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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Why I Still Won’t Invest in Banks

I do not hold any bank shares at present, and have no plans to change that policy. But I thought it would be worthwhile to look at the results announced by Lloyds Banking Group (LLOY) yesterday for the third quarter. That particularly is so now that the revelations about the HBOS takeover are coming out on a daily basis.

The announced results were positive. The prospective dividend yield on Lloyds is now near 6% and the p/e is about 9, which is all that some investors look at. But I learned from my experience of investing in Lloyds and RBS before the financial crisis of 2008 to look at the balance sheet.

The latest figures for Lloyds Banking Group show total assets of £810 billion and liabilities of £761 billion, which you might consider safe. But if you look at the asset side there is £161bn in “trading and other financial assets at fair value”, i.e. presumably marked to market. They have £27bn in “derivative financial instruments”, which Warren Buffett has called “weapons of mass destruction”, and £480bn of “loans and receivable”, again probably marked to market.

Shareholders equity to support the £810bn of assets is £49bn. Which does not strike me as particularly safe bearing in mind what happened in the financial crisis. For example, that small bank HBOS, which Lloyds bailed out, eventually wrote off £29.6bn alone on their property loans after everyone suddenly realised that their lending had been injudicious and the loans were unlikely to be recovered in full.

In addition, banks can conceal their assets and liabilities as we learned at RBS and more recently in the Lloyds case. Indeed tens of billions of loans from Lloyds and others to HBOS were concealed and hidden from shareholders in the prospectus with apparently the consent of the FSA.

So I follow the mantra of Terry Smith of Fundsmith who said in 2013: “We do not own any banks stocks and will never do so” having learned from my own experience that it is a very risky, and cyclical sector. I am not convinced that improved regulation, and better capital ratios have made them “investable” when one can invest in other companies with far fewer risks.

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

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