Interactive Investor

Terry Smith: your questions answered

Find out which stock the Fundsmith star is worried about, and if he thinks his winning streak can continu

Find out which stock the Fundsmith star is really worried about, if he thinks his winning streak can continue and whether you could replace him with an algorithm. 

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.

  • 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: Terry, as you know, we gave users of the interactive investor platform the chance to ask you questions, so we had a massive response, but we only have time for 10, so we picked out some of the most common questions, and those that were particularly interesting.

Now, the first one, technology is something that interests a lot of Fundsmith investors currently, they would like to know, do you see the technology boom continuing, and is Fundsmith too exposed to technology.

Terry Smith: As you know from earlier discussions, I don’t really regard technology as a particularly good label. And people talk about it as if it’s somehow generic, whereas I think, even if you just take the companies that we own, you know, they stand, airline reservations are counting software operating systems, payment processing and so on, they’re driven by other factors, not just by technology.

And so, I don’t think it’s a very helpful label, however, generically speaking, do I see it continuing, yes probably. Why? I think if you look at the Covid situation with the pandemic, and you look back to the Spanish Flu as a comparator, the Spanish Flu caused an acceleration of existing trends out there in business.

For example, the assembly lines for mass production existed before that, and the Model T Ford was an assembly line in 1913 up in Trafford Park, Manchester, believe it or not, now famous for other things, of course. That was a pioneer though, I mean other people moved to this after the Spanish Flu because of the reduction in the labour force.

And it meant that consumer goods, cars, motorcycles, radios, refrigerators and so on, could be more easily produced by people who had lower skill when they went passed on a production line and did a single repetitive task, and it lowered the cost of production, and that lowered the price. And the result was an economic and stock market boom, the roaring 20s no less.

I would claim to be the first one to suggest that that might be the outcome of this pandemic, in fact. And I think if you say, oh right, well what trends that existed before this pandemic might have accelerated? Well, clearly, anything to do with e-commerce, home-working, communications, you know.

A company like L'Oreal SA (EURONEXT:OR), which we invest in, and will tell you they had 10 years of digital transformation in the course of 10 weeks last year. So, yeah, I mean I think that people who supply communication systems, working systems of the sort that we’ve got here, operating systems, e-commerce, anything that goes into all these things, factory automation systems, things that can read things without human input, I think there’s a pretty good chance that there’s further to come on this.

And I don’t think it’s a zero-sum game, I don’t think it’s, oh, we’ve pulled toward future demands so that means we must hit an air pocket at some point, No, it may just be something which can continue growing.

Lee Wild:  Again, we’ve talked about fund size, but it is something that a number of investors have raised, and so over the last six to 12 months one says, I keep reading that your fund is apparently too large, and that it should be a concern for me, do you agree?

Terry Smith:  I would suggest he stops reading, or she stops reading. If you don’t like what you see just turn the TV off, you know, it’s quite simple. I don’t think it’s an issue, you know, our fund size is big in UK terms but it’s tiny in relation to the companies that we invest in, or the size of capital markets, or we wouldn’t be in the top ten active funds in America.

If we owned 1% of each of our current holdings, which I’ve only chosen because hopefully we can agree it’s not a very liquid position, the fund would be twice it’s size. I mean, and I’ve selected one percent, how about two percent, you know, fairly clearly then it would be four times its current size.

We are not big, we’re big in relation to the UK, the UK is not big in relation to the world.

Kyle Caldwell:  Our next customer asks what’s your view about the growing use of computers for stock-picking, and do you think that the traditional floor manager will be replaced by computers in the future?

Terry Smith:  Look, there’s no doubt that you can use computers for this, I mean the whole passive industry is basically driven by the use of computers to make the stock non selection, in fact. But beyond that, into the active area, we don’t need to debate whether it’s possible, and Jim Simon’s renaissance technology is, is successfully done for quite a long period of time.

Yes, you can definitely do this. Equally though, I would say I think there’s likely to be a role for human beings in active management for, maybe forever, certainly for a very long time. The best way I can express it is this, you can do an awful lot of this stuff mechanically, but the human element comes in when you get somebody who is intelligent and very experienced like Julian, our head of research.

Who will tell you that if you read a company’s, you know, 10K or annual report, if it’s 10-Qs then every quarter and you listen to the management present at meetings, conferences, and you meet them and so on, the way he puts it, and unless you’ve done this, you won’t get it, but I know exactly what he means.

He says, it talks to you in there, something about the way that they present themselves just talks to you, you know, in the most extreme, some of them just tell you how it is, some of them are playing buzz word bingo when they’re speaking to you, right?

That’s the simplest way I can put it, you know, Jean-Paul Agon at L’Oréal, the retiring chief executive was, we were huge fans of his. Memorably on one occasion he was asked something which actually most chief executives don’t even need to be asked, but he was asked by an analyst at a meeting. If you took out all the bad bits at the moment, the bits that are not working very well in your portfolio, like professional salons in America and so on, what would the results be?

