Investors can get easily distracted by the fascinating algorithm trading and quantitative investing in today's stock market. But for those who have less and less faith in Warren Buffett (Trades, Portfolio)'s value investing strategy to generate superior returns nowadays, Terry Smith, the founder of Fundsmith, has given quite valid lessons. Since its inception, the flagship Fundsmith Equity Fund managed by the so-called "English Warren Buffett (Trades, Portfolio)" has been consistently outperforming the market considerably.
The secret sauce? The simple BDD approach: Buy good companies, Don't overpay and Do nothing. This exactly echoes Mr. Buffett's strategy of "buying wonderful businesses at fair prices." The major difference lies in the size and structure. Being a mutual fund with a smaller amount of money, Fundsmith has a larger investable universe but only conducts minority investments.
If you attend or watch any of Smith's presentations, the slides below should look familiar to you.
This demonstrates how Fundsmith manages its portfolio in order to increase its chance of beating the market in the future. These metrics are calculated at the portfolio level periodically (if not in real time) and then compared to those of the benchmarks. Among them, six are regarding the quality (i.e., how wonderful is the business) as below:
- ROCE: indicates management's capital allocation skill.
- Gross margin: indicates the cost advantage (if any) and customer bargain power.
- Operating margin: indicates the operational efficiency and low-cost production (if any).
- Cash conversion: indicates the cash-generative capability.
- Leverage: indicates the debt level.
- Interest cover: indicates financial health.
And two are about the valuation (i.e., how fair is the price):
- Free cash flow growth.
- Free cash flow yield.
Here, we see that Smith intentionally avoids metrics like earnings growth, price-earnings ratio or Ebitda and focus on free cash flow, which is hard to "manipulate."
It is also worth noticing that the quality is always preferred over the valuation at Fundsmith. The only metric that lags behind the benchmark is the free cash flow yield. Long-term investors like Smith are definitely more interested in harvesting returns from the compounding effect of the growth in free cash flow rather than the multiple expansion.
As a result, Fundsmith's portfolio is filled with companies with high cash returns on capital protected by economic moats and growth driven from reinvestment of cash flows at attractive rates of return, such as Microsoft (MSFT), Facebook (FB), Intuit (INTU) and Idexx (IDXX).
Disclosure: I am/we are long Facebook. Mentioning of any stock in the article does not constitute investment recommendations. Investors should always conduct careful analysis themselves and/or consult with their investment advisors before acting in the stock market.
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