Fundsmith Equity marginally underperformed in 2021. In a letter to investors, Terry Smith explains why.
In a year of recovery for stock markets, it did not come as a surprise to star stock-picker Terry Smith that Fundsmith Equity fell slightly short of the MSCI World Index in 2021.
In his annual letter to investors, it was stated that over the one-year period Fundsmith Equity returned 22.1% versus 22.9% for the MSCI World Index.
Fundsmith Equity, a member of interactive investor's Super 60 list, was ahead of its fund sector. According to FE Analytics, the average global fund returned 17.7%.
Smith described the underperformance versus the index as both marginal and inevitable. He pointed out that no investment strategy will outperform every single year and in every type of market condition. He added: “So, as much as we may not like it, we can expect some periods of underperformance.”
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Over the long term, since launch in November 2010, Smith pointed out that Fundsmith Equity is still the best performer in the Investment Association’s global fund sector, with a return 357 percentage points above the sector average, which has delivered 213.9% over the same period.
In 2021, value stocks were back in favour, as investors looked to allocate to companies that would benefit most from the post-pandemic economic recovery. This proved to be a headwind, given Smith’s investment approach is to invest only in quality growth companies.
In terms of individual holdings, the top three contributing stocks to performance in 2021 were Microsoft (NASDAQ:MSFT), Intuit (NASDAQ:INTU) and Novo Nordisk (NYSE:NVO). The bottom three were PayPal (NASDAQ:PYPL), Amadeus (XMAD:AMS) and Kone.
Smith said: “Our fund outperformed the market by 6% in 2020 when the economic effects of the pandemic were at their height and most of the businesses we are invested in proved to be highly resilient. However, last year was more of a year of recovery and our companies had relatively little to recover from.
“We find it difficult to outperform in particularly bullish periods where the market has a strong rise — 22.9% in 2021 — as a rising tide floats all ships, including some which might otherwise have remained stranded and that we would not wish to own.
“In investment, as in life, you cannot have your cake and eat it, so it is difficult if not impossible to find companies which are resilient in a downturn but which also benefit fully from the subsequent recovery.”
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Smith noted that there are several problems with buying value stocks. The first is that getting the timing right is notoriously difficult. Second, his view is that low-quality businesses produce persistently poor returns.
He added: “Even if you manage to identify a truly cheap value or reopening stock and time the rotation into that stock correctly so as to make a profit, this will not transform it into a good long-term investment. You need to sell it at a good moment — presumably when some of your fellow investors will also be doing so because its cheapness will not transform it into a good business, and in the long run it is the quality of the business that you invest in which determines your returns.”
Also in the letter, Smith addressed one of the big risks facing investors in 2022; rising levels of inflation. The stock-picker said he expects the companies held in Fundsmith Equity to “be better able to weather inflation” than other stocks, due to having high margins. “The higher a company’s gross margin — the difference between its sales revenues and cost of goods sold — the better its profitability is protected from inflation,” said Smith.
According to Smith, if inflation proves to be more sustained than central bankers are forecasting then “we are probably in for an uncomfortably bumpy ride in terms of valuations but we can be relatively sanguine in terms of the effect on the fundamental performance of our portfolio businesses which is our primary focus”.
He added: “The good news is that we do not invest on the basis of our ability to forecast inflation or any other macroeconomic factor. We invest in companies not countries, indices or macroeconomic forecasts.”
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