Terry Smith: Fundsmith valuation at cheapest level in five years

Rising interest rates have hurt Smith’s portfolio, but the star fund manager argues at least that now means it’s cheaper.  

The steep sell-off in technology stocks this year has hammered Fundsmith Equity – but star manager Terry Smith argues his portfolio is now good value compared to its own history and other stocks.

Smith, updating investors in his half-year shareholder letter, noted the drop of 17.8% in the first half of this year meant his shares were as cheap as in 2017 relative to how much cash they generated.

He said: “To try to get some objectivity into where we are now on valuation, the free cash flow yield on the portfolio (a ratio of cash generation to share price), which had ended 2021 at 2.7%, increased to 3.6% at the end of June 2022.

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“This means that in the space of six months, the valuation of the portfolio has declined all the way back to where it was at the end of 2017.”

Fundsmith Equity, Britain’s largest investment fund with £23 billion in assets and a member of interactive investor’s Super 60 list, has been a victim of the rotation in investor preference from “growth” to “value” shares in the wake of higher interest rates and inflation.

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But Smith said this rotation had gone too far and the narrative of the “highly-rated tech sector” had been turned on its head because technology stocks were now cheaper than consumer staples stocks, despite faster growth.

“The median free cash flow yield on the 78 technology stocks in the S&P 500 Index is 4.6% and the mean is 5.2%. Conversely, the equivalent numbers for the 36 stocks in the consumer staples sector are 3.8% and 4.6%,” he said.

The technology stocks in the S&P 500 are therefore actually now cheaper relative to how much cash they generate than consumer staples, according to Smith.

Smith argued the reason this narrative of expensive tech exists was because of the large number of tech stocks do not generate any profit.

He said: “Probably the best-known investor for these types of stock has been ARK Investment Management, notably in the form of the ARK Innovation ETF. Bloomberg suggests that the forward price-to-earnings (PE) ratios for this ETF’s top 10 holdings are in seven cases ‘N/A’, i.e., there are no earnings, and in the other three cases average 53 times.

“Conversely the price-to-earnings ratio on most of the stocks in our portfolio that could loosely be described as ‘tech’ — Microsoft, Adobe, Alphabet, Visa, ADP, Intuit, PayPal and Meta — averages 24x. Amazon.com Inc (NASDAQ:AMZN) is the only outlier. It is worth bearing these contrasting valuations in mind when people lump the whole technology sector together."

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Portfolio confidence

Even in the face of falling share prices, high inflation and slowing growth, Smith is confident that his portfolio will prosper.

He noted that his companies continued to deliver good underlying business performance in the first half of 2022, with free cash flow per share in June 2022 4% higher than in December 2021, equivalent to annualised growth of about 8%. Revenue growth was also strong, he added.

“Results reported in the first half of 2022 showed two-year top line growth — which we look at in attempt to avoid confusion caused by the gyrations during the pandemic — of 48% at Adobe, 66% at Alphabet, 51% at Brown-Forman, 79% at Intuit, 40% at Microsoft, 39% at PayPal and 47% at Waters.

“If these were our privately owned family businesses we would still for the most part be applauding the growth they had delivered in much the same way as we were six months ago, albeit we might well be concerned about their ability to replicate this performance over the next couple of years,” he said.

Investors are grappling to understand where inflation will go next and what central banks will do to contain it.

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However, Smith withdrew himself from that debate, saying that he had no insight to add on the direction of inflation.

“Fortunately, we do not invest on the basis of our prognostications about macroeconomics, but it is not a matter of speculation that we now have inflation,” he said.

Nevertheless, he is confident that his portfolio can withstand rising prices. This is because his stocks have high gross margins – the difference between sales revenues and costs of making something.

“On average last year the companies in our portfolio had a gross margin of 60% compared with about 40% for the average large, listed company. Our companies make things for £4 and sell them for £10 whereas the average company makes things for £6 and sells them for £10,” he said.