Terry Smith on Market Timing and PI World Presentation by David Thornton

David Thornton, who is the Editor of Growth Company Investor, did an interesting presentation for PI World this week. He made an interesting observation in that he likes to avoid stocks that are both highly valued and lowly valued, i.e. on high or low P/Es. This is very wise. The high P/Es are typically discounting a lot of future growth and show the enthusiasm by investors for the business. In reality the high valuation may be a mirage and is being driven by share price momentum and the keenness by retail investors to get on the bandwagon for small cap shares. At the other extreme, they may be lowly valued because the business has some fundamental weaknesses or big strategic problems. Growth at a Reasonable Price (GARP) may be a better investment strategy for overall long-term performance.

See https://www.piworld.co.uk/2020/07/03/piworld-webinar-david-thornton-small-is-beautiful-why-small-caps-what-to-buy-now/

Terry Smith of Fundsmith has written an interesting article on market timing for the Financial Times. He is very opposed to trying to time the market and suggests that taking your money out of the market, as many people did in March, was a bad mistake. He equates it to driving while only looking in the rear-view mirror.

For an institutional fund manager, who cannot move large positions easily, that may be wise. It has certainly worked out well for the Fundsmith Equity Fund which has bounced back, and more, from its low in March.

But I am not totally convinced that it is wise for all investors. Markets do not always recover rapidly as they have done from the Covid-19 epidemic – at least so far although that story may not yet be ended. In the case of the Wall Street crash of 1929 it took 25 years to fully recover. So taking money out of the market early on might have been very wise.

Hedging your bets by taking some money off the table and hence managing your risk exposure is surely a sensible thing to do when the market is heading down. There are three things to bear in mind though:

  1. Small cap shares such as those on AIM can be very illiquid and hence a few sellers can drive the shares well below fundamental value. These are not the kinds of shares to dump in a market sell off unless they are directly impacted by the negative news (e.g. by the virus epidemic closing their businesses and they are at risk of going bust).

 

  1. You also need to be wary about Investment trusts. These again are often not actively traded so they can suffer not just from declining share prices in their portfolio holdings but from widening share price discounts. When the discounts get very wide, it is time to buy not sell.

 

  1. If you have moved into cash, it is very important to know when to buy back into the market. You need to keep a close eye on the direction of the market because bounces from market lows after a crash can be very rapid. Many retail investors sell at the first hint of a crash, but miss out on the recovery which is very damaging to overall portfolio performance. They miss out because they are demoralised and have lost faith in stock market investment. You do need to take a view though on whether a bounce is just emotional reaction to the realisation that the world may get back to normal, and how the recovery may affect individual stocks. In other words, you may want to move your cash back into different holdings.

As a holder of the Fundsmith Equity Fund, I would not normally argue with his investment wisdom but he may be in a different position to many retail investors. I did take some cash out of the market after the peak bull hysteria of late 2019 and in March after it was clear some companies would be badly hit by the epidemic. This provided some funds for picking up other depressed companies. But Fundsmith was not one I dumped.

The Terry Smith article is here: https://www.fundsmith.co.uk/news/article/2020/07/02/financial-times—there-are-only-two-types-of-investors

Roger Lawson (Twitter: https://twitter.com/RogerWLawson  )

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Bank Dividends and Fundsmith Performance

The bad news for many private investors is that most of the major listed UK banks are suspending dividend payments, even ones already announced. This is after they received a letter from the Bank of England requesting that they do so. The dividends are unlikely to be resumed before the end of the year. This is surely a prudent measure as the banks will undoubtedly have many requests for loans from companies to tide them over the virus crisis, while other companies will default on loans already made.  Bank balance sheets are always on a knife edge which is one reason I don’t hold shares in them.