And he said, why would you do that? The bad bits are in there just like the good bits, we like people like that, they speak to you, right? Their lack of desire to sugar coat or varnish things, speaks to you, right. And we’ve got people at the other end where they can utter whole paragraphs, never mind sentences, we don’t actually understand what they’ve said.

Kyle Caldwell:  We have another related question, which asks, could the common sense rules that are operated by Fundsmith be replicated by an algorithm?

Terry Smith: Yeah, I guess to some degree, what you’ve got here is a team of human algorithms employing these. But there is, there’s also this thing called experience that overlays some of what we do so, you know, you probably, I’m not sure, your algorithm might have said Wirecard was a pretty good investment, certainly, some people’s algorithm said it was a pretty good investment but, you know, there’s something in our experience that tells us differently.

 And that has kept us away from an awful lot of things which are disastrous, I’ve found over time. I’m not sure of how you replicate that, it’s what professionals in other walks of life, you know, crime detection, fraud detection, sports and so on, would say it’s this, I can just somehow smell this, you know. That’s difficult to replicate.

Lee Wild: Well, understandably, a big question has concerned performance, so holders have been richly rewarded obviously since inception in 2010, but this can be difficult to maintain over very long periods of time. So, the question is, do you think your winning streak can continue in the coming years?

Terry Smith: Interesting that they don’t regard 10 years as a long period of time, I would have said for most investors 10 minutes seems quite a long period of time. So, I would put forward the starting proposition that 10 years is quite a long period of time to maintain it over. Can we keep going though, I would look at it this way, I mean clearly, I’m, I wouldn’t wish to even if it weren’t a breach of every regulation there is, promise you what the returns would be in the future.

So, you know, who knows with regards to that. But I do know this, providing we do not depart from our mantra of owning very good companies that make high returns on capital, typically in the high 20s, 30 percent bracket, that can invest some or all of their earnings each year to grow at that rate, the returns from the fund will gravitate to the returns on capital with the companies.

I’m not putting that forward as a theory, it’s a fact, providing we are able to continue holding companies of that sort, that is what will happen.

Kyle Caldwell: We have a few moans about transparency, some investors said they would like to see a bit more regular stock commentary, and one asks, why is there no percentage given for each of the top 10 holdings on the Fundsmith factsheets?

Terry Smith: Did any of these questioners study the catastrophe at Woodford Investment Management I wonder. Whatever may have been the cause of the problem, lack of transparency wasn’t it, I mean, you know, its transparency is a two-edged sword I’m afraid, and we’re not going to go beyond the regulatory requirements in terms of transparency.

When we are buying or selling a whole position, we’re quite often talking about somewhere in the region of a billion pounds of stock, right. I’m not quite sure how it would help our investors in terms of performance if we advertised right from the get-go that we were buying or selling that amount of stock, basically.

So, it’s actually I think positive endurance, the people who campaign for this, and I’m not talking about your questioners, I’m talking about people in the media who sometimes campaign for it, seem to completely ignore things like that when they’re talking about it.

Kyle Caldwell:  Investors are told to diversify risk, our next customer question asks, since your fund is usually made up of 20 to 30 holdings, do you see any danger of investing in just one fund, namely your own fund, funds with equity, for their equity asset allocation?

Terry Smith: Fairly obviously, I’m not going to venture into giving your customer any investment advice, because I’m not licensed to do so. So, let’s take it as written on the record that I’m not doing that. I think diversification is a subject that people don’t study, like most things in investments, to anything like the degree that they should.

Markowitz got a Nobel Prize in economics for demonstrating the additional return that was obtained from diversification, which in most people’s thinking just becomes a label, more diversification equals better returns, no it doesn’t, there are limits on it.

Once you get beyond a certain number of stocks, in any market, then you will find that you will obtain no further diversification benefits from the reduction of risk, but you are automatically venturing away from quality companies, there’s not an unlimited number of them, and away from things that you know, the more things you own the less you know about them.

 I can know quite a lot about 20 something companies, 300 companies, a bit tricky, not sure I could pull that off. And if you look across most major markets, somewhere around the mid-20s is the number of stocks that gained you optimum diversification.

Lee Wild: We haven’t had many stock-specific questions, but Unilever (LSE:ULVR) has popped up a few times, is now the time to sell we’ve been asked?

Terry Smith:  I’m not sure it’s time to sell, but I think your questioners are topical because it’s one that I’m worried about, I’ve got to say. I think the Unilever business lost its way a bit under Paul Polman, the previous CEO, and became obsessed with sort of socioeconomic environmental matters, and I’m not suggesting for a moment that they should be ignored.

I’m just saying, they can’t, they shouldn’t be the sole thing that you think about and you let the operating aspects of the business in terms of product innovation, sales, profitability and cash flow take a second place to it. And I’m not convinced that we’ve got far away from that at the moment, to be blunt with you.

I mean they were obviously bid for by Kraft-Heinz, and we were not supporters of that approach, we’ve never owned Kraft-Heinz, we’ve always seen their model as flawed, and therefore, you know, not that anyone asks us our opinion, but if they had we would have said no, we’re not in favour of this.

