Usually there are two distinct elements from which value investors can choose to structure their investment methods:
- Investing in deep undervalued securities and generally with a shorter time horizon, within the value investing framework.
- Investing in high-quality companies, with a longer time horizon that can extend until forever.
One could name the first method the “Benjamin Graham approach” and the second the “Charlie Munger (Trades, Portfolio) approach.” These two individuals were the most important investing influencers for Warren Buffett (Trades, Portfolio).
Terry Smith
Terry Smith is CEO and CIO of Fundsmith Equity Fund, a U.K. star fund that has registered a 19.5% annualized return since inception in November 2010 and has 16.2 billion pounds in assets under management. Smith is a fanatic of the “Charlie Munger (Trades, Portfolio) approach.”
Investment criteria
Fundsmith’s stringent investment criteria focus on selecting companies that, according to the fund's website, are:
- High quality businesses that can sustain a high return on operating capital employed.
- Businesses whose advantages are difficult to replicate.
- Businesses which do not require significant leverage to generate returns.
- Businesses with a high degree of certainty of growth from reinvestment of their cash flows at high rates of return.
- Businesses that are resilient to change, particularly technological innovation.
- Businesses whose valuation is considered by the Company to be attractive.
Their 10 biggest positions are: Microsoft, Paypal, Amadeus, Philip Morris, Reckitt Benckiser, Waters, Idexx, Pepsico, Facebook and Stryker.
To make the strategy very clear, Fundsmith published an owner’s manual (much like Berkshire Hathaway’s), that helps every investor understand why they do not engage in the “Greater Fool Theory” or why they never attempt to engage in market timing, for example.
What not to do
As important as the fund’s investment criteria is its list of prohibitive elements:
- No fees for performance
- No up front fees
- No nonsense
- No debt or derivatives
- No shorting
- No market timing
- No index hugging
- No trading
- No hedging
This can be summed up in what Smith calls the “do nothing” strategy. In fact, in 2017 the fund had portfolio turnover of 5.4% and spent a total of 0.011% of the fund's assets under management on trading charges. The fund has held 13 stocks since inception.
Within sectors to be avoid, Fundsmith won’t invest in emerging technology firms, owing to their inherent unpredictability; in heavily cyclical industries, such as airlines and real estate; and in banks, because of their reliance on leverage and financial engineering.
In a follow up article, we will analyze just how important ROCE is for the long-term success of the Charlie Muger approach in the Fundsmith Equity Fund.