Another investor who does not invest in banks is Terry Smith of Fundsmith. He has just published a letter to investors about the year to date performance of his Fundsmith Equity Fund. It is down only 7.9% when the fund’s benchmark MSCI World Index is down 15.7% and the FTSE-100 is down 23.8%. See www.tinyURL.com/tfjuzno for more information. As I hold the Fundsmith fund, it’s probably made my portfolio performance better than it otherwise would have been as a number of small cap stocks I hold and investment trusts have fallen further. I have not been selling the Fundsmith Equity Fund so that may be one of the few wise decisions made of late.

Terry Smith’s has another go at “value stocks” in his letter. He says they don’t protect you in a market downturn mainly because they are lowly rated for good reason. They are often cyclical, highly leveraged, have poor returns on capital or face other challenges. He could be referring to banks!

Another wise comment he makes is “What will emerge from the current apocalyptic state? How many of us will become sick or worse? When will we be allowed out again? Will we travel as much as we have in the past? Will the extreme measures taken by governments to maintain the economy lead to inflation? I haven’t a clue”. Comment: I don’t either, but like Terry I believe that investing in good businesses remains the best strategy.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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FinTech Valuations, EU Harmonisation and Fundsmith Report

I received an interesting item from Sharepad/Sharescope by Jeremy Grime this morning. It was headlined “Culture in Payments” but the interesting part was the coverage of the valuations of Fintech companies. It listed some of the recent takeover transactions of such companies where the valuations ranged from multiples of 1.1 to 7.8 times revenue (Source: W.H.Ireland), but many of them were on more than 7 times. Profits are not even mentioned! One example was UK listed company Earthport, taken over at 7.3 times revenue by Visa when it had been consistently loss making.

The article also mentions three small such UK listed companies – Alpha FX (AFX), Argentex (AGFX) and Equals Group (EQLS) and explains how they seem to be evolving from being primarily suppliers of foreign exchange to evolving into banks. I have an interest in one of those companies and another in the sector, but some of  the valuations seem to be way too high to me. There are clearly a lot of share speculators betting on their future, but not all are likely to be successful. Maybe they are just looking further ahead than me (source of the word “speculator” is Latin “speculatus”, the past participle of the verb speculari, which means “to spy out” or “to examine” but it tends to now mean acting without looking).

Chancellor Sajid Javid has put the cat among the pigeons over the weekend by suggesting on Friday in an FT interview that UK businesses need to prepare for divergence from EU rules. He said “There will not be alignment, we will not be a rule taker, we will not be in the single market and we will not be in the customs union”. This may create potential difficulties for large importers/exporters from/to the EU, such as auto manufacturers, aerospace companies, pharmaceutical companies and food/drink suppliers. It is also somewhat inconsistent with the “political declaration” which was part of the Brexit Withdrawal Agreement.

Perhaps this is just a negotiating position. I hope so because some harmonisation on goods might surely be preferable to ease trade flows, even if we depart to some extent from EU financial regulations and other rules. However, just to give you one example where harmonisation might be objected to, the EU is mandating Intelligent Speed Adaptation (ISA) for all new cars from 2022. Many UK drivers consider this unreasonable as speed limits are often inappropriate and there are a number of technical objections to it. Exporting compliant vehicles to the EU should not be difficult for car manufacturers but for German manufacturers if the UK drops that rule then problems may arise. The devil is in the detail on harmonisation. The answer is surely to agree harmonisation on technical standards where there is an obvious benefit to both parties, but not where the regulations attempt to dictate policies in the UK, or how our citizens behave.

Lastly I covered the latest Fundsmith Equity Fund Annual Report in a previous blog post (see https://roliscon.blog/2020/01/18/another-good-year-for-fundsmith/ ). It’s now available from this web page: https://www.fundsmith.co.uk/docs/default-source/analysis—annual-letters/annual-letter-to-shareholders-2019.pdf? and is well worth reading.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Another Good Year for Fundsmith

Terry Smith has issued his latest report to investors on the performance of the Fundsmith Equity Fund. It contains some of his usual acerbic comments on the financial world which I cover below.

