Terry Smith’s overhaul: what’s behind it and what’s changed?

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Terry Smith, arguably the most famous fund manager running money in Britain today, has abandoned his buy and hold “do nothing” strategy and carried out a major overhaul of the portfolio of Fundsmith Equity I Acc (B41YBW7). Joining Kyle to discuss this significant change and explain the reasons for it is Dave Baxter, senior fund content specialist at interactive investor. The duo consider Smith’s buys and sells, whether the style of the fund has changed, and whether portfolios in general are becoming too tech-heavy. 

00:00-00:37 – Intro 
00:37-02:08 - Why Terry Smith has become more active 
02:08–03:42 - Terry Smith’s sells 
03:42-07:10 - Terry Smith’s buys 
07:10-08:01 - Fundsmith Equity’s performance 
08:01-11:25 - Has the style of the fund changed? 
11:25–14:05 - Buy and hold vs being more active 
14:05 –16:17 - Star fund manager culture less prominent 
16:17–17:47 - Should investors take note with their own portfolios?
17:47-20:35 - Are investors too tech heavy with their fund choices? 
20:35 –22:23 - Rebalancing reduces risk 
22:23-22:59 – Outro

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello and welcome to On The Money, a weekly show that tackles investments and pension topics in a practical manner.

Today we’re going to be talking about a notable change that Terry Smith, arguably Britain’s most famous investor running money today, has made to the way in which he invests.

In short, he’s moved away from his famous ‘do nothing’, low turnover strategy and carried out a major overhaul of Fundsmith Equity.

Joining me to discuss this topic is Dave Baxter, senior fund content specialist at interactive investor.

So, Dave, you covered Terry Smith’s recent twice a year letter in which he announced this notable change. Could you first run through the reasons why he’s dropped his ‘do nothing’ mantra?

Dave Baxter, senior fund content specialist at interactive investor: It comes back to his old problem of recent years, which is performance. So, if we look at performance over the first half of this year, the fund lost something like almost 3% in a rising period for markets. Then, if we look over five years, his returns are very anaemic, whereas they’re very strong for the global index. Even over 10 years, he’s lagging.

And then even since the fund’s inception in 2010, so remembering that performance used to be very strong, he’s not that far ahead of the market. So, he is trying to address this. Basically, when he’s talking about his underperformance, he thinks the culprit is tracker funds, something he’s spoken about before, and this idea that momentum is driving the market too much. So, what he’s trying to do is be a bit more active, lean into those momentum effects to an extent, and, I guess, try and stop fighting the market so much.

Kyle Caldwell: So, turnover for the fund tends to be very low. But in the first half of this year, turnover hit nearly 52%. So, let’s dig into the changes that were made.

Overall, he’s started to build stakes in 12 new companies, and he has exited, or started to exit, 13 positions.

The fund now has 31 holdings, which is a bit higher than usual. I think, typically, he’s had around 25 holdings. For those watching on YouTube or Spotify, we’re going to show two tables showing the sells and the buys.

Dave, let’s start with the sells. Could you pick out those that piqued your interest the most?

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Dave Baxter: Let’s start with Unilever (LSE:ULVR). It’s almost surprising in hindsight that he hadn’t sold it before because he’s been quite spiky with management in recent years. He argues that he’s been upset with the fact they’ve made some disposals, like spinning off The Magnum Ice Cream Co NV (LSE:MICC) and then doing a kind of tie-up with the food company McCormick & Co Inc (NYSE:MKC.V). Generally, he’s been quite dissatisfied with management’s behaviour and that kind of thing. So, they’ve dropped that.

They’ve also dropped Nike Inc Class B (NYSE:NKE), which is an interesting one because that’s been a bit of a troubled turnaround story in recent years. He thinks that turnaround story is going to take much longer to work out, if it works out at all.

Then just to highlight one other well-known name, there’s the luxury goods brand Lvmh Moet Hennessy Louis Vuitton SE (EURONEXT:MC). He worries that issues like, for example, problems in China will mean that, again, the turnaround will take longer to come through, if it does.

Kyle Caldwell: I’m moving on to the buys. The one that stands out for me is Taiwan Semiconductor Manufacturing Co Ltd ADR (NYSE:TSM), as the fund has previously stuck with shares listed in developed markets, whereas this is listed in emerging markets. What did you make of that, and which others caught your eye?

Dave Baxter: I think it’s interesting because, as you say, Fundsmith Equity has been a developed markets fund, and famously, Fundsmith actually ran an emerging markets investment trust, and they shut it down a few years ago because their approach didn’t really seem to be paying off that well in that region.

