Key takeaways from "Investing for Growth" by Terry Smith

I have been introduced to Terry Smith and his fund by a friend of mine who shares core aspects of Terry’s investment philosophy and is a successful private investor himself. It took me some time and personal lessons (mostly painful) learned in the market to fully appreciate Terry’s approach. However, what I liked about it from day one is how elegantly he distilled his investment philosophy into just three points:

1. Invest in good companies

2. Do not overpay

3. Do nothing

As often happens, this simplicity is backed by decades of experience, hard work and lots of nuances behind each of the points. Although I still continue learning more about the approach, I believe Terry Smith’s book “Investing for Growth” (essentially a collection of articles and investor letters) provides a good overview of key ideas and stock selection methodology implemented by Fundsmith. Obviously, there is no “one size fits all” in investing, but Terry’s approach has a long enough history of decent performance (17.4% annualized returns since 2010) to pay attention to and to borrow ideas from.

I tried to group key ideas of the book into topics, inspired by the structure of Lawrence Cunnigham’s “Essays of Warren Buffet”.


Industries

• Fundsmith’s core focus - consumer staples

• Limit exposure to each sector since there is always a risk to be wrong

• Attractive characteristics of a product (example - pet food):

  • Small ticket: no credit required to purchase it

  • Consumer: large number of customers, not able to bargain on price, brand loyal

  • Non-durable: must be constantly replenished

• No bank stocks because it’s next to impossible to assess them based on financial statements (due to derivatives that are not fully disclosed). If you invest in banks, go for pure retail banks (take deposits, lend money to their own clients and make payments for them)

• No pharma stocks because the sector is often rated based on “underlying” earnings which exclude actual recurring expenses. Apparently, this has changed as Novo Nordisk is among the fund’s top-3 positions as of January 2022

• Some industries (e.g. airlines) have chronically low returns, but people still often bet on them hoping for entering at the right stage of the cycle, some specific company turnaround or other events that are hard to predict and time

• Franchisors are one of the best businesses because they get high ROICs as most of the capital is provided by franchisees

Stock selection criteria

• Not trying to predict the winners, just betting on those who have already won. Wait until the market misprices the shares of a certain winner

• Companies that offer superior product/service to their customers which leads to superior returns and keeps competition away

• Opportunity to buy good businesses cheaply may arise when they experience issues. Every company has a problem. Key is to determine whether these problems are temporary or an existential threat

• Predictability of the business (e.g. profiting from a large number of small, everyday predictable events)

• High cash returns on capital, the business distributes part of these returns as dividends and reinvests the remainder at high rates of return

• Ideally undervalued, at worst fairly valued

• Do not rely on a greater fool that could lead to higher prices

• Never invest in a business that requires leverage to earn an adequate ROE

• Investing in turnaround cases is hard because companies rarely improve fundamentally and such events are hard to predict

• Invest only in what you understand. Investors often struggle to determine what they understand narrowly enough

Metrics

• Key metrics used for stock selection:

  • Company age: old companies have proven their resilience (average year of foundations for fund companies: 1880-1920)

  • Gross margins

  • Operating margins

  • ROCE (Return on capital employed). Usually defined as (Cash operating profits / [Equity + Long-term liabilities]). ROCE should be above cost of capital, this means the company is creating value. Cost of capital is hard to determine, so you can just choose businesses with ROCE that exceeds any reasonable cost of capital. Over the long term the stocks performance tends to be close to the company’s return on capital

  • Conversion of profits into cash

  • FCF yield: not less than expected inflation+1%

  • Interest coverage (should show that the company is not excessively levered)

• Usually do not use P/Es because earnings quality differs (conversion of earnings into cash and capital required to get these earnings), prefer to focus on cash flows

• Growth is often achieved at the expense of returns on capital and doesn’t create shareholder value

• FCF growth is more reliable when driven by revenue growth, not cost optimization or share buybacks because they have limited potential. Growth cannot be fueled by cost cutting

Risk and reward

• Often investing in predictable high quality companies generates better returns than smaller, riskier, more obscure businesses. However, people seem to like making bold bets with high potential returns but low probability of success

