Tag: Terry Smith

Why I Never Invest in Banks

This has been said by Terry Smith, and reiterated in a recent FT article, but it could just as well have been said by me. He says “I think it is precisely because I understand banks that I never invest in their shares. The recent events surrounding the collapse of Silicon Valley Bank (“SVB”) and Credit Suisse reinforce this stance”. Banks are inherently highly geared and on a knife edge of instability that can be disrupted by the slightest wind.

See https://www.fundsmith.co.uk/news/2023/4933-financial-times-why-i-never-invest-in-bank-shares/ for Terry’s explanation.

From my involvement in the collapse of the Royal Bank of Scotland I came to realise that the accounts of banks can conceal all kinds of risk taking and are often simply incomprehensible. Recent events reinforce that view. Banks should probably not be listed companies in my view as normal equity investors will not understand the reality.

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

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Fundsmith Annual Investor Letter

Terry Smith has published his thirteenth annual letter for investors in the Fundsmith Equity Fund (which I hold). As usual it’s a good mixture of sound analysis of market events and witticisms. I’ll cover a few significant points:

The fund underperformed the MSCI World Index with a total return of minus 13.8%, which was better than my own portfolio. As he points out the only way to beat the market last year was to hold energy stocks and nothing else. But both I and Fundsmith have a focus on growth companies so we have been under-weight in the dinosaurs of the investment world.

As Terry says: “Whilst a period of underperformance against the index is never welcome it is nonetheless inevitable. We have consistently warned that no investment strategy will outperform in every reporting period and every type of market condition. So, as much as we may not like it, we can expect some periods of underperformance” which is a fair comment.

Terry points out that we have gone through a period of “easy money” when central banks ignored the consequences of their actions. He says “One of the problems of easy money is that it leads to bad capital allocation or investment decisions which are exposed as the tide goes out”.

He is particularly critical about the management of Paypal and Facebook  (Meta) plus makes negative comments on Alphabet and Amazon and their expenditure on non-core businesses. He is scathing about the failure of some companies in which the fund has holdings to engage or even to provide information about the return they are getting on investments. He says: “What I am complaining about is the bipolar response some companies have to long-standing shareholders versus newly arrived activists”.

He has a particular attack on Unilever as in previous years and makes this acerbic comment on their marketing of soap: “When I last checked it was for washing. However, apparently that is not the purpose of Lux, the Unilever brand, which apparently is all about ‘Inspiring women to rise above everyday sexist judgements and express their beauty and femininity unapologetically”.

Lastly he attacks the exclusion of share-based compensation from financial reporting which can completely distort comparisons with other company’s figures.

In summary, another thoughtful report from Terry Smith and I am happy with the funds continued focus on investing in companies with a high return on capital and high margins with good cash conversion.

The Fundsmith EquIty Fund letter can be read in full here: https://www.fundsmith.co.uk/media/bm0lyc22/annual-letter-to-shareholders-2022.pdf

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

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Book Review – Investing for Growth

“Investing for Growth” is a recently published book by Terry Smith, the founder of the Fundsmith fund management company. Anyone who has invested in his Fundsmith Equity Fund, as I first did 7 years ago, will find the book to be simply a refresher on the principles Terry Smith first laid down and has stuck to ever since. That can be summarised as “buy good companies, don’t overpay and do nothing” – the latter meaning don’t over-trade.

The book consists of a mixture of the Fundsmith Equity Fund annual reports over the last ten years, plus articles Terry Smith has written for various publications in that period. It tends to be somewhat repetitive and could have done with some more aggressive editing. It does of course highlight the strong performance of the Equity Fund over the last few years which has attracted many private investors so that it is now one of the largest UK funds. You can see the details of the fund’s performance here: https://www.fundsmith.co.uk/fund-factsheet which shows an annualised return since inception of 18.2% per annum, well ahead of its benchmark.

The book is a good reminder of how Terry Smith has achieved this success which is worth any investor understanding. But there are a few articles in the book worthy of particular mention that even investors in his funds may not previously have been familiar with, which I shall pick out.

The chapter entitled “Lessons of the Great Wall Street Crash” makes some interesting comments on the causes of that crash and what he suggests was the failure to deal with it properly – even by FD Roosevelt who normally gets a lot of credit for the eventual revival. It complements well the previous book I read called “Boom and Bust” which also covers that subject.