Total Return on the fund last year was 25.6% and that beat the MSCI World Index benchmark which was only up 22.7%. As Fundsmith is one of my bigger holdings, that helped to contribute to my own portfolio performance although my overall gain was better. But that compares with the previous year when Fundsmith was well ahead of my portfolio which has more small cap stocks in it. Undoubtedly investors in Fundsmith will be happy with this continued good performance and the fund has continued to attract new investors so is now the largest UK retail equity fund. Many people have concerns that the fund is now so large that returns may drop away but Terry Smith continues to confound them.

The top five contributors to outperformance were Microsoft, Estee Lauder, Facebook, Paypal and Philip Morris with the detractors being 3M, Colgate Palmolive, Clorox, Brown-Forman and Reckitt Benckiser. Terry continues his management style which he defines as buying good companies, not overpaying and then doing nothing. He also likes to invest in companies with a good Return on Capital Employed (ROCE), good margins and good cash conversion. These are good lessons for all stock market investors.

He derides “value investing”, i.e. buying apparently cheap stocks and the alleged rotation from growth into value. He says “most of the stocks which have valuations which attract value investors have them for good reason – they are not good businesses”. He argues that returns from stock market investment come from the growth in company earnings and the compounding of reinvested retained capital, not from buying cheap companies.

He clearly does not intend to change his investment style and makes some critical comments on the Woodford debacle which he assigns to a change in investment strategy with Woodford moving into illiquid small cap stocks in an open-ended fund.

Fundsmith are holding the Annual Shareholders Meeting on the 25th February for those who wish to question Terry on his management, or on why he is not reducing the fund management charges given the growing size of the fund, although they are not expensive in comparison with some actively managed funds.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Safestore and Fundsmith AGMs

Today I attended the Annual General Meeting of Safestore Holdings Plc (SAFE) in Borehamwood. Their head office is next to one of their self-storage units. They now have 146 stores with a concentration in London/South-East England, and in major UK cities, plus some in Paris.

The Chairman, Alan Lewis, commenced the meeting with a very brief statement. He said 2018 was a good year with good strategic progress. He is confident value creation will continue. Note that Mr Lewis is stepping down as Chairman and they are looking for a replacement as he has now served for 9 years.

Safestore is a growing company in a growing sector. As people accumulate more junk, house sizes shrink and more people live in flats, they run out of space for their belongings. The demand is also driven by divorce and death. In addition to personal users, small businesses find such facilities useful to store goods, tools & equipment, or display material.

Revenue was up 11% last year, and earnings up 125% (or as this can be seen as a property company, EPRA earnings were up 15.5%). The dividend was increased by 13.8%. Self-storage companies can be perceived as property companies but they are best viewed as operating businesses in my view (the CEO seemed to agree with that). The market cap is way higher than the book value of the assets unlike in most property companies of late. Self-storage is one of the few growth areas in the property sector at present.

Page 8 of the Annual Report gives some information on the market for such facilities. Compared with say the USA, the UK storage space per head of population is only a small fraction of the USA. In other words, the UK market is relatively immature and to reach the same level as the USA would require another 12,000 stores!

I asked the Chairman why the company did not expand more rapidly if the potential is there? The response from the CEO was that there were problems with finding suitable new sites and with planning restrictions. They are also conservative on finance. A question on potential acquisitions arose as it is a fairly fragmented market in the UK but it seems few such opportunities are reasonably priced and meet the quality criteria they have. They did take over Alligator last year. Competitors don’t seem to be growing any more rapidly, and the CEO suggested they were gaining market share.

The main other question I raised was about their Remuneration scheme. At the 2017 AGM they only just managed to win the Remuneration Policy vote and at the 2018 AGM the Remuneration resolution was again just narrowly voted through. Remuneration Committee Chairperson Claire Balmforth explained that institutional investors were unhappy with the LTIP and the “quantum” of pay – that’s a polite way of saying it was too high. Indeed remuneration at this company is high in relation to the size of the business – the CEO received a total pay of £1.6 million last year (single figure remuneration). Even the Chairman received £135,000.