So that, first of all, is a departure, but it’s also a departure in terms of his approach. You could argue that TSMC is one of those momentum shares at the minute. At the time of recording, the shares have returned something like 110% over 12 months. So, he’s jumping on to one of those rocketing shares.

One other thing to note is that with TSMC, it is very easy to argue that it’s an AI play, and previously, Terry has made quite a big deal of this idea that you can’t yet predict who’s going to be a winner from the AI theme. 

And another new holding AppLovin Corp Ordinary Shares - Class A (NASDAQ:APP), you could also argue is kind of an AI play.

Then, if we turn to just a couple of other interesting buys, what caught my eye was that he’s bought back into Sage Group (The) (LSE:SGE), and he’s also bought into a company called Veeva Systems Inc Class A (NYSE:VEEV). These are both in the software space. So, he is buying some of those software sell-off victims. 

But one thing we hadn’t pointed out yet is another change is he wants to try and avoid buying into glitches. So famously, he bought names like Microsoft Corp (NASDAQ:MSFT), and you could argue Meta Platforms Inc Class A (NASDAQ:META), when they were on a bit of a down moment, and that paid off very handsomely. But now he’s a bit scared of getting caught out by this momentum-driven market and avoiding that.

But you could argue that these are cases of glitches, so maybe there’s some inconsistency going on there.

And then finally, he’s brought in some of those very well followed big US names. So, you’ve had Netflix Inc (NASDAQ:NFLX), you’ve had Uber Technologies Inc (NYSE:UBER), and you’ve had Mastercard Inc Class A (NYSE:MA), which joins Visa Inc Class A (NYSE:V) in the portfolio.

Kyle Caldwell: It’s worth noting that Terry Smith does give very detailed rationales, in particular for the buys that he’s made, in his semi-annual letter to investors.

He’s very good at communicating, and he’s very transparent. We’ve both interviewed Terry Smith over the years, and he doesn’t shy away from answering the tough questions. I think he actually welcomes them.

He doesn’t have to write these letters twice a year, and we don’t see other fund management groups adopt this widely. I think it’s really important to communicate with retail investors effectively, and when you’re making changes to a portfolio, to get them across and to explain your reasons. 

For me, this is one of the reasons why I like investment trusts because they have to produce a half-yearly and an annual report. As a retail investor, you get lots of detail in there in terms of the fund manager’s recent thinking, and what they’ve been doing in terms of changes to the portfolio.

In terms of performance, as you’ve mentioned, Dave, the outperformance gap since launch versus the MSCI World index has narrowed. However, the fund has still outperformed since it launched in November 2010. So, if you bought from launch, and held all the way through, you’re still going to be pleased because the fund has outperformed a global tracker over that period.

However, if you bought five years ago, that’s a different experience. You will have underperformed pretty notably.

In an ideal scenario, you’d have taken some profits around five or six years ago, and you’d have been very happy then because the outperformance gap would have been much bigger than it is today. 

In terms of the changes that have been made to the portfolio, I can see both sides of the argument. On the one hand, some investors may have been hoping that the investments in the fund prior to these changes may have been ripe for a recovery, as many of the shares had underperformed over the past five years.

But on the other hand, if you’re entrusting a fund manager to invest on your behalf, then you want them to invest where they’re seeing the best opportunities. So, you’re going to want a manager to refresh the portfolio if they think that’s the best thing to do.

One important thing to get across is that, yes, he may have dropped the ‘do nothing’ mantra, but the style of the fund, seeking out high-quality growth companies, hasn’t changed.

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Dave Baxter: I think you could disagree with that, though, because he is trying to shove more momentum into his funds. Some people have at least argued there is style drift. And to play devil’s advocate, on the one hand, it’s good someone’s trying to adapt, especially if they think markets have changed materially.

But the key concern I would have if I held Fundsmith or were considering buying would be, has he now strayed into things that are not his forte, that he doesn’t understand, for example? Can he call things like who the AI winner is?

Also, in recent years, one of the big criticisms of Fundsmith, from parties like Morningstar, has been that he has struggled with timing his buys and sells. For example, he sold out of Amazon.com Inc (NASDAQ:AMZN) relatively quickly, maybe after 18 months or so, and then it did very well. And he had some timing issues with names like Adobe Inc (NASDAQ:ADBE). 

If he’s committed to being more active, and he said that we’re not necessarily going to see that 52% turnover level again, but you’re probably going to see higher turnover than you are used to, are we going to run into more of these timing issues, or would we actually expect the team to get better on that front now they are doing it?

Kyle Caldwell: It could well be that he just made one big set of changes in the first half of the year, and we’re not going to get portfolio turnover anywhere near that going forward in the years to come.

