Interactive Investor

Six things we learnt at Fundsmith’s annual shareholders’ meeting

22nd March 2022 12:02

Sam Benstead from interactive investor

From why Terry Smith is still holding on to Unilever to what war in Ukraine means for stocks, Sam Benstead breaks down the latest insights from the star investor. 

Managing £25 billion in Fundsmith Equity, Terry Smith has the ear of hobbyist and professional investors alike whenever he speaks about his approach to stock picking.

But addressing investors at Fundsmith’s annual shareholders’ meeting, held remotely, Smith was under more scrutiny than normal.

The fund has fallen 11% so far this year, and in 2021 it underperformed the MSCI World Index, returning 22.1% compared with 22.9%.

High inflation and rising interest rates threaten to derail his strategy of paying a premium for stocks that have predictable earnings and plenty of growth ahead of them.

Here are six takeaways from Smith’s latest questions and answer session with investors.

Smith still likes PayPal and Meta (Facebook) despite share crashes

Famed for his stock picking prowess, Smith found himself on the wrong side of two trades this year.

PayPal (NASDAQ:PYPL) and Meta (NASDAQ:FB) started the year in Fundsmith Equity’s top 10 positions, but after falls of 41% and 37% year-to-date they are out of Smith’s most-held stocks.

In their results for 2021, Meta reported its first drop in users across its family of apps and PayPal lowered its profit outlook.

But Smith continues to hold the two companies. He said: “PayPal had multiple years of success then a very poor 2021 and 2022 so far. It is still a very strong business, but management has lost their way by trying to acquire too many businesses rather than concentrating on PayPal’s core business.”

On Facebook, he noted that its digital advertising business had a price-to-earnings ratio of just 14, which is about the same as the UK market, making it undervalued and worth holding.

Julian Robins, Fundsmith’s head of research, added that its shift to building an online world known as the “metaverse” was less weird and speculative than most people today think.

He said: “In five or 10 years time we will look back at laugh that we thought the metaverse was weird. We will all be living in it then.”

The value rotation is real and hurting Smith's shares

The big investment theme of the past six months has been the shift in investors’ preferences for cheap stocks over expensive ones due to rising interest rates.

Higher returns from safe government bonds decrease the appeal of the stocks that Smith owns which promise profits in the future.

Smith said: “We will definitely have a torrid period if markets react to bond yields going up.”

However, he made it clear that he would not change his investment approach of buying expensive but high-quality companies.

He said: “Bad business do not become good ones. We are never going to own banks or energy stocks. Good business can keep competitors out and are worth paying for.”

Amazon’s changing business model persuaded Smith to buy it

One of the surprise additions to the portfolio last year was Amazon (NASDAQ:AMZN). Smith had previously said he did not like its retail business. Shares have risen about 1,800% since his launched his fund in November 2010.

However, he changed his mind on Amazon for several reasons. He said its ecommerce operation was now more attractive as it was becoming a platform for other merchants to sell goods on, and its advertising business was growing rapidly.

Smith said: “Third party revenue is going up and they get a huge commission here which is pure profit as they have already built the delivery infrastructure. Advertising is growing revenue 50% a year and its already a $20 billion a year business.”

Another appeal is its subscription service, Amazon Prime. Smith said: “Prime now has over 200 million members, around double Apple and Disney Plus’s subscription base.  This is powerful stuff as Prime members shop more and pay subscription, which was just increased by $20 a year in America.”

Wars are a good buying opportunity, generally

Smith said conflicts were typically good times to buy shares, citing strong returns following a dip in the market during the Gulf and Korean wars in 1990 and 1950. “The sweep of history suggests buying the dip works,” he said.

However, he added there was one worrying example of a conflict kickstarting a decade of poor returns: the 1973 Yom Kippur war between Israel and a coalition of Arab states.

Smith said: “This is worrisome as there are similarities between the 1970s and today. There is inflation and an oil supply shock.”

Fundsmith Equity’s biggest direct loser from the war in Russia was tobacco firm Philip Morris International , as 6% of its revenue comes from Russia.

Smith’s shares are resilient to inflation

Rising raw material prices are pushing up costs for businesses, but Smith said his firms would weather this storm better than the market because they had higher gross margins.

Gross margin is the cost of how much it costs to make something compared with what it sells it for. A firm with a gross margin of 60% buys its goods for 40p and sells them for a pound.

Fundsmith Equity has an average gross margin of 64% compared with 45% for the UK and US market. This means that higher input costs have less of an impact on profit margins for its portfolio than the market. Smith said: “Gross margin is the first line of defence against inflation.”

He’s holding onto Unilever – for now

Unilever has been one of the most hotly-debated stocks in Smith’s portfolio. Shares have fallen 15% in the past five years and Smith has accused it of putting politics over profits. Last year he said the firm had “lost the plot”.

However, he continues to hold shares, arguing that it is still a good business.

“We are hoping it will get back to its best. It should be the best version of Unilever and not try and be something different. It has some pretty powerful brands.

“We hope that the management will try and get back to what they were producing. But to date the odds look against that.”

He also praised its global distribution network and strong presence in Nigeria, India and Indonesia.

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