Terry Smith: my scepticism of value stocks was proven correct in market sell-off

Fundsmith Equity held up well in the first quarter of 2020, a result fund manager Terry Smith he ‘would have expected, hoped and predicted’.

Fundsmith Equity manager Terry Smith’s focus on high-quality businesses and long-held scepticism of value stocks paid off during the first quarter of 2020, a period in which steep falls materialised from 21 February onwards in response to the coronavirus pandemic.

From the start of 2020 to the end of March, Fundsmith Equity declined 7.9%, markedly less than the MSCI World index, which was down 15.7%. The FTSE 100 index incurred steeper losses still, of 23.8%.

- Explore our latest content on investment funds
- Special Money Observer subscription offers

Moreover, the fund’s performance stacked up well against other global funds, with the sector average for the Investment Association’s (IA) global sector recording a loss of 15.4%, figures from FE Analytics show. Over this very short-term timeframe Fundsmith Equity ranked in 36th place in the sector, out of a total of 337 funds.

• Invest with ii: Top Investment Funds | Index Tracker Funds | FTSE Tracker Funds

In a letter to investors in Fundsmith Equity, Smith said the performance “has been as we would have expected, hoped and predicted. I would even say it is satisfactory if you accept that some fall in valuation is inevitable in a bear market.

“It also outperformed all these indices significantly in the fall from the peak of the market to its trough before the recent rally. Bear in mind the MSCI World and FTSE 100 indices benefit from the inclusion of our companies. The companies we do not own are collectively performing worse than the index numbers.”

Smith’s investment approach, which is to invest in high-quality and well-established companies that “have already won”, has a stellar track record. Over the past five years it has returned 99.5% versus the IA global sector average track record of 28.4%.

Concerns in certain quarters have over the years been raised that the fund might suffer as a result of a change in sentiment away from high-quality growth stocks to value stocks, which carry cheaper price tags. Since the financial crisis growth stocks have notably outperformed value stocks, and various experts have said this is unsustainable.

Smith, though, has stuck to his guns, and during the market sell-off his position was vindicated, as the high-quality stocks held in the portfolio limited losses for investors.

He says: “I was immensely sceptical of the view that so-called value stocks could protect you in a downturn. I have never been a believer in the philosophy that so-called value investments would perform well or protect your investment in an economic and market downturn.

“Shares in companies that are lowly rated are so mostly for good reasons – because their businesses are heavily cyclical, highly leveraged, they have poor returns on capital and/or they face other structural or management issues. It doesn’t sound like a combination likely to protect the business and your investment in difficult times, and so it has proven thus far.”

Smith notes the two companies he holds that are “most in the firing line” at present are Amadeus, an online travel business, and InterContinental Hotels. He adds that if both holdings are vaporised, about 5% of the portfolio would be lost.

Smith continues: “Whilst I would not be pleased with that, if that’s the worst thing that happens I would suggest we can live with it. Whilst we have various stocks exposed to knock-on effects in travel retail, for example in cosmetics and drinks, and supply chain issues in other portfolio companies, if we were forced to guess we think about a third of the portfolio will endure this year with increased revenues – Microsoft, the payment processors, [cleaning supplies manufacturer] Clorox, and Reckitt Benckiser, for example.

“It is said that every cloud has a silver lining and we are seeing opportunities and have bought two new holdings, which we have been following for some while and that have been hard hit in this market because of China exposure and a classic ‘glitch’.”