However it’s apparently all change after extensive conversations with institutional investors. The executive directors have agreed changes to the LTIP and a “more conventional” LTIP will be introduced in 2020. As a result they did better on the remuneration vote, and the votes on the re-election of Balmforth and Lewis, with the Remuneration resolution passing with 70% support.

It was not until later when I chatted to the directors that I discovered where I had come across Claire Balmforth before. She used to be HR Director, then Operations Director, at Carpetright when I held shares in that company.

Anyway I gave them my views on remuneration. Namely I don’t like LTIPs at all, particularly those that pay out more than 100% of base salary. I prefer directors are paid a higher basic salary with an annual bonus paid partly in cash, partly in shares.

Other than the pay issue, I was positively impressed as a result of attending the meeting.

One issue that arose was the poor turnout of shareholders at the meeting. There were more “suits” (i.e. advisors) than the 3 ordinary shareholders (two of those were me and son Alex). Now it happens that earlier in the day I was watching a recording of the annual meeting of Fundsmith Equity Fund which I had not been able to attend in person this year. Terry Smith was in his usual good form, and he said there were 1,300 investors at the meeting. That’s more than any other UK listed company or fund (most funds do not even have such meetings). An amusing and informative presentation helps enormously to attract investors of course. I wish all companies would bear that in mind.

You can watch the Fundsmith meeting recording here: https://www.fundsmith.co.uk/tv .

Anyone who wishes to learn how to make money in stock markets should watch it. Terry Smith has a remarkable record at Fundsmith. He said last year was not a vintage year as the fund was only up 2.2%. But that beat their benchmark and only 7.8% of UK funds generated positive returns last year. In the top 15 largest UK funds over 3 and 5 years, they are the clear winner.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Market Bouncing Up or Down – Sophos, Greggs, Apple and Fundsmith

 

After a dire market performance before Xmas, we seem to be back to the good times in the last 3 days. Is it time to get back into the market for those who moved into cash as the market fell down and down and down in the autumn? Rather early to generalise I suggest although I have been picking up some shares recently.

One which I purchased a small holding in was Softcat (SCT). Yesterday it issued a trading update simply saying that trading was strong and they are materially ahead of where they expected to be at this stage in the year. The share price promptly jumped by 20%. I no doubt should have bought more. But there was a wider rise, no doubt driven by a rise in US markets and effectively ignoring the political turmoil in the UK.

Another company issuing a trading update yesterday was Greggs (GRG). They reported total sales up by 7.2% in the year and like-for-like sales up by 4.2% in the second half. The share price rose over 6% yesterday and it rose again this morning. CEO Roger Whiteside has done a remarkable job of turning around this company from being a rather old-fashioned bakery chain to a fast “food-on-the-go” business. New products have been introduced and new locations opened. The latest product initiative which got a lot of media coverage was vegan sausage rolls, now combined with “vegan-friendly” soup in a meal deal for just £2.25! A good example of how new management with new ideas can turn a boring and financially under-performing one into a growth story. But this comment of Lex in the FT is worth noting: “The positives, like the mycoprotein, are baked in. At almost 20 times forward earnings, the stock rating is well above the long-term average. Investors should wait for this dish to cool before taking a bite”. I remain a holder.

There have been lots of media comment on the profit warning from Apple with questions about whether we have hit “peak i-Phone”. Sales in China are slowing it seems and folks everywhere are not upgrading as frequently as before. Apple phone users may be loyal but they are now tending to upgrade after 3 years rather than 2.

Having just recently upgraded from a Model 6 to an 8, I can see why. The new phone is slightly faster but battery life has not significantly changed. Phone prices have gone up and I could not justify the even higher priced models. Software functionality is of course identical anyway.

Apple is the sort of company I do not invest directly in for two reasons. Firstly it’s very dependent on one product – iPhones are more than 50% of sales revenue. Secondly, all electronic hardware is vulnerable to being leapfrogged by competitors with newer, better products. With growing price competition in smartphones, particularly from low-cost Chinese producers, the world is surely going to get tougher for Apple.

