Established in 2010, Fundsmith is the largest mutual fund in the United Kingdom with £18bn assets under management.
Led by its founder, Terry Smith, the fund has more than doubled the market since its inception nine years ago. Investors who invested with Fundsmith from the get-go have earned a total return of 353.2%, or an annualised return of 18.3%, as of 31 October 2019. Comparatively, global equities in general “only” returned a cumulative total of 171.1% over the same time frame, or 11.7% annualised.
Its impressive performance makes FundSmith the number one performing fund in the UK. From its inception to the end of 2018, Fundsmith had a cumulative margin of 13% over the second-best fund and 188% over the average for the sector, which delivered a market-lagging 81.9% cumulative return.
Although I am not invested in the fund, I am extremely impressed by the way Fundsmith is managed. Terry Smith’s annual letter to shareholders is also filled with insightful comments and timeless lessons that we can apply in our own investing. With that, here are some of the key takeaways from Fund Smith’s latest annual report.
Stop trying to time the market!
We are all too familiar with market commentators warning of an impending bear market. Smith says:
“I can now trace back six years of market commentary that has warned that shares of the sort we invest in, our strategy and our Fund would underperform.
During that time the Fund has risen in value by over 185%. The fact that you would have forgone this gain if you had followed their advice will, of course, be forgotten by them if, or when, their predictions pay off for a period. I suggest you don’t forget it.”
Legendary investor Peter Lynch once said that “far more money has been lost by investors preparing for corrections than has been lost in corrections themselves.”
If you find yourself worried that the bull market has run its course, it will be wise to remember these words of advice.
Growth versus Value
Fundsmith’s investment strategy involves buying and holding fast-growing companies. This strategy has outperformed value investing over the last decade. However, with growth stocks reaching rich valuations, some market commentators believe that value investing may come back in favour.
In his annual shareholder letter, Smith outlines two main handicaps he sees in the value investing strategy:
“One is that whilst the value investor waits for the event(s) which will crystallise a rise in the share price to the intrinsic value that has been identified, the company is unlikely to be compounding in value in the same way as the stocks we seek. In fact, it is quite likely to be destroying value.
Moreover, it is a much more active strategy. Even when the value investor succeeds in reaping gains from a rise in the share price to reflect the intrinsic value he identified, he or she needs to find a replacement value stock, and as events of the past few years have demonstrated, this is far from easy. Moreover, this activity has a transaction cost.”
Let time work its magic
FundSmith has a simple three-step investment strategy: (1) Buy good companies, (2) Don’t overpay, and (3) Do nothing.
While some actively managed fund managers may scoff at the idea of the third point, it is actually one of the key reasons why Fundsmith has done so well since its inception. Smith explains:
“Minimising portfolio turnover remains one of our objectives and this was again achieved with a portfolio turnover of 13.4% during the period. This is the highest level of annual turnover which we have undertaken to date, but it is still tiny in comparison with most funds.”
He adds:
“Why is this important? It helps to minimise costs and minimising the costs of investment is a vital contribution to achieving a satisfactory outcome as an investor.”
The low portfolio turnover ratio resulted in FundSmith having by far the lowest transaction costs among the 15 largest active equity funds in the UK.
In fact, Smith attached a table of the returns of the 15 funds over a 3-year and 5-year period and compared them to their transaction costs. There was, unsurprisingly, a strong correlation between funds with lower transaction costs and higher returns (With FundSmith sitting at the top of the pile).
Final Thoughts
Terry Smith has become one of the most successful fund managers of his generation. He has even been compared to the legendary Warren Buffett. From his investing principles above, it is easy to see why Smith has found so much success in an industry that has traditionally underperformed low-cost index funds. His guiding investment principals can also help retail investors invest better. If you want to read more of Terry Smith’s letters to shareholders, you can head here.
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