When we were growing up as analysts in the early years of this century, we used to read and re-read Terry Smith’s “Accounting for Growth” (first published in 1992) so as to learn from the great man how to spot accounting fraud in well known companies. Terry then went on to build and then sell (for billions of dollars) one of the world’s largest inter-dealer brokers. As analysts, we used to cover his company and that gave us one more chance to learn from him. Then in 2010, Terry began his third innings – he set up Fundsmith and became a fund manager. As the Investors Chronicle says, “Fundsmith Equity Fund has delivered an annualised total return of 18.4 per cent since its inception in November 2010, compared with 12.8 per cent for its benchmark MSCI World Index. It had assets under management of £27.9bn on 30 November 2021.”
Now, as fund managers we follow Terry Smith’s newsletters and podcasts and continue benefiting from his incredible clarity of thought (note: some of us in Marcellus are clients of Fundsmith). In this podcast, Terry explains “how he analyses and selects companies, how the rise of software has folded into his investment thinking and what trends he thinks currently look most promising. He also talks about…what spurred him to buy Amazon (US:AMZN) this summer.”
Some of the key takeaways from the podcast are given below:
  • The average investor – including the professional investor – does not read the accounts. Instead, he relies on the slides handed out by management and these slides omit/subtract out all the bad stuff. Terry gives an example of how in a year old set of IBM accounts, his colleague spotted a $1.9bn mistake in the cashflows. IBM said that no one other investor had spotted that mistake.
  • Terry places a lot of importance on the financial statements published by companies that have “proven themselves”. “It is the numbers that count in the end…I don’t need the management to tell me that ‘this is a wonderful business’. I will be able to see it in the numbers. I will be able to see the high ROCE, very high cash conversion, good gross & operating margin, etc…”
  • Terry believes in investing in good companies and “no amount of cheapness is going to” make a bad company good. [This is where we at Marcellus remain mystified by the approach taken by many investors investing in the Indian market.] “If you are long term investor it is very very important to invest in good companies.”
  • Once you have understood from the numbers that this is a good business, you then want to understand what the company does and whether it is a sustainable business. How does the company make money and fend off competition? How good are management in re-investing surplus capital? How capable is the management of continuing to re-invest surplus capital well rather than succumbing to the next brilliant idea they come across?
  • Terry meets management teams but prefers to maintain “some distance from management…we are not friends with management…we don’t need them to tell us the things we can figure out ourselves from analysis….we are not interested in knowing from management what will happen in the next 3 months because we are interested in the next 33 years.”
  • Every management of a successful company faces the following choice every year: reinvest, acquire or distribute surplus cash to shareholders. We are interested in how management makes this choice. What parameters does the management use to choose amongst these 3 alternatives?
  • Terry’s preferred valuation methodology is to look at FCF yield i.e. free cashflow (before dividends) divided by market cap. Terry then compares that figure with other companies in his investment universe and the broader market. Terry makes this comparison not just using current day figures but he also tries to make this comparison 5 years hence (sitting in the current day) i.e. Terry is factoring in growth in the FCF of the target company. Terry tries to see whether what he’s buying is “good value”. Terry is prepared to buy something with a low FCF yield today if his analysis tells him that the growth in FCF over the next 5 years will push the yield up. So Terry is effectively looking at “FCF yield + FCF growth” whilst valuing a company.
  • Terry believes that this business of forecasting future returns from stocks is a futile one. “I don’t spend a lot of time worrying about the macro….macro does not effect the way I invest.”
  • The rise of tech & software companies had made Terry re-evaluate how he assesses companies. In the old world, companies had hard assets on their balance sheet and one used to assess and value that. Good software companies have sticky businesses i.e. it is difficult for the customer to switch, say, from Microsoft. That stickiness is an asset which the analyst has to value. Another big difference between traditional companies and software companies is how capex-style investments are done – in a software company much of the spending on R&D or on marketing (i.e. creating intangible assets) is being done to enhance the future value of the franchise but these spends hit the current day operating profit (whereas in a traditional business it would have hit the balance sheet). So investors who compare Microsoft’s P/E with that of a traditional company are making a mistake (thanks to a apples vs pears comparison). Over the last 20 years, in the West, more capex is done by intangibles than via tangibles. Most fund managers have not been able to get their head around this.

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Note: the above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services. Marcellus Investment Managers is also regulated in the United States as an Investment Advisor.

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