Fundsmith Equity's Terry Smith reveals top tips for profitable investing

Star manager Terry Smith tells Helen Knapman how he runs his popular and hugely successful fund, and why he's about to launch a new global small cap investment trust.

What is Fundsmith Equity?

Fundsmith Equity is a long-only global equity fund [meaning it invests with a long-term view in global companies].  

What do you look for in companies you buy?

We only invest in good businesses. This may sound blindingly obvious, but you might be surprised how many investors either don't do this or don't have a good definition of a high-quality business. 

In our view, a high-quality business is one that can sustain a high return on operating capital employed [assets minus liabilities] in cash. In other words, if you take the cash flow it generates each year and divide it by the capital employed in the business, you get a high number – currently about 28%.

We invest in companies where the assets are intangible and difficult to replicate, such as big brands. We want companies that are resilient to change, particularly technological innovation, and with growth potential. We avoid anything that needs leverage or debt in order to generate returns.

Fundsmith Equity held 27 stocks [companies] at the end of August.

It had a 92% active share against its benchmark [MSCI World Index]. Active share measures how much a fund differs from its benchmark index.

Close to two-thirds of the portfolio is in the US – why is that?

We have no bias towards any country, including the US, and are simply looking for the best companies to invest in. We are looking for a combination of high quality and reasonable value, wherever they may be incorporated, headquartered or listed in the world.

At what point do you sell companies?

After managing to buy good companies at reasonable prices (or better), we hope that we need take no further action.

We don't believe that we, and frankly anyone, has the ability to time the markets. You should think about your investments in the stockmarket on a long-term basis because if you have at least 15 years to invest, you are very likely to make money. 

We sell companies when:

• They get taken over – if we are offered cash or don't want to hold the shares of the acquirer.
• Managers of the company start making what we consider to be bad decisions about the allocation of our capital.
• Something happens to make the business much worse than when we originally bought the shares.
• The shares become too highly valued relative to other companies we would like to own.
• When we get it wrong and realise we shouldn’t have bought the shares.
• The portfolio turnover ratio for 2017 was 5.4%, which is much lower than most funds.

What stocks have you sold recently?

We sold our holding in Nestle after the company announced its acquisition of the distribution rights for certain Starbucks products. This concerned us, as the price paid was high for a very limited range of products, and there is also a royalty payment to Starbucks.

What stocks have you bought recently?

We recently bought Facebook. The tech company produces a high return on capital and has enjoyed a spectacular growth rate.

Although we expect that growth rate to maybe halve to, say, 20% a year, that is still very good. As a result of the recent furore over the use of data, the shares are only valued as an average company.

What has been your best and worst investment decision since starting the fund?

We sold out of our holding in Domino's Pizza in 2015 as it had reached a valuation that we felt was only justifiable if Domino's rapid rate of growth was sustainable, which we doubted. We made seven times our initial investment. 

At the time, I said that we sold it with some regret and trepidation. Regret, since it is undoubtedly a fine business and had been our best performing share since the launch of our fund. Trepidation, since selling shares in good companies is something we are justifiably reluctant to do and is almost always a mistake. This was the case with Domino's, which remains a quality company and has continued to perform strongly.

What opportunities and concerns do you have for the fund next year?

I don't like to think in terms of years. A year is the time it takes the earth to go around the sun and has no significance in business or investment, except in agriculture. 

What is the rationale for launching the small and mid cap focused Smithson Investment trust?

Last year we hired Simon Barnard and Will Morgan from Goldman Sachs to research the opportunity presented by applying Fundsmith's proven investment process to companies typically smaller than the ones the Fundsmith Equity Fund would invest in, hence the name Smithson. The results were compelling, hence they are launching this new fund.

How could Smithson sit alongside Fundsmith Equity within a broader portfolio?

Our analysis shows that small and mid cap companies tend to have higher expected returns but also higher expected risk, defined as price volatility, when compared to larger companies. However, adding a small and mid cap portfolio to a large cap portfolio can raise expected returns without increasing risk, due to the different risk and return characteristics that small and mid cap companies provide.

What's your top tip for a beginner investor?

My advice would be to understand what you are investing in. If you have a scintilla of doubt about whether you understand it, you don't. If you don't, then opt for a low-cost index tracker fund.

The investment industry is full of unnecessarily complex products that are designed to baffle investors, which is one of the key reasons why I launched Fundsmith. 

The man behind the fund

Terry Smith founded Fundsmith, where he is chief executive and chief investment officer, in 2010. Fundsmith's range includes Fundsmith Equity, Fundsmith Sustainable Equity, and Fundsmith Emerging Equities Trust. Prior to setting up the fund management business, Mr Smith held senior positions at Tullett Prebon, Collins Stewart, and UBS Phillips & Drew. Prior to this, he worked at Barclays Bank, where he became an Associate of the Chartered Institute of Bankers. Mr Smith has a degree in History from University College Cardiff.

Fundsmith Equity: Key stats

Launched: November 2010Fund size: £17 billionOngoing charge: 1.05%
(T share class)Yield: 1.54% (i) (gross)

(i) As at 31 August 2018. Source: Fundsmith Equity factsheet. Past performance is not a guide to future performance.