover his costs.

Now with his 1% management fee, the fund management business is probably earning around £50m in fee income a year on 29 times that initial target sum. the obvious question now is: how long can the performance of the fund continue to leave all competitors in the wake?

Since launch the fund has generated a compound annual rate of return of more than 17% per annum, an impressive figure in an era of low returns. The fund has trumped both the peer group (see the Trustnet chart below) and the MSCI World benchmark by a handsome margin. Of course the style of the fund, which focuses on established cash generative businesses with strong competitive advantages and high returns on capital has proved to be tailor-made for today’s yield-hungry but risk-averse market conditions, in which so-called “bond proxies” have flourished.

Many of his competitors are waiting eagerly for those unduly favourable conditions to change, which at some point they certainly will. The fund may well underperform for a while at that point. I can’t see the fund ever doing really badly for long however. Why? Simply because the method has once crucial advantage over most mainstream global equity funds. Just as Warren Buffett does, by focusing on businesses with sustainable high returns on capital, and holding them for longish periods, his method exploits the inherent short term bias of both fund managers and investors in general.

No matter how many times this short-termism phenomenon is documented (and it is as old as the hills), it is never likely to change. A systemic bias that overweights near-term and underweights long term growth is a persistent source of market inefficiency. So while there will inevitably be poor individual years for the Fundsmith fund, long term returns are likely to remain significantly above average as long as the strategy remains unchanged and it continues to be implemented as advertised. Can we quantify that? The rule of thumb that Terry himself uses to project long term future returns is to add the yield on a stock (or portfolio) and add the sustainable growth rate in that metric, whether you use dividend yield, earnings yield or free cash flow yield (his personal favourite).

Charlie Munger, Buffett’s long-standing sidekick, pointed out years ago that over the longer term the return on any stock (or portfolio) must approximate to the long term return on capital that the business is capable of generating, with the price that you pay for it at the outset a secondary factor (and one that becomes ever less important the longer your holding period). This is not a wild surmise, simply a mathematical necessity. The secret as an investor is to be patient enough to allow those returns to materialise, given the inevitable volatility that earnings-obsessed, broker-driven traders and fund managers will generate in the quoted share price at any point in time.

The hardest part for the fund manager – more acute than ever in an era of rapid technological change – is to find the businesses that do have business models which are genuinely sustainable over long periods of time. There aren’t that many, but the challenge is something that Terry and his colleague Julian Robins, who are both experienced stock analysts, have so far shown themselves capable of meeting. The Fundsmith Equity Fund currently trades on an earnings yield of 4.2% and has a portfolio whose trailing 12-month earnings are growing at 6.6% per annum. If that rate of growth can be sustained, it implies a long term compound rate of return of between 10% and 11% per annum – handsome enough in a low inflation world, to be sure, but a good way below the 17% per annum it has generated so far. (The free cash flow yield is currently 4.8%, and implies a broadly similar outcome, assuming say a 5% growth expectation).

Conclusion: at some point the rate of return generated by the fund is likely to fall back. Because the fund has a concentrated portfolio of 27 stocks, and a high active share, the setback may well be quite sharp at one point. But that is not necessarily a good reason to sell or reduce your holdings. Funds like Fundsmith and Lindsell Train’s, which follow a similar approach, are most valuable as core portfolio components, held through thick and thin. The real wonder, given the obvious merit of the approach, is that so few other UK fund managers to date have adopted a similar strategy in managing global equity funds.

Both he and Terry Smith have demonstrated that the method worked well for many years before the onset of today’s current exceptionally favourable market conditions. The absence of effective competition so far can only be explained by the lop-sided incentives of the fund management business, which gives more weight to minimising business risk than it does to maximising investment returns. With these honourable exceptions, the global equity sector is one of the least effective of all fund sectors as a result.

What then of the emerging market investment trust, Terry Smith’s second fund venture, which has made a disappointing start to life as a quoted entity? The Fundsmith Emerging Equities Trust, to give it its full name, is much smaller than the global equity fund, having raised £193 million at launch in 2013 and and issued an additional 0.8m shares subsequently, taking advantage of the premium to asset value which it has enjoyed for much of its time on the market.

With emerging markets close to all-time lows in terms of relative performance against developed market equities, the Net Asset Value of the trust remains 5% below the issue price. The investment strategy is the same as that of the sister fund, with the difference that the component holdings have to be companies which derive the clear majority of their revenues from developing countries. Taking the same metrics as those adopted above, the portfolio has an earnings yield of just 2.7% and recorded earnings growth of 16.6%, which points to an expected long term return of around 19% if those figures are maintained (more likely perhaps is that the former may rise and the former will moderate).

In my view this outlook is subject to more uncertainty than the one for the global equity fund. Many of the holdings in the investment trust have limited free floats; several are local subsidiaries of multinational companies; liquidity is often poor and there are specific country political risks. Governance standards in some cases may not be so good. All this means that the mechanism by which the underlying performance of the businesses translates, Munger-style, into commensurate share price returns is less clear-cut and less certain than with the well-established liquid holdings in the open-ended fund. Nevertheless emerging markets as a class are undoubtedly attractively priced at the moment and the performance of the investment trust, when sentiment towards developing economies eventually starts to turn, may well turn out to be excellent too.