Terry Smith: my view on tech shares, and why it’s not too late to buy

As the tech sector boom continues the Fundsmith CEO explains his approach to technology investments. He also gives his view on Apple, Amazon and Alphabet and reveals why he hasn’t invested in them so far.  

Lee Wild, head of equity strategy at interactive investor: Hello, today I have with me my colleague Kyle Caldwell, collectives editor at interactive investor, and someone who needs no introduction, Terry Smith, founder, chief executive and chief investment officer at Fundsmith, which includes the UK's largest investment fund, Fundsmith Equity.

Hello Terry, delighted that you could join us today.

Terry Smith: Morning.

Lee Wild: Terry, I’d like to talk about technology, and it’s something that interests a lot of Fundsmith investors currently.

Terry Smith:  Yeah.

• This interview is part of a longer conversation with the UK’s most popular fund manager. To watch the other interviews, visit our YouTube channel.

Lee Wild: First of all, Microsoft (NASDAQ:MSFT) was held in the top 10 shortly after the fund launched, it’s still in the top 10 today, how many of the original holdings still remain in the fund and, in addition, how much of a positive impact has buying and holding had on performance?

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Terry Smith: Well, you are absolutely right about Microsoft, I’d need to go back and check, but I think it’s 10 stocks now from the original fund that’s still there. And I mean, quite a lot of the turnover you have to bear in mind is involuntary, we’ve lost quite a lot of companies without us doing anything. So, C.R. Bard and Dr Pepper, Snapple, so on have disappeared without us doing anything, they just got taken over.

The original Del Monte business that we owned disappeared, so quite a lot of it is involuntary. Funny old thing, if you own good things people come and try and buy them off you. So, look, I think that basically it’s what the companies does that makes money. I mean we don’t turnover very much, last year we turned over 4%, all those changes that we discussed, turned over just 4% of the portfolio.

If you are a long-term investor, it’s the return on capital that the company makes in its ability to reinvest that return on capital which generates most of the return. If the company can generate a 30% return on capital and reinvest a significant portion of its cashflow or earnings each year at that 30%, it can do better for you than I can, basically.

And so, look, it’s nice from time to time that we manage to do something a bit clever in terms of buying something when there’s a glitch, or the market, it’s out of favour with the market, and it can add to it. But the reality is in the end, it’s the companies that are making the money for you here, not my buying and selling that’s doing it.

Kyle Caldwell: And the weighting to technology has become more significant over the years. In an interview back in 2014, you said that on the whole we are really suspicious of new technology, so what made you change your mind in 2018 in respect of Facebook?

Terry Smith:  I’m not sure I changed my mind generically about new technology, because I guess what I would query with you is whether Facebook (NASDAQ:FB) is genuinely new technology. If you have a look in the MSCI, it’s listed under communication services, and that’s what I think it is, I don’t think it’s doing anything particularly whiz-bang out there.

But if you look at what we own in technology, I mean, we own Amadeus Airline Reservations, ADP (NASDAQ:ADP) payroll processing, Facebook, Intuit (NASDAQ:INTU), an accounting and tax software, Microsoft, operating systems, cloud computing, gaming, etc. PayPal (NASDAQ:PYPL) payment services, Sage (LSE:SGE) accounting software, Visa (NYSE:V) payment services.

They’re all “technology” companies, but is technology really the single driving factor? I mean I think often in investment labels are unhelpful in people’s thinking. So, I don’t think people think, oh technology, I think what drives those companies, the main driver of them is not technology, I think its employment in payroll, or business in accounting, or computing of the sort that we’re doing now, communicating using Microsoft Teams.

Or airline reservations in travel, or social media and digital advertising. The drivers are quite separate and different, it’s not technology, and I think, you know, technology is a label, FAANGS is a label, BRICS is a label, cause people to make these sort of generic decisions about groups of things, which are very different.

I mean like the FAANGS are very different if you think about it, you know, between Facebook, Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), Google now Alphabet (NASDAQ:GOOGL), I mean what’s the commonality between, you know, home viewing of cinema, mobile devices, social networks and that, not a lot really, they’ve got quite different returns on capital employed, quite different growth profiles, and quite different valuations.

Making a generic decision is a mistake, I mean, on Facebook itself, and just to say what made you change, nothing made us change our mind about technology, we still don’t invest directly in things like AI, or virtual reality, it’s very interesting, I’m sure it might change our lives, maybe even for the better, who knows.

When I think I’ve got somebody who understands it and applies it and makes a great return on capital out of it, I’ll have a think about investing in it. But in the meantime, it’s going on over there, I’m doing technology but if you think about it, it’s old-line technology to quite a degree, and its technology which is basically facilitating an underlying business, rather than pure, and the like. Going back to Facebook, I mean what happened was we had the Cambridge Analytica scandal, if you like, about data, and all the hoo-ha that came out about the use of Facebook for political campaigns, or to influence elections.