• People often assume that a high return investment must be esoteric, obscure, difficult to understand and undiscovered by other investors. In reality the best investments are often the most obvious

• Higher risk ≠ higher returns. The least volatile 10% of stocks generated 8.7% returns while the most volatile decile lost 8.8%

• Possibility effect: new possible realities are overweighted in importance (e.g. new technologies)

• Certainty effect: strong desire for certainty leads to underweighing of near certainty. May explain why high quality “boring” stocks are consistently undervalued which leads to superior returns

• Stocks of low quality businesses may well outperform high quality businesses in a bull market, especially during recovery from a recession. But in the long-run high quality should generate better returns

• When you invest in poor quality companies, time works against you, when you invest in high quality companies it’s vice versa

• Many investors believe it’s better to be diversified across a number of low quality companies rather than be concentrated in a few quality companies

• Don’t overdiversify: 90% of diversification benefits can be obtained with just 20 stocks

• Large positive returns from a few stocks offset modest or negative returns from all the others. 5 out of 26,000 companies account for 10% of total wealth creation in 90 years. Just 4% of all companies account for all the wealth created

• Adding small and midcap stocks to the portfolio can increase returns while reducing risk

• Investing in emerging markets may be less risky if you invest in subsidiaries or franchisees of Western companies as it removes part of corporate governance risk

• Most companies trading at levels attractive for value investors are cheap for a reason - they are not good businesses (heavily cyclical, highly leveraged, low returns on capital, managements issues, etc)

• Buffett made a transition from a classical Graham-style value investor to a quality investor under the influence of Charlie Munger and Phil Fisher

• Classical value investing requires constantly redirecting capital into new stocks as share price converges with fair value

Valuation

• Low rated ≠ good value, highly rated ≠ poor value

• Many investors focus on finding cheap shares rather than finding good businesses. If you are a long term investor, investing in a good business determines a much higher portion of your future returns than buying shares cheaply

• Own higher quality companies at a valuation on par or slightly higher than market average

• Performance from multiple rerating is a finite game, FCF performance is a more reliable driver of stock performance

• 80% of S&P gains in the 20th century were generated not by changes in valuation but by earnings and their reinvestment

• No one got poor by taking a profit, but no one got rich either. In the long run it may be better to hold on to high quality stocks despite valuation overshooting from time to time

Financial statements

• Bad signs:

  • Lots of adjustments

  • Using euphemisms (eg “adjustments” instead of “extra costs” or “losses”) and vague words. Rule of thumb: never use an expression the opposite of which is nonsense (e.g. “selective acquisitions”, “forward planning”)

• Most investors don’t read financial statements and rely mostly on presentations featuring “adjusted” earnings

• Excluding intangible asset impairment and amortization may be valid, but this turns the P&L intro a hybrid of a P&L and a cash-flow statement

Management

• Don’t buy businesses that require a genius or a charismatic leader to lead them

• Shareholder value creation should be the result, not the objective of management

• Signals to watch:

  • Managers doing things which are different, exciting and outside their core area of competence

  • Capital allocation decisions

  • Reaction to poor performance of the business

• Fundsmith often meets management teams, but this is not the primary test of whether to invest into a business; key factor is the numbers that the business produces

• Fundsmith does not suggest management what to do because if management doesn’t know it themselves, investors are in trouble

Share buybacks

• Buybacks create value only if shares are trading below intrinsic value and there are no better uses for the company’s capital

• Most buybacks destroy value for remaining shareholders

• Buybacks are almost always regarded as a good move no matter what the price is

Dividends

• Bogle: during 81 years up to 2007 reinvested dividend income accounted for 95% of compound long-term returns of S&P 500 companies. Key point is that dividends are reinvested and the company continues to generate returns on the reinvested amount. But the majority of returns is generated by the company reinvesting its profits: when reinvesting dividends by purchasing shares you pay a premium to book value, while the company reinvests profits without a markup

• Berkshire never paid a dividend because Buffett believes that he can reinvest the profits to achieve better returns than the index

