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Hugo Roque
Hugo Roque
Articles (33) 

Buy Good Companies, Don't Overpay, Do Nothing = Facebook

Fundsmith's outperformance record continues

February 03, 2019 | About:

Terry Smith, the CEO and CIO of Fundsmith, recently published his 2018 letter for investors. The fund registered an annual return of 2.2% versus -3.3% for the MSCI World Index and 17.4% annualized since 2010.

Smith explains that the fund applies a simple, three-step investment strategy:

  • Buy good companies.
  • Don’t overpay.
  • Do nothing.

Buy good companies

In terms of quality, the average ROCE in 2018 of the companies in Fundsmith's portfolio was 29% versus 16% for the average of the S&P 500.

Don’t overpay

Smith is not afraid to pay a bit more for quality and growth. But he doesn’t want to overpay. The year-end median free cash flow yield of Fundsmith’s portfolio was 4%. That compares with 4.7% for the S&P 500.

Do nothing

Do nothing means minimizing the portfolio turnover. That objective was “again achieved with a portfolio turnover of 13.4%.”

Facebook

As an example of their investment method and selection discipline, the CIO presented their thesis for their investment in Facebook (NASDAQ:FB), made during 2018:

“Facebook’s historic numbers are certainly impressive. It has some 1.5 billion Daily Active Users (‘DAU’) and some 2.3 billion Monthly Active Users (‘MAU’). Bearing in mind that Facebook has no presence in China these numbers suggest ubiquity.

In 2017 Facebook had a return on capital of 30%, gross margins of 87% and operating profit margins of 50%. Its revenue growth rate has averaged 49% p.a. for the past five years and over the same period operating profits have grown by 106% p.a. (one hundred and six percent per annum).

Of course, all that is in the past and the future for Facebook is likely to be different. When we started buying its shares we estimated that its revenue growth rate would halve to about 20% p.a. In the third quarter of 2018 they grew at 34% p.a., but the company has indicated that the growth rate would slow further to perhaps the mid 20% range in the fourth quarter, and the operating margin was down to a still impressive 42%. Against the background of the media furore over the use of personal data, this has been enough for some commentators on Facebook to experience very public attacks of the vapours.

But bear in mind the following: The 42% operating margin in the third quarter which gave 13% profit growth was after a 53% increase in costs. You could look at this as a glass half full or empty, but in its third quarter Facebook increased R&D costs by 29%, marketing and sales costs by 65% and general and administrative costs by 76%. You might see such a rise in costs as problematic, but I suspect that faced with a furore Facebook’s management has decided to very publicly spend a lot of money on data security and content control and to improve users’ experience. In doing so it has, a) depressed Facebook’s results, albeit to a still very acceptable level — showing great results whilst under such scrutiny might be a red rag to a bull, and b) built an even bigger barrier to entry for competitors. Ironically the response to the furore may just have cemented Facebook’s competitive position. I also note that at the time of writing, Facebook’s new political advertising transparency tools show that the UK government spent £96,684 on Facebook ads promoting Prime Minister May’s Brexit deal. Political attacks on Facebook have the look of a circular firing squad.

Similarly, Facebook’s capital expenditure doubled in the first nine months of 2018 to $9.6 billion, yet free cash flow in the third quarter was still 16% higher than it was a year ago. Yet Facebook is on an historic P/E of 19.7x — about the same as the S&P 500. Unless there is going to be a much more severe deterioration in Facebook’s operational performance than we have seen to date or reasonably expect, this looks cheap to us.

Also consider the following: Facebook makes no money from its social network users. It makes most of its revenue from online advertising, a business in which it has a virtual duopoly with Google. I strongly suspect that most people’s judgement of Facebook is based upon their personal experience and prejudices. But 69% of Facebook’s DAU and 73% of its MAU are outside the United States and Europe. How much do you think they care about allegations of misuse of data in a US election? Not much I would suggest which seems to be borne out by the fact that in the third quarter the number of DAU grew by 9% and MAU by 10%.

Facebook has yet to ‘monetise’ WhatsApp. I found it particularly amusing that one person queried our holding in Facebook using a message sent on WhatsApp. Who said the age of irony is dead?

Our Facebook holding has cost us some performance to date and no doubt it will continue to be a difficult stock to hold in terms of media attention, but we have often found that the only time you can hope to buy stock in great businesses at a cheap valuation is when they have a glitch.”


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