But, you know, I’d need to go back and refresh my mind on the numbers, Kraft-Heinz is achieving somewhere, I can’t remember the exact number, somewhere around two to three times the revenues per employee that Unilever is achieving. Discuss, you know, it’s not that the Kraft-Heinz approach was raising questions that don’t need to be answered, and they haven’t been answered about this business.

So, I see Unilever as a great opportunity, I think it’s got a very, very strong roster of brands. I see it as a great opportunity because it has a fantastic footprint and distribution into the developing world. And I think, at the moment, it’s not being realised because I think the focus is not in the right sort of balance within the business, and I hope that gets addressed.

I would doubt whether it’s right to sell it as a result, because it hasn’t been a particularly great performer, and typically, you know, I think these businesses which are very strong businesses with powerful brands and great distribution and footprint, come right in the end, even if they’re not being managed optimally at any one moment.

Lee Wild: Now GameStop (NYSE:GME) and the investor revolt on Wall Street, that grabbed headlines recently, so that’s the rise of the app driven self-investor, so especially post GameStop, do you think we’re going to see greater long-term volatility in markets as the smaller pockets of investors speculate on short term gains. And if so, will you be changing the investment strategies to account for this?

Terry Smith: The short answer is probably yes, but I mean, GameStop and, as you say, the revolt against the short sellers that came along, is just a new twist on something that’s happening anyway. If you go back to pretty much when I came into this business, stocks were traded on a stock exchange, it was a club basically.

And you went down there and there were a bunch of jobbers with boards, with China glass balls who would write prices on them, and there was a lot wrong with that, you know, obviously the amount of charge for it was wrong, and the centralised market growth packs led to greater possibility, you might say a manipulation.

And we then had the deregulation of that, if you like, and negotiating commissions and competition in the form of a number of venues which have come in this, an explosion of electronic exchanges, dark pools of liquidity, etc., etc., etc.

The problem with that now is, I mean I’ve lost track of this, but if I asked my dealer and say I want to deal in Procter & Gamble, how many places are we linked up to you can deal, the answer is 11 or something like that. And of course, that means there are pockets of liquidity all around, so the liquidity has become a) has become very much siloed in these places, so you haven’t got this central, you don’t go to the, go down to the big board in Wall Street and a man in a sort of coloured jacket tells you a price looking at a screen up above him on, and there’s a specialist on the New York Stock Exchange.

 Now it’s all over the damn place, it’s cut down the liquidity, and of course, the rise of the algorithmic traders has meant that you get followed around by people who try to tailcoat you or get in advance of you. So, I think this is just another twist in terms of what’s going on, it’s adding a different form of volatility to an existing lack of liquidity out there.

So, I think the short answer is yes. Will it change what we do, no I don’t think it will change what we do. I think what it may present us with sooner or later though, is another opportunity of the sort that we try to grasp from time to time in these glitches when very good companies have something that happens to them.

And we’re presented with an opportunity to buy them at the wrong price, that’s where I think it’s most likely to link to something that affects us directly.

Kyle Caldwell: Another customer question asks whether there are any companies that in hindsight you missed out on, that you wish you had held, and does this evolve your thinking for the future?

Terry Smith: I’ve got companies that literally range from A-Z with that description. A would be Adobe (NASDAQ:ADBE), a software business, and Z would be Zoetis (NYSE:ZTS), the veterinary pharmaceutical and animal testing business. And I have quite a few jumping off points in between, I’ve got Mettler-Toledo (NYSE:MTD), the weighing equipment manufacturer, Intuitive Surgical (NASDAQ:ISRG) that make the Da Vinci surgical robot. Home Depot (NYSE:HD) and Costco (NASDAQ:COST) in US retailing, lots of companies.

What would I say about it in terms of my thinking, I mean one thing that doesn’t alter is this, we probably won’t fail as a strategy for investors if we don’t own the best companies in the world, the very best companies in the world. We probably will fail if we start to own bad ones, right, I’m pretty sure.

And so, if in doubt do nowt, we don’t go out there and do things unless we’ve got a high level, a high degree of certainty about it. So, that probably won’t change. I think where things might change, however, is in talking to my team about things that we do. I’ve always shied away, for example, from retail businesses, I’ve seen too many things go wrong in retail businesses where they’re very landlocked into a geography, things like Tesco they go abroad, it’s almost always a disaster mixed with a tragedy as a result.

As soon as there’s a downturn they’re very high fixed cost with their premises and so on, mean that the profitability is of a small margin retail business vaporised, etc. And I’ve missed out on a couple of very good business I think as a result of that, and I probably, in my darker moments have to sort of listen to, one or two times, particularly since, you know, I have got a team sitting in America, and they can sometimes tell me about businesses that, although I know about them and read about them, they really know about them, I mean they actually do see them in operation quite regularly, they tell me things that I wouldn’t otherwise see.

  • 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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