15th May 2013
Boring is best when it comes to stockmarket investment, says Terry Smith, founder of the fund management group Fundsmith. Jill Insley reports.
By boring, Smith means a “good” company. Not one that is possibly going to discover some great medical cure or develop the next generation of mobile device, or one that is in dire ﬁnancial circumstances and about to recover, but a company that is long established with products or services that meet a long and growing demand. The average company in his own portfolio was founded in 1902, and “has seen its way through two world wars and the Great Depression”.
Speaking at the Morningstar UK Investment Conference, Smith said that to qualify as “good”, a company must have a high return on capital employed in cash. “Why in cash? Because it’s the only thing you can pay for things with,” he said. “Call me old fashioned but once I own an investment I like it to send me cash.”
Why is the return on capital important? “Because if you invest in a company where the return on capital employed exceeds the cost of capital, every reporting period – every day, every week, every month, every quarter, every year…. it’s creating value for you every single day.”
In contrast investors who buy on the basis that they expect the company’s management to change or a new product to do well will lose money, every single day while they are waiting for this event to happen, if the cost of capital exceeds the return on capital employed.
Smith cited the airline industry as an example of this. On average the cost of capital between 2000 and 2010 was 7.5%, while the actual return was 2.8%. “It destroyed $20bn of value every year for investors. Owning an airline stock is an opportunity to do just two things: lose money and get upset,” he said. “How do these industries continue to exist? Well, you keep sending them money. Stop it!”
However, having a high return on capital is not enough in itself: the company must be able to reinvest some of that capital to compound value – to ensure growth going forward. They must be able to do this without requiring leverage. “I would never buy a company that makes a small unleveraged return and then applies a lot of leverage to get to a satisfactory result,” said Smith.
He also avoids stocks where he can be “blind sided” by swift developments in technology, and pays little attention to the strength of a company’s management team: “I’m a believer of the adage ‘Buy a business that can be run by an idiot, because sooner or later it will be’.”
Smith said he is frequently asked whether it is possible to make money from investing in “good” companies, particularly since the ﬁnancial crisis when their price has increased.
He pointed to analysis by Goldman Sachs, Paying for Quality: Is the market too cynical?, published in May 2012, which covers the top 1000-1200 stocks in the Goldman Sachs
Research database for the period from 2007 to 2012. The study deﬁnes quality on the basis of Cash Return on Cash Invested or CROCI, and “shows quite clearly that market returns increase with relative CROCI”.
Robert Pemberton, investment director for wealth manager HFM Columbus Asset Management, and Danny Cox, head of advice at independent ﬁnancial advisers Hargreaves Lansdown both agree that investment in quality companies, generating a high return on capital, should form the core of most investors’ portfolios.
“For too many people investment is about ‘trading’ or ‘speculation’ or ‘turning a quick buck’, but in reality it is about preserving and growing your wealth over your lifetime. Time and patience should be your allies and you should concentrate on companies that take the same viewpoint, have a sound long-term business model with strong ﬁnances, a predictable earnings stream and the ability to pay a rising dividend over time,” said Pemberton.
Pemberton added that reinvestment worked just as well for investors as it does for companies, and that its importance could not be over-emphasised. “The Barclays Gilt Equity Study of 2013 tells us that investing £100 in equities would produce a return of just £168 in real terms (that is after inﬂation) without the income reinvested,” he said. “But if you keep re-investing the dividends then the real return would be £24,184.”
Cox said UK equity income funds are probably the best example of a boring but sure sector: “Equity income funds invest in well run, proﬁtable companies which distribute most of their proﬁts in the form of dividends. The most famous is Neil Woodford’s Invesco Perpetual High Income fund, whose top ten holdings include the blue chip giants such as Astrazenica, BT Group, BAT and GlaxoSmithKline.”
Pemberton also uses Artemis and Threadneedle equity income funds, and added: “We also like the Fidelity Enhanced Income Fund which is full of ‘boring’ companies, but also uses a ‘covered calls’ derivatives overlay strategy to boost the yield to 7%, obviously very attractive given the minimal return from savings accounts and gilts.”
However he warned that the quality of the company should form only part of your investment criteria: “Equally important is the price you are paying for this company, and following the strong rally in these stocks, many are starting to look somewhat expensive so the rate of your returns may be diminished.
“Beware the company ‘priced for perfection’ with all the good news already discounted by the current sky high valuation.”