Key take-outs compiled by Reder van Rooyen (investment analyst at Dynasty)
- Metrics used in the investment process: As a precursor, the Fundsmith Equity Fund looks at the following metrics when identifying strong and resilient companies to invest in: Return on Capital Employed (ROCE), gross margins, operating profit margins, cash conversion and interest cover. As proof of their commitment to their investment process and decision-making framework they show how these metrics for their fund are far superior (twice as high in the case of ROCE and interest cover in particular), to two of the most widely used equity market indices; the S&P500 and the FTSE 100. As an investor, it is important that a fund manager remains steadfast in their investment approach that has a proven track record. This is especially true during turbulent market conditions where fund managers could fall victim to the ebb and flow of the market. Given the Fundsmith Equity Fund’s investment criteria it also means that companies in which it invests remain in the fund for long periods. Consequently, the Fundsmith Equity Fund displays low levels of portfolio churn and hence decreased Total Cost of Investment (TCI) from trading.
- ROE and its impact on long-term performance: The previous point also allows the fund to consistently benefit from strong performing companies. In their presentation they show how, historically, when looking at Return on Equity (ROE), companies that perform well tend to keep performing well, whereas companies that struggle in this regard are not generally able to change their fortunes. This characteristic can in part be explained by strong performing companies’ competitive advantage and the existence of barriers to entry that prevent major disruptions from new players. This is true despite some people’s views of an upcoming rotation and stretched valuations, which Fundsmith believes will cause some volatility but no meaningful long-term change in the performance of the companies in the fund.
- The investment case for Amazon: During the course of the pandemic there have been some changes to the composition of the Fundsmith Equity Fund, most notably the buying of Amazon shares. Amazon has, despite interest from all corners of the investment world, previously been seen by Fundsmith as an unattractive investment opportunity and one which has in the past failed to meet all the criteria put in place for the fund, mainly as a result of their retail business which served as a drag on overall returns of the company. Their perception of Amazon as an investment case changed in recent history, particularly as a result of the transition from first-party to third-party services in their retail business which now makes up some 60% of total sales, something which is still underappreciated by the market. More than just the volume of sales, third-party services’ characteristics are different to that of the first-party services. When it comes to the third-party services, working capital now sits with the principal vendor whereas in the case of first-party services it would have been carried by Amazon. The transition to third-party services is therefore crucial to Amazon as it has far more superior cashflow-return and profitability whereby it now only accounts for the commission earned on the sale of goods as opposed to accounting for the full value of the goods sold as is required in the first-party services. Along with the ongoing increase in strength of Amazon Prime and Amazon’s advertising business and solid AWS component (which has been the favoured segment from Fundsmith’s point of view), this has made for a much more compelling investment opportunity.
- Inflation risks and the relative resilience of the Fundsmith Equity Fund: Current market dynamics include prints of inflation higher than what has been experienced in recent history, especially in developed economies. It remains to be seen how various companies will deal with this somewhat sticky inflation (not transitory as was originally thought) and whether their performance would be materially hampered by its lingering presence. In Fundsmith’s Update Webinar, Terry Smith alludes to the fact that one of the contributors to higher inflation has been an increase in commodity prices. In the long-term however the correlation between commodity prices and CPI is weak to non-existent, and for certain commodities there even exists a slightly negative correlation. This, along with his feelings that supply chain bottlenecks will eventually gravitate back to normality and that the “great resignation” will come to an end, make him believe that in the long-term, we will move back to an environment marked by more benign inflation. Regardless, even with higher inflation, companies with greater gross profit margins, are able to deal with an increase in cost of goods and experience less of a deterioration in terms of profitability. Gross profit margin is one of the key characteristics considered by the Fundsmith Equity Fund, meaning a greater level of imbedded resilience for companies of the fund.
- Fundsmith’s performance trend over various interest rate cycles: Hand-in-hand with the inflation discussion, there has also been a lot of talk on rising interest rates by the Federal Reserve, which will definitely happen this year, and the impact that would have on markets and asset prices. At Fundsmith they concede that during periods of rising interest rates the fund tends to underperform relative to its value-strategy counterpart. However, once one moves past the noise of everchanging interest rates, the Fundsmith Equity Fund has handsomely outperformed on a cumulative basis if you take the past 11 years as an example (outperformance relative to the S&P value index of approximately 376% during this period stretching from November 2010 to January 2022).
- ESG and Fundsmith’s focus on fundamental sustainability: An extremely pertinent issue for modern investors is around the environmental, social and governance (ESG) implications of where and with who funds are invested. Indeed, in recent times, we have seen a shift in the way fund managers think about ESG, the metrics used to measure this and their overall responsibility not only towards investors, but also the society and the environment in general. The Fundsmith Equity Fund focuses on the so-called “fundamental sustainability” of the companies in which it invests. This places an emphasis on these companies’ organic growth rate, product innovation and research and development. Furthermore, academic research has also shown that when looking at the performance of ESG portfolios, 75% of portfolio outperformance is derived from traditional quality factors, consistent with Fundsmith’s views on the topic and their criteria for inclusion of companies in their fund. In short this means that, even though the Fundsmith Equity Fund does not explicitly use ESG metrics to make investment decisions, they are naturally accounted for in its everyday investment criteria and the fund stands to benefit from this in terms of performance.
- A side note on cryptocurrency: Another question which arises in the minds of investors is regarding the role of cryptocurrency. In this Update Webinar held by Fundsmith, an attendee asked whether cryptocurrency has the ability to disrupt the financial stability of the global economy, one which currently uses the US dollar as its reserve currency. This is particularly relevant given higher inflation, rising interest rates and the indebtedness of the US government and global economy as a whole, which is currently causing a lot of anxiety in markets. As we have noted in one of our previous commentary pieces, and similar to sentiments shared by Terry Smith himself, there is still some way for cryptocurrency to go before we can start thinking of it as a legitimate alternative to current fiat currencies. The main concern being its price volatility and hence uncertainty regarding its value from one day to the next, a major prerequisite for a potential exchange currency.