Another chapter is entitled “Why buy Brics when you can have Mugs?”. This covers the question of whether you should invest in developed market economies (typically North America and Western Europe) when clearly there is rapid growth taking place in some economies, typically called “Emerging Markets”. Terry wrote the article in 2014 when investing in Brazil, Russia, India and China were the popular countries to back. He reported that investing in an emerging market index tracking fund over the previous 5 years would still have underperformed a developed market index.

I recall looking at this issue when I first started investing 20 years ago. Should one back countries where you may know little about them other than their economies are forecast to grow rapidly? As of course China and India have subsequently achieved. But the answer in reality is far from simple. Looking at the latest statistics covering the last five years for a few investment trusts, the only certainty seems to be that investing in the UK “All companies” sector would have been a very poor choice as against a Global fund, or even a North American fund. In fact as US stock markets dominate the overall world value at about 50% of market valuations, that distorts any Global fund figure. With the UK being in a political crisis over Brexit that clearly damaged overseas investors view of UK shares, plus of course the FTSE-100 is full of “mature” companies in sectors with little growth, while the USA has many leading technology companies. As Terry Smith says “If you are willing to invest on the basis of a snappy acronym with no regard for the political and economic characteristics of the countries, perhaps you should have subscribed to the MUGS – Moldova, Uganda, Greece and Suriname. The key is surely to back fund managers who have a proven record in their chosen sectors such as Mr Smith.

Another interesting chapter in the book is headed “Why bother cooking the books if no one reads them?”. Terry Smith first made his name by publishing a book entitled “Accounting for Growth” which showed how the accounts published by companies were frequently manipulated to fool investors, particularly as regards acquisitions. Since then accounting rules have been tightened up but companies, and analysts, have now chosen to promote “adjusted” figures. He highlights restructuring charges, exceptional costs (particularly legal charges) and intangible asset amortisation and impairment charges as being used to distort accounts. He particularly attacks pharmaceutical companies such as AstraZeneca and GlaxoSmithKline and I definitely agree with him this has become a major issue for investors.

Other good chapters are “ESG? SRI? Is your green portfolio really green?” and “The myths of fund management”. He clearly enjoys sacrificing the sacred cows of the fund management industry.

I would recommend this book to any investor. It’s an easy read and not too long at 290 pages.

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

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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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Another Good Article from Terry Smith on Dividends

As usual, there were some very perceptive comments from Terry Smith of Fundsmith on dividends and income funds in FT Money on Saturday (6/10/2018). Many investors want income – for example to finance spending in retirement – so they invest in high dividend paying stocks. Some simply think that reinvested dividends will enable them to grow their portfolio value but this is a poor result in reality. As Terry explains it would be better if the companies retained the earnings and reinvested them. The maths shows the negative impact of the tax you pay on the dividends.

Terry bemoans the fact that income funds outsell all other types by some margin, even though in reality many have only a yield that is slightly higher than the average. Needless to point out perhaps that the funds he runs are not income funds. But that does not destroy the wisdom of what he is saying.

All that matters is total return. If a company can reinvest the generated profits with a good return, there is no good reason to pay them out as dividends; as Warren Bufftet’s Berkshire Hathaway has never done with great results. Retained earnings compound even faster if no dividends are paid.

A personal investor can always sell a few shares to generate a cash income if necessary, and generally at a lower tax rate than they would pay on dividends.

Companies can usually find projects or acquisitions that can generate good returns. There are a few exceptions of course. Incompetent managements who pursue mirages or make disastrous acquisitions are examples, but those are the kinds of companies you should be selling not buying anyway.

Today the stock market is falling yet again, with growth stocks badly hit. There can be a tendency to hold on to those boring defensive and high-yielding stocks in a market rout. But that is a mistake. For the same reason you probably should not have bought them in the first place, don’t hold on to them. A yield of 4%, 5% or higher does not offset the risk of share price decline. Just consider when you are cleaning out your portfolio today to get rid of the duds that won’t be generating high and growing profits in the future. That’s all that matters.

Incidentally I had a letter published in the Financial Times today on the subject of Brexit, which was very kind of them as I effectively criticised their editorial policies. It was headlined “Please – no more letters from moaning Remainers” and was in response to two previous letters from clearly biased correspondents. You can find it on the FT web site.

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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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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