Hargreaves Lansdown have reduced their recommended fund list down from 85 funds to 61 and it’s now called the Wealth 50, but Fundsmith Equity Fund is still not included even though it was one of the best performing funds last year. But they have kept faith in the Woodford Equity Income Fund which is most peculiar given its recent performance. It seems they think the big bets that Neil Woodford has been making on companies and sectors will come good in the long term, as they have in the past. We will see in due course no doubt.

But their reluctance to recommend Fundsmith seems to be more about the discounts on charges that some fund managers give them, which they do pass onto customers of course. It’s worth pointing out that the lowest cost way to invest in the Fundsmith Equity Fund can be to do it directly with Fundsmith rather than via a stockbroker or platform. That’s in the “T” class with an on-going charge of 1.05% which achieved an accumulated total return of 2.2% last year, beating most global indices and my own portfolio performance.

Indeed one commentator on my fund performance reported in a previous blog post suggested that an alternative to individual stock picking was just to pick the best performing fund. Certainly if all of my portfolio had been in Fundsmith last year rather than just a part then I would have done better. But that ignores the fact that my prior year performance was comparable and having a mix of smaller UK companies helped to diversify while Fundsmith is subject to currency risk as it is mainly invested in large US stocks. Backing one horse, or one fund manager, is almost as bad as buying only one share. Fund managers can lose their touch, or have poor short-term performance, as we have seen with Neil Woodford. Incidentally the Fundsmith Annual Meeting for investors is on the 26th February if you wish to learn more. Terry Smith is always an interesting speaker.

Stockopedia have just published an interesting analysis of how their “Guru” screens performed last year. Very mixed results with an overall figure worse than my portfolio. For example “Quality Composite” was down 19.7% and Income Composite was down 13.9%, with only “Bargain” screens doing well. It seems to me that screens can be helpful but relying on them alone to pick a few winning stocks which you hold on for months is not a recipe for assured success. It ignores the need to do some short-term trading as news flow appears, or to manage cash and market exposure based on market trends. As ever it’s worth reiterating that there is no one simplistic solution to achieve good long-term investment performance without too much risk taking.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Should I Buy Smithson Investment Trust?

I am a great fan of Terry Smith and his investment approach. As an investor in his Fundsmith Equity Fund, I have seen annual returns of 21.7% according to ShareScope since I first purchased it in 2014. That fund is a global large cap fund. Terry has now launched a small and mid-cap investment trust based on similar investment principles which is called the Smithson Investment Trust. Subscriptions are being invited here: https://www.smithson.co.uk/

The Fundsmith Equity Fund is an open-ended fund whereas Smithson is a closed-end investment trust so may trade at a premium or a discount to net asset value (NAV). Fundsmith already have another investment trust in their stable – the Fundsmith Emerging Equities Trust (FEET) which was launched in 2014 and had a disappointing initial performance, but it has done better of late. It has consistently traded at a premium to NAV and is now at 1.5%. That is not common for investment trusts and rather shows the confidence investors have in Terry Smith and his team.

Smithson will be following the same investment philosophy as the main Fundsmith fund – namely “Buy good companies, “Don’t overpay” and “Do nothing”, i.e. they will not be active traders and will have a low stock turnover.

The “Owner’s Manual” for Smithson is worth reading. The focus will be on companies with an average market cap of £7 billion, so these are not going to be really small companies. The document argues that small and medium size companies have outperformed larger companies which is probably true in recent times. Hence the investment saying “elephants don’t gallop” originally attributed to Jim Slater.

The Owner’s Manual makes some interesting comments about their preference for companies with intangible assets as opposed to physical ones. To quote: “Intangible assets, on the other hand, are much more difficult to replicate. They are typically not ‘bankable’ in the sense of being able to borrow debt against them and so require more equity and long- term illiquid investment to build them, for which rational investors will demand a high return, all of which is good if this is being attempted by your competitors. And the best thing about investing in listed companies with strong intangible assets is that from time to time the stock market values them as if their high returns will decline in the future, just as other companies’ returns are prone to do.”