In terms of the points I made earlier on style, for me, I’d be more concerned if the types of shares [he] were buying did not fit the quality growth description. That would ring the alarm bells with me. But I do take your point as well, Dave. For some investors, the reason they may have bought the fund originally is because they liked the buy and hold approach, and he’s now dropped that mantra.

Dave Baxter: One other point in his defence is perhaps there is some consistency remaining in that six of these metrics that have guided the fund, so he’s tended to look at things like return on capital employed, free cash flow yield, and so on, and he did try to argue that the new portfolio looks quite good for those measures. I always thought that should give a level of discipline and robustness to what they’re doing.

Kyle Caldwell: Another investor seeking to buy and hold who has also had performance issues is Nick Train. Now, in the past couple of years, Nick Train has been a little more active than usual. He has bought some companies, but those changes have been minimal. What are your thoughts, Dave, overall, on whether to ring the changes to try and improve performance or to  stick to the holdings that you’ve had for years?

Dave Baxter: I personally find it a bit alarming to see more the kind of Smith approach. Six months ago, I remember myself arguing with someone that perhaps these portfolios, the Fundsmith and the Lindsell Trains and so on, looked appealing because they’re so out of favour, and a lot of that’s to do with style, [and] that, really, it could be something useful to hold in your portfolio because hopefully at some point when the market turns, that should do well. 

So, it is useful to have that consistency, but I guess it’s just with Nick Train, it’s such an extreme. You have very big position sizes and things like London Stock Exchange Group (LSE:LSEG), Experian (LSE:EXPN), and so on. They’ve really struggled, so it is quite a big bet, and it does become quite challenging. 

As we’ve written before, it’s been interesting to see the much more high turnover funds, so names like Ranmore Global Equity Institutional GBP (BR2Q8G6), WS Blue Whale Growth I Sterling Acc (BD6PG56), that kind of thing, really come through in terms of performance in recent years. So, maybe it’s just a different market that rewards nimbleness more.

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Kyle Caldwell: But the other side of the argument, I suppose, is that if you’ve held a share for a long time and it’s underperformed, you’re being quite stubborn in keeping hold of it.

Obviously, you’re holding it because you think, in time, the prospects will improve, and ultimately, as a fund manager, you’ll be proved correct. But it can take a very long time for narratives to change, and sometimes, you can end up holding on for a company too long and waiting too long for a recovery to play out, and you’re missing out on other potential opportunities in the meantime.

Dave Baxter: Yeah, and maybe that makes the case for being more active and more incremental, so you trim a bit, add a bit, as you see, for example, in funds like Scottish Mortgage Ord (LSE:SMT). Because if you’re simply doing buy and hold, and with big position sizes, then you’re stuck to that position to an extent, and it becomes a much bigger issue, positive or negative, for performance.

Kyle Caldwell: In terms of star managers in the UK, Terry Smith and Nick Train are two very well-known names. There’s also Bill Ackman, the famous US investor. However, overall, the star fund manager culture is much less of a thing today than it was, say, 15 years ago when I started out as a cub reporter for an investment trade title.

I think it’s fair to say that back then, particularly from a marketing perspective, fund firms marketed the lead manager on the fund [in terms of] ‘this is the stock picker that can potentially beat the market’. What are your thoughts, Dave, on fund management companies moving to this more team-based approach? You see some funds these days that have, say, three, four, or five named managers on the fund.

Dave Baxter: In a way it lowers the stakes for the fund and for the company because back in those days you spoke about, you’d have these really big names, and then if the big manager left and went to another company, you’d see loads and loads of money pile out of that fund, and if that’s an open-ended fund that causes problems because they’re having to provide cash for investors.

So, it seems sensible, but I would just highlight the fact that the choice of lead manager and the choice of deputy manager, if applicable, can still be really important to how the portfolio is run. Because, yes, you can have a team approach, but - and I’m sure you’ve had the same - I’ve definitely encountered funds where one lead manager has a very specific view on one thing or one kind of investment, and then when someone else succeeds them, they have a totally different view. So, the portfolio can change quite radically.

Kyle Caldwell: I agree. For me, I like that there’s a lead manager on funds, or two lead managers, because I think it gives retail investors accountability for performance. I think there’s a danger that if you have four or five named managers, it’s like, who is the person at the top of the tree who can address why a fund has underperformed?

Let’s go back to the reason why Terry Smith decided to do this portfolio overhaul. As you mentioned earlier, Dave, he’s acted due to the dominance of passive funds, so either index funds or exchange-traded funds (ETFs), which he says has made the stock market become more dominated by momentum rather than fundamentals, such as how profitable a company is. In light of this, should we as investors take notes and look to make changes to our own portfolios?

