Terry Smith’s Owners Manual – 14 Filters For Purchasing A Great Investment

Few people in fund management can claim to be as iconoclastic as Terry Smith. For many of us at Marcellus, Terry is an inspiration of sorts given the common beliefs and backgrounds. First, Terry never pulled his punches as a sell-side analyst, most famously as an analyst at Barclays for having written a sell note on Barclays itself. Second, a penchant for forensic accounting – Terry wrote a controversial report ‘Accounting for growth’ (which later became a best selling book by the same name) talking about accounting frauds by listed companies, only to get fired by his then employer, UBS. Finally, for his outspoken views on the fund management industry’s shenanigans, especially the high fees and expenses resulting from heavy churn. Terry now runs FundSmith which manages over $20bn, where his candid newsletters and annual investor presentations continue to inspire. This blog attempts to summarise the key investing principles from his Owners Manual. We’ll highlight a few here but recommend reading the whole thing and if possible the manual itself:
“…We seek to invest in businesses whose assets are intangible and difficult to replicate
It may seem counter-intuitive to seek businesses which do not rely upon tangible assets, but bear with us. The businesses we seek to invest in do something very unusual: they break the rule of mean reversion that states returns must revert to the average as new capital is attracted to business activities earning super-normal returns.
We never engage in “Greater Fool Theory”
We really want to own all of the companies in the Fundsmith Equity Fund. We do not own them knowing that they are not good businesses or are over-valued in the hope that someone more gullible will come along and pay an even higher price for them. We wisely assume that there is no greater fool than us.
The businesses we seek must have growth potential
It is not enough for companies to earn a high unlevered rate of return. Our definition of growth is that they must also be able to reinvest at least a portion of their excess cash flow back into the business to grow while generating a high return on the cash thus reinvested.
We do not attempt market timing
We do not attempt to manage the percentage invested in equities in our portfolio to reflect any view of market levels, timing or developments. Getting market timing right is a skill we do not claim to possess. Looking at their results, neither do many other fund managers, but that does not seem to stop them trying.
We don’t over diversify
We do seek portfolio diversification, but the strictness of our investment criteria will inevitably leave us with a concentrated portfolio of 20 – 30 companies. We do not fear the concentration risk.
Our investments are liquid and the Fundsmith Equity Fund is open-ended
The companies we invest in have large market capitalisations without major blocks being held by controlling shareholders. Therefore their shares are easily tradeable. In addition, the Fundsmith Equity Fund is an OEIC, i.e. an open-ended fund.”