They are going to be looking for growth companies, but not extremely fast-growing ones which are often over-priced. They will avoid highly leveraged companies but will look for companies that invest in R&D.

Management charges on Smithson will be 0.9% of the value of the funds managed per annum and there will be no performance fees. This is good news. But it’s somewhat unusual in that it will be based on the market cap of the company, not the normal net asset value. The investment trust form was chosen because it enables the manager to invest in smaller companies without being concerned about liquidity – they won’t need to bail out if investors wish to sell their holding in the trust unlike in open-ended funds which require constant buying and selling.

The portfolio managers will be Simon Barnard and Will Morgan under the supervision of Terry Smith as CIO.

As regards dividends, this is what the prospectus says about dividend policy: “The company’s intention is to look for overall return rather than seeking any particular level of dividend. The Company will comply with the investment trust rules regarding distributable income but does not expect significant income from the shares in which it invests. Any dividends and distributions will be at the discretion of the Board”. So clearly the focus is on capital growth rather than dividends which might be quite small.

One of the key questions is will the shares trade at a discount or not? Small cap investment trusts often do and as the prospectus warns: “A liquid market for the Ordinary Shares may fail to develop”. There is no specific discount control mechanism although the company can buy back shares in the market and there is a provision for a continuation vote if there is a persistently wide discount after 4 years. Smaller company investment trusts often trade at significant discounts but this is more a medium-cap than small-cap trust and Terry Smith’s reputation may result in a premium as with FEET.

If you apply for shares in the IPO you can receive either a paper share certificate, have the shares deposited in a nominee account with Link Market Services Trustees or, if you are already a personal crest member have the shares deposited in your account.

Clearly though there is uncertainty about the future likely performance of the company. I said in a recent blog post that you should never buy in an IPO. To repeat what I said in that “there can be some initial enthusiasm for companies after an IPO that can drive the price higher but the hoopla soon fades”. So personally I think I may wait and see. But I suspect there may be some enthusiasm among retail investors for this offer. Terry Smith now has a lot of fans.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Return Versus Risk and Tips from Terry Smith

There was an interesting article by Fundsmith founder Terry Smith in the Financial Times on Saturday under the heading “Think globally and add a dash of small caps”. His articles are usually full of wisdom.

In this case he first tackled the issue that the Capital Asset Pricing Model (CAPM) tells you that your returns relate to how much investment risk you are willing to take on. This might be seen as common sense – why would anyone take more risks if they did not get a better return? But based on an academic study of actual stock market returns, low risk seems to give better returns. This is a persistent anomaly.

But my reservation on this truth is that risk was measured by the volatility of the share price, which is a conventional way to calculate the risk of an individual share. But it simply does not tell you the major risks that a company faces. It only tells you about the level of variability in the share price over the short term, or the amount of speculation there is in the stock. For example, it will not tell you that the company operates in a market that is rapidly changing or the company’s products are subject to technological obsolescence. There are many risks that are simply not reflected in conventional risk metrics which only a study of the market in which the company operators and its business model will reveal the truth about.

Terry also discussed the other conventional wisdom that asset allocation is responsible for most of the returns one obtains – he quoted a figure of 91.5% from another academic study. He said this has led “a large portion of the investment industry to focus almost exclusively on asset allocation”. That’s as opposed to the choice of individual assets.

Mr Smith also criticized the parochial approach of many investors who only invest in their home markets (e.g. UK listed shares for UK investors even though many such companies have very international businesses). He went on to suggest a portfolio of global large-cap stocks plus some small/mid-cap stocks can “achieve the seemingly impossible feat of generating additional return whilst reducing risk”. This is because such a portfolio that might comprise 35% of small cap stocks is more likely to be near the “efficient frontier” for which investment professionals aim.

He concluded by saying that “we should all manage equity portfolios on a global basis and add an element of small-cap exposure”. That might be a puff to some extent for his Fundsmith fund, which I hold – perhaps suggesting Fundsmith could provide one element in this strategy. But it is certainly an approach I have found to be a wise one.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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