• Investors should maximize total return, not current yield. However, many focus on dividend income as it is perceived as a more safe way of taking out the money from the investment

• If you insist investing based on dividend income, a good idea might be investing alongside a family which founded and controls the company as they often rely on dividends

Activist shareholders

• Activists usually focus on short term changes, often sell the stock shortly after share price appreciation and may leave the long term shareholders with problems (e.g. new management team, spin-offs made/more debt/share buybacks at high prices, etc)

• Activists usually aim for share price appreciation, not shareholder value creation

• Activists often announce purchases of significant stakes but hold derivates which means they don’t need to commit that much capital

• Persuading the management to change the course is probably more effective via private discussions, while public attention is used mostly to create some public profile

• When a company announces revised financial targets, buybacks, acquisitions/disposals as a response to activism, this is not a good sign (why hasn’t the company done it before if it made sense?)

Fund management

• Fundsmith’s approach

  • Target: the best return adjusted for risk

  • Maximum 30 shares

  • Strives to have zero turnover

  • Always fully invested because market timing doesn’t work

  • Key sectors: consumer staples, some consumer discretionary products, healthcare, technology

  • 60% of portfolio in US companies

• Performance fees do not work because they take away too much of the return and encourage excessive risk taking. The fund manager should invest a major portion of his net worth together with you and on the same terms

• Hedge funds’ fees accounted for 86-98% of total returns earned in 1998-2010

• Most fund managers believe their greatest risk is underperforming the index/peers, not losing investors’ money

• No one can outperform in all market conditions. A fund’s performance should be assessed by seeing its results across a full economic cycle

• A common source of fund managers underperforming is changing their approach to investments (”style drift”)

• Investors almost always switch between funds and strategies at the wrong time

• Investment horizon should be minimum 10 years

• Fund managers often benefit from residing outside of financial centers, this way they avoid part of the noise

ETFs

• Daily compounding of returns means that an ETF’s return may significantly deviate from underlying asset or index returns in times of high volatility

• Some ETFs hold not the underlying assets but asset swap agreements which creates counterparty risk

• There is not limit to short selling an ETF because new ETF shares can always be created. As a result, ETFs may become heavily shorted (e.g. 1,000%), while those who are long these ETFs own not the ETF shares themselves but short sellers’ obligation to return ETF shares

• ETFs are considered the lowest cost instrument but they are among the largest profit contributors for some banks thanks to swap, custodian, prime brokerage and other fees

• Higher inflows into ETFs may lead to more inefficiencies in prices of specific stocks, thus creating more opportunities for active fund managers. However, higher inflows into ETFs also make it harder to outperform the indices

Psychology and decision making

• We are often defeated not by competition or difficulty of the task but by our own psyche

• A “no-brainer” is probably the most dangerous concept in investing

• When you get it wrong, 1) admit it (most importantly to yourself); 2) reverse the decision

• Waiting for the stock to hit a particular target before re-entering or cutting the loss is almost always a bad idea

• When you sell a high quality company stock you almost always regret about it later watching share price performance. Run your winners (while we often prefer to keep our losers and take profits in winners)

• There are two types of investors: those who can’t time the market and those who don’t know they can’t. Humans are hard wired to be bad at market timing: it feels very uncomfortable to be contrarian, especially in downturns. Money flows into markets and funds at exactly the wrong time (when they have risen) and vice versa

• Critics who believe quality companies are overvalued have been saying so for years, so even if they are right at some point, they missed all the returns up to that point

• Many investors don’t realize how narrow their circle of competence is

Macro

• There are many discussions and time spent on macro, interest rates, asset allocation, currencies, while most of these topics are hardly predictable and controllable. At the same time investing in good businesses is rarely discussed

• J.K. Galbraith (economist): “The only function of economic forecasting is to make astrology look respectable”

• Bull markets don’t die of age, they usually die from some external event, often rising interest rates. Bull markets do not broaden as they age, they narrow

• The best course of action for a bear market is just to ignore it. This way you can avoid forgoing gains. Even the best companies experience significant drawdowns from time to time, e.g. Berkshire was down >50% in 1973-75 and 2008-09; down 37% in 1987