The star fund manager vows to ‘keep going through hell’ as Fundsmith Equity registers worst-ever year of performance.
Fundsmith Equity manager Terry Smith has pushed back against reports that his portfolio has a bias to technology, which was the worst-performing investment sector last year as it is vulnerable to rising interest rates.
Technology shares tend to be highly valued versus their current profits as they promise fast future growth. However, when interest rates rise the return investor can lock in from safe investments improves, so betting on future profits becomes less appealing.
However, Smith, writing in his 2023 annual letter to investors, rejected claims that the fund is becoming more technology focused – and therefore more expensive. Instead, he said that he was sticking to his proven investment approach of buying good companies, not overpaying and then “doing nothing”.
Smith said: “Our companies are more lowly rated than they were a year ago, now being rated roughly in line with the market. This does not make them cheap and there is no guarantee that they will not become more lowly rated, but our focus is on their fundamental performance, as it should be, because in the long term that will determine the outcome for us as investors”.
He also cited portfolio data, ranging from gross and operating profit margin, to return on capital employed (a measure of how well a company invests in its own business), to show that his portfolio was of a higher quality than the benchmark. For example, the portfolio’s operating profit margin is 28% compared with 18% for the S&P 500 and FTSE 100 indices.
Smith said that just 20.7% of the portfolio is defined as technology by MSCI, the index provider, compared with 23.2% in December 2014, suggesting that there was no such buying “spree”.
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Smith says that he is not keen on relying on sector classifications to define a business, with some technology firms actually in the communication services sector – Alphabet and Meta – while Amazon is classified as consumer discretionary.
“It is worth noting that a number of stocks which are in the MSCI Technology sector and are, or were until seven recently, in our portfolio are not in my view primarily technology companies, but rather they use technology to deliver differing services.”
He makes the point that using “technology” as a catch-all classification makes little sense and instead investors should focus on what a company’s underlying business is, such as payroll for ADP, tax and accounting services for Intuit, and airline and hotel reservations for Amadeus.
Smith continues: “Moreover, commentators tend to take an all-or-nothing approach to reporting our holdings — as in the reference to Apple already noted — without any mention of the size of the holding, which is hardly surprising as this is only disclosed semi-annually. But to put this in context, our combined holdings of Alphabet, Amazon, Apple, Adobe and Meta amount to just 9% of the portfolio, compared to our holding in Microsoft of 7.6%.
“I would therefore suggest that the fund’s exposure to technology is a lot more subtle and nuanced, as well as smaller and more widely spread than the headlines sometimes suggest.”
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The fund manager admits that as well as valuation pressures due to lower interest rates, technology shares are facing other headwinds, such a slowdown in tech spending following a sharp acceleration during the pandemic and an online advertising decline as the economy slows.
However, he says that pressure on their businesses may spur more discipline, with less time and money spent chasing profits in speculative areas, such as Google’s “Other Bets” division or Meta’s ambitions for metaverse dominance.
Technology shares were among the worst performers in 2022, with four of the five biggest detractors to performance coming from that investment sector, according to Smith.
He said: “Four of the five stocks are in what might loosely be termed the technology sector (although Meta is actually in the MSCI Communication Services sector and MSCI has Amazon as a consumer discretionary stock) and at least two — PayPal and IDEXX — started the period with valuations which were particularly vulnerable to the effect of rising rates.”
Smith adds that his highly valued tech stocks did not fare as poorly last year as companies that did not have strong profits, cash flows or even revenues.
“If one word had to be used to describe last year’s winners it would be ‘defensive’. Two of them are fast-moving consumer goods companies and one is a drug company. However, it is worth pointing out that ADP is actually in the MSCI Technology sector,” he said.
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Fundsmith Equity underperformed the MSCI World index in 2022, delivering a 13.8% loss versus a 7.8% loss for its benchmark.
Since launch in November 2010, it has returned 15.5% annually and is the best-performing fund in the Investment Association’s (IA) global sector.
Smith said: “While a period of underperformance against the index is never welcome, it is nonetheless inevitable. We have consistently warned that no investment strategy will outperform in every reporting period and every type of market condition. So, as much as we may not like it, we can expect some periods of underperformance.”
Quoting Winston Churchill, he said if you “are going through hell, keep going” – adding that “at Fundsmith we intend to”.
Smith took aim at a number of portfolio positions in his 2023 letter. He slammed Unilever for virtue signalling, and also said the company had made poor acquisitions recently and did not communicate well enough with shareholders. He continues to own the British consumer goods company, but it is not a top 10 position.
He also said that PayPal did not engage with Fundsmith after Smith suggested that management remuneration incentives included some measure of return on capital, and the payments firm was spending too much on acquisitions. Fundsmith Equity sold out of PayPal at the end of 2022.
Smith also criticised Intuit for not including stock-based compensation in its earnings numbers, meaning that profits and return on investment were lower than they seemed. Smith also sold Intuit shares at the end of last year.
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