And I always say to people, I think if you’re going to own one of these really good companies and you’re going to do it at a fair price, or better, you need a glitch, you need something that happens that goes wrong. I mean time and time again; we’ve found ourselves in a situation where that’s what we’re confronted with.

Of course, you have to make your mind up whether it’s a glitch, or whether it’s an existential threat to the company before you dive in there. But that’s really what that presented to us in Facebook, you know, we were looking at a company that was growing, well at that point at about 40% per annum, probably down in the 20s now because nothing can keep growing at that rate.

Making, you know, a high 20s return on capital employed, with quite possibly superable barriers to entry out there. And it is that sort of thing that gives you an opportunity, you’ve got to make up your mind whether it really is an opportunity.

So far, he said, looking for some wood to touch as he speaks, that’s proven to be an opportunity, that glitch, and we think it continues to be so.

Lee Wild:  Well, look, you’ve already mentioned three of the companies I was just about to talk about, I mean other tech types, so Apple, Amazon, and Alphabet, so they appear natural contenders to be held in the fund, given the various qualities that they have. Why have you not invested in those three companies and is it too late now anyway?

Terry Smith: Let me run you through them, I mean, Alphabet or Google is really in a, currently a duopoly outside of China in basically digital advertising. Google is search based and Facebook is obviously social media based. But they’re the two means of attacking digital advertisement, which is clearly the growth area and a dominant area now increasingly of advertising.

In the case of Google, what they’ve done is a couple of other things, they’ve done their next bets, or whatever they call it, which they are losing five or six billion dollars per annum on their new bets right. I mean, it’s a pretty good business but I am worried about, I mean, you asked a question earlier about how the money is made, is it clever dealing by me or is it actually the companies doing it and I unfortunately confessed and said it’s the companies doing it.

I pick the right companies and so on, and that’s mainly what drives things. It’s the same with this, I mean once we’ve given the money to our company, which is effectively what we’re doing, we may buy the shares from somebody else, we’re owning a portion of capital, we are reliant upon them for capital allocations decisions.

When people consistently keep doing things which don’t seem to produce anything and lose five or six billion dollars a year, it worries me a bit. Particularly, if we’ve got no say through the voting structure. So, you know, if they didn’t have that I’m pretty sure we would very likely own it, and maybe we still will.

But because I don’t, the answer to your end question, is it too late, no I don’t think it’s too late. They’ve also got a similar level of loss from their attempts with the Google Cloud, I maybe completely wrong with the Google Cloud in terms of assessment, but I’ve got to say, my guess is that they’re third in a two-horse race, which is problematic.

I think for Apple, what scares me with Apple is that I lived through the rise and fall of Nokia, and I heard all the same reasons why we shouldn’t worry about a consumer electronics business reverting to mean returns because it was “an ecosystem”, and maybe it is, and maybe I’m wrong, but it does worry me.

That this is a business which is, seems to me, driven at least in part by the need to continue to churn out the next nice flat device with rounded corners that you want to buy even though it’s the same as the last one roughly speaking, it worries me.

And it worries me particularly if you only get to the day where you don’t have a guiding single mind at the top of the organisation. But I might be wrong, I mean bear in mind with all these, I might be wrong, is it too late, probably not. Amazon’s got two businesses, one of them is really great, and the other one is hmm, I mean, you know, we’ve got the retail business which makes about 2% margins, and has been described by Tweedy, Browne, one of the fund managers I mentioned earlier, as a charity or utility for the benefit of consumers funded by Wall Street.

They’ve got a point, I mean, it’s clearly not making adequate margins or returns on retail business, and of course it quad subsidised by Amazon web services the cloud business. And I think people are quite confused about this because they seem to think about it as though somehow, they’ve got to own the cloud business to power the online e-commerce business, no they haven’t.

The two businesses have got no synergy whatsoever in reality, and again, there if they were to break the two out, I might really be interested in one of the two, but I’m quite worried about it as it stands, the structure, in terms of where we will end up with a business with a massive cross-subsidy across those two.

But we are, as a team, people who continually re-examine these things, I mean we don’t think, I’m never going to own Amazon or something, and then just forget about it, we regularly sort of blow the dust off metaphorically from the online file and have a look at it.

And we’ve done that in the past with companies and changed our mind, and we might change our mind again, on all or any of those, or they might change.

• This interview is part of a longer conversation with the UK’s most popular fund manager. To watch the other interviews, visit our YouTube channel.