Dave Baxter: Yes and no. It’s good to adapt and I think it’s good to be wary of how capricious and volatile markets can be at the minute, but it’s very dangerous to be chasing performance. 

People, of course, could turn to me and say, well, TSMC is up 100% over a year, that kind of thing, but it can turn. My mantra would always be the quite boring one of ‘do participate in these markets, but remember to diversify’.

So, look at regions maybe like the UK alongside the US, and look at those more kind of boring sectors as we’ve discussed before as well.

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Kyle Caldwell: Totally agree, Dave. We regularly speak on this podcast about the importance of diversification. In terms of areas where investors might want to consider whether they’re potentially a bit overexposed at the moment, I’d say the standout one is technology, and by extension, the artificial intelligence theme.

For three years now, we’ve been publishing a report each quarter called the ii Top 50 Fund Index. We rank the most-bought funds, investment trusts, and ETFs over a three-month period. We base it on the number of buys, and we strip out regular investing because we want to give a sense of the active decisions that DIY investors are making.

We’ve just published our latest report, which you can view at ii.co.uk. One of the trends we’ve seen in the second quarter of this year is, of those 50 funds in that index, the number of technology funds has risen from five to 10, and of those 10, three are actively managed funds. 

So, there’s Polar Capital Technology Ord (LSE:PCT). There’s also the open-ended Polar Capital Global Tech I Inc GBP (B42W4J8) fund, and Allianz Technology Trust Ord (LSE:ATT).

And then the other seven, they’re all index funds or ETFs that give dedicated exposure to technology. 

They are VanEck Semiconductor ETF GBP (LSE:SMGB) - that appears twice in our index, with both its accumulation and income share class featuring.

Then there’s also L&G Global Technology Index I Acc (B0CNH16), Invesco EQQQ NASDAQ-100 ETF GBP (LSE:EQQQ), iShares MSCI Global Semicondctrs ETF$Acc GBP (LSE:SEMI), iShares S&P 500 Info Tech Sect ETF$Acc GBP (LSE:IITU), and there’s also a technology leveraged ETF that’s managed by WisdomTree.

In the second quarter of the year, I think what helped fuel demand for specialist technology funds was the initial public offering (IPO) of Space Exploration Technologies Corp Class A (NASDAQ:SPCX). We also saw in our ii Top 50 Fund Index Seraphim Space Investment Trust Ord (LSE:SSIT), which rose eight places in the rankings to 14th, while we also saw a new entrant in VanEck Space Innovators ETF A USD Acc GBP (LSE:JEDG).

What are your thoughts, Dave? Do you think investors are becoming a bit too overexposed to technology?

Dave Baxter: Yeah, I think it’s a big risk. It’s very easy to get excited. You’re having these thematic exposures which have a lot of overlap, at least in terms of investment style. 

Then, as we’ve discussed before, one part of the market in the ascendancy has been emerging markets. People might increasingly get drawn into that. But a lot of that is also kind of the AI play, things like SK Hynix and Samsung Electronics. 

It’s almost quite hard to avoid the tech/AI area at the minute, but it is worth trying to dig around and find some proper diversification.

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Kyle Caldwell: If you bought a technology fund five years ago, now could be a good time to consider rebalancing and taking some of those paper profits and turning them into real profits.

I’ve had conversations with many private investors over the years, and I know some of them don’t like the idea of rebalancing. One investor said to me, isn’t this just throwing good money after bad? 

Some people worry about taking profits in a star performer too soon, and [worry] the investments they decide to redeploy into might take a while to recover.

Well, the thing to bear in mind with rebalancing is that it restores the risk level of your portfolio to what it was when it was first put together.

I do totally agree that you can potentially sell a winner too soon, and you could end up investing into an underperforming area that mightn’t actually recover. So, care does need to be taken, but you just need to bear in mind what rebalancing is and what it’s seeking to achieve.

Dave Baxter: Yeah. Rebalancing is fundamentally not very sexy, but if you want to look at some extreme examples, say you were lucky enough to have held Scottish Mortgage in 2020, that roughly doubled your money in that single year, so you might think the good times will continue.

Performance came back eventually, but it had a really difficult five years or so and I think in 2022 it roughly halved. So, although it’s not exciting, rebalancing would protect you from some of that.

Kyle Caldwell: Dave, I think it’s time to wrap up the episode. Thanks for coming on today.

Dave Baxter: Thanks for having me on.

Kyle Caldwell: That’s it for our latest episode of On The Money. I hope you’ve enjoyed it. We love to hear from listeners, and the way to get in touch is by emailing us at: otm@ii.co.uk. Hopefully, I’ll see you again next Thursday.