Interactive Investor

Terry Smith on Warren Buffett and how to find good companies

The Fundsmith founder talks to us about the Sage of Omaha and the influence of other investing legends.

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:  Both yourself and Fundsmith Equity have had quite phenomenal success, and you’re often referred to as the English Warren Buffett, now your approach is similar to the American, but are there any other investing legends that have shaped your approach, [and] who have had a significant influence on you?

Terry Smith:  Warren who?

Lee Wild: Buffett, you might have heard of him.

  • 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.

Terry Smith:  Look, I’ve been reading Warren Buffett’s annual report, and all of the various texts that have been written on him since the early 1980s, you know, the methodology that he’s developed over the years is clearly a big influence. But having said that, he himself was influenced by quite a few people as well, you know.

Ben Graham is the one who most people refer to who is the father of value analysis in investment. But there are other people as well, Charlie Munger, Philip Fisher, author of Common Stocks and Uncommon Profits is a pretty big influence.

I think they influenced him to move away from a pretty pure value approach into one that looked at the quality of the business that he was investing in. And so, you know, they’re influences on him and on me. And I’ve met, through, I mean I was a broker and an analyst for 20 years before I kind of kicked off in this.

And during that period, I marketed my research and the investment research systems to pretty much everybody that you’d heard of at that point. So, I met an awfully large number of people. And I would say, part of it that I do is a synthesis out of some of the people that I met doing that, I would say.

So, you know, there was a very influential team, for example, at Morgan Stanley Asset Management in London, who had two or three very talented individuals working there, who variously spun out and did other things, like Dominic Caldecott became the chairman of Finsbury Growth Trust, Andy Brown, who founded a firm called Cedar Rock, William Lock I think is still there.

Peter Wright, I’m not sure but may still be there. People in the United States as well, people like David Wintergreen, Tom Russo of Russo Gardner, Tom Schrader at Tweedy, Browne, which of course is a firm that Warren Buffett worked at, you know.

I worked with a lot of people, I’ve worked with a lot of the great shorts as well like Jim Chanos at Kynikos, and others going back longer in time in terms of the principles of the Soros business, for example.

And I would say what I’ve tried to do to a degree is educate myself and take some of the best bits that I saw of that, that I could see worked, and that I thought I could make work.

Kyle Caldwell:  Hi, Terry could you run through your investible universe, how many good companies there are versus bad companies, and what are the qualities that you look for that you think makes a good business?

Terry Smith:  Yes sure, look I’m not going to run through every stock in the investible universe otherwise it will take up the entirety of the remainder of your interview to do that. It’s got about 70 companies in it, it doesn’t vary an awful lot, sometimes it goes up one or two when there’s a spin out, or it discovers something new.

Like Otis Elevator (NYSE:OTIS) for example is there and it wouldn’t have been in there over a year ago because it was part of United Technologies, and we didn’t want any exposure to Sikorsky helicopter and things like that. Sometimes we lose companies from it as well by takeover and things disappear there. So, it can change an awful lot of over time.

There aren’t that many really good companies in my view. I mean we may not have the right number there and bear in mind we’ve got a size cut off as well, we can’t own micro-cap companies or even small cap companies that would qualify.

But once you take a size cut off, you know, we’ve got approximately what I regard as a number of good businesses in the work. What makes a good business, I mean first of all just to define it financially, I think it basically is if it makes a high return on capital employed.

Without that you’re not going anywhere in terms of actually creating value, you know, I too can run a business for you with a lot of return on capital if it’s silly enough to give you the capital as it were, which people do, of course, regularly with businesses.

The other thing is it has to have a source of growth, no good having a high return on capital unless there’s some sort of growth in which you can retain at least a portion of the returns you’re generating and reinvest them at a similar rate.

You need both those things, it’s no good having growth without returns, and it’s no good having returns without growth, you need, they’re basically two pillars, financial pillars of this kind of business.

I could go through a number of subsidiary things but those are really the two essentials. Operationally, I would say we like a business that makes its revenues from a large number of repeat relatively predictable transactions, not will they discover oil, will they get a contract to do a huge project, will it work, will they make money, will the movie make money, I don’t know, they don’t know either.

We like, you know, people who supply everyday necessities, the luxuries that we use without thinking about it in our business lives, in our personal lives as consumers and so on and so forth. And we like companies who’ve got some kind of defensive mechanism, because if you’ve discovered companies that have got great returns on capital and a source of growth, and all those, naturally they will attract competition, I mean that’s kind of one of the laws of economics.

 And what you’re looking for is the people who have got what Warren Buffett has termed remote and that’s I think become a somewhat overused term, but nonetheless, since I haven’t thought of a better one, I’d better stick with it really.

Which is some means of fending off the stock people coming and eating your lunch, and typically, it’s things like brands, control of supply chain, control of distribution, installed basis of equipment or software that are difficult to change. And know how, patents, those are the sort of things which typically give you the ability to fend off the competition and retain those great returns.

And, I mean, some of the companies in our portfolio have been doing this for a century, they clearly have got a defensive mechanism.

Kyle Caldwell:  You mentioned there Warren Buffett and that you look for a high return on capital employed, but back in 1979, Warren Buffett described return on capital employed as the primary test of managerial economic performance, and not the achievement of consistent gains in earnings per share. So, why does the investment industry not follow this advice?

Terry Smith:  I mean this is a guy you should probably listen to. So, trying to do something that flies in the face of this fundamental talent of his is clearly not right. I always have this sort of blind bet with my audience, I say, if you’re the recipient of the company research from a broker platform, or a research house, I’ll bet you £20, right, that if you get the last 10 notes out that you’ve received, if it says the primary thing they’re relying upon assisting the company is, one of them, if one of them says its return on capital employed, you’ve won £20, OK.

Now, my guess is I’ll own the £20 when you look through the check notes, so I’ll give you double or quits, all of them will mention growth in earnings per share. I’ll be £40 better off on average on most of those bets, it’s an amazing thing that people don’t look at it.                             

And they’ll come up with all kinds of reasons why, because, you know, still when people listen to analyst calls, they talk about whether someone’s accretive to earnings, given that interest rates are currently approximate zero, you pretty much would have to get money and flush it down the toilet in terms of a project, to not make it accretive to earnings, right.

The P/E on cash is about 150, yeah, anything you do better than that must be accretive to earnings, but it doesn’t create value.

  • 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.

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