Investing for Growth is a compilation of Fundsmith’s annual letters and articles Terry Smith wrote for the Financial Times. Just a bit of background, Fundsmith is a UK-based fund that was founded by Terry Smith with a strategy focused on investing only in high quality businesses. Fundsmith has a track record of 18.1% p.a since inception in 2010.
Here are a few takeaways.
It’s okay to pay up for quality
What P/E multiples can you pay for a quality business such as L’Oreal in 1973 to earn a market return over the next 46 years? 281 P/E. The reason is that quality businesses can generate a high return on capital. Compounded that with a good growth rate over several decades, you’ll still end up fine despite paying an insanely high P/E multiple. High P/E doesn’t necessarily mean expensive for high quality businesses just as low P/E doesn’t necessarily mean cheap for a poor quality business.
What drives long-term return has more to do with the return of the business than its P/E multiples. As Charlie Munger famously puts it, “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns.”
Why boring is the best
Boring companies—stable and predictable quality companies—are persistently undervalued because we underestimate near certain events. The graph above shows that we tend to overestimate low probability events (possibility effect) while underestimating high probability events (certainty effect).
We dismiss quality stocks because they look overvalued while past performance is no guarantee of future results. Or they’re just plain boring compared to turnaround stocks. That explains why these companies often produce an above-average return.
Don’t try to time the market
Time in the market is more important than timing the market. It is hard to make predictions on things like inflation, interest rate, exchange rate, the next bear market etc. The stock market is a complex adaptive system. What that means is not only do you have to be correct about your prediction as to when things are going to happen, you also need to predict how the market is going to react to that the event you’re predicting. Put it differently, trying to predict something changes its outcome.
Don’t over diversify
Diversification is a good way to reduce company-specific risk. However, over-diversification can dilute return without any substantial reduction in unsystematic risk. The sweet spot is around 20-30 stocks.
High return doesn’t have to come from obscure stocks
You don’t have to seek out micro/small-cap stocks or obscure ideas just to get a high return. High return companies are generally ones that are right under your nose. Domino’s Pizza is an excellent example. Everyone knows Domino’s Pizza. And the fast-food industry is not a hot industry like technology or cybersecurity where many thinks are the only place to look for high return.
Thoughts on valuation
“We seek to buy our portfolio companies when their free cash flow (FCF) yield is at or above the yield we would expect to get on long-term government bonds in the same currency.” – Terry Smith
Fundsmith’s Investment Process
- Invest in good companies
- Don’t overpay
- Do nothing
Don’t try to predict which company will win. Look for ones that have already won.
Terry Smith compares investing to picking the winning horse after the race finishes. Instead of trying to predict which company is going to win, look for those that have already won; companies with a strong track record that will continue to deliver.
Firms which provide good products or services are key to investing
The long-term winners in the stock market are companies that have unique assets to produce products or services their customers desire. These unique assets cannot easily be replicated by their competitors. Therefore, allow these companies to continue to grow their volume (and/or raise price) for a long time.
If you don’t like what’s happening to your shares, switch off the screen
Probably one of the most important pieces of advice. The long-term fundamental of a business affects its share price, not the other way round. If you find yourself having sleepless nights from the market volatility, it is best to delete that stock app.