5 Insights from Fundsmith in Outperforming the S&P 500 (Updated: 2024)

Recently, I read and studied the latest investment letter of Fundsmith for 2024.

Honestly, I wasn’t looking into investing in Fundsmith or any other unit trusts as I enjoy sizing up companies and making my own investment decisions. As a way to hone my investing skills, I like to read, learn and gain insights from how other successful investors and fund managers run their portfolios. 

Here, Fundsmith is chosen as it is a value investing fund which is outperforming the infamous S&P 500 by 5% per year. This is incredible considering 2 factors: 

1. The S&P 500 grew at a rate close to 11% per annum in 2015-2024. 

Source: Google Finance

2. According to SPIVA, 87.4% of unit trust funds in the US have underperformed against the S&P 500. It means that these funds failed to deliver 10% per year to their unitholders in 2015-2024. For these unitholders, they are better off if they leave their capital in an ETF that tracks the S&P 500 as the S&P 500 brought in a much better return at lower costs in 2015-2024. 

So, if Fundsmith is established in the US, it will be among the top 15% US funds. In 2015-2024, Fundsmith reported an annualised gain of 15%. This is impressive and I believe Terry Smith, the Founder & Manager of Fundsmith, is deserving of his accolade of being known as England’s Warren Buffett. 

The question is: “What’s his secret sauce?”. What are the strategies he employs in managing his £20+ billion fund? Well, they aren’t difficult to find or fathom. At his website, owner’s manual and investment letters, he had openly revealed his 3 recipes for his investment successes. 

They are as follows: 

1. Buy good businesses. 
2. Don’t overpay. 
3. Do nothing. 

It seems Buffett-like. But, the thing is Terry Smith is not Buffett himself. Hence, I read his letters to find out the context of the 3 recipes stated above. Of which, I believe you can adopt and replicate them when managing your stock portfolio. 

1. Buy Good Businesses

In its owner’s manual, Smith prefers businesses which earn “repeat businesses” from their customers. Rather than tangible assets, Smith identifies stocks which possess quality intangible assets such as brands, patents, market shares, and so on and so forth. Businesses that have a number of such economic moats should generate superior financial results to shareholders. Such are measured by 5 key financial metrics: 

1. Gross margin. 
2. Operating margin. 
3. Return on capital employed (ROCE). 
4. Cash conversion. 
5. Interest cover. 

In its investment letters, Fundsmith computed the average for the 5 key metrics stated for stocks in its portfolio (Fundsmith) versus stocks in the S&P 500. In the letters, Smith laid out clearly that Fundsmith stocks had: 

1. Earned $15-20 more in gross profits than stocks in the S&P 500. 
2. Earned $10-14 more in operating profits than stocks in the S&P 500. 

Plus, Fundsmith stocks had been more capital efficient in delivering profits. This is evident for the average ROCE achieved by Fundsmith stocks in 2015-2024 has been substantially higher at 28.8% as compared to the S&P 500 at 16.0%.

Smith places great emphasis on cash returns over accounting profits. It explains why he calculates cash conversion to measure the degree of profits delivered in cash. In his letters, I’d learnt that Fundsmith stocks have higher cash conversion than the S&P 500. This means Smith is intentional in investing in stocks that are consistent not just in growing earnings but also generating free cash flows.

Smith is not just about profitability and cash flow. He revealed his preference to stocks that are unleveraged (little or no debt). Such is assessed in interest cover and in the 10-year period (2015-2024), we could find that the interest cover for Fundsmith stocks are significantly higher than the S&P 500. It means that in the Fundsmith portfolio, its stocks can pay its interest costs more easily with profits generated from their businesses than the S&P 500.

2. Don’t Overpay

Smith values a stock based on its ability to generate free cash flow. The formula stated is “Free Cash Flow per share as a percentage of Share Price”. Such would be known as FCF yield. By using this metric, I find that Fundsmith is encouraged to invest in good quality businesses when their stock prices are lower. 

Imagine this. Let’s say we have a good quality business known as Stock A and in a particular year, Stock A generates $1.00 in free cash flow per share. 

If Stock A is trading at $25 per share, its FCF yield is 4% a year. However, if stock price has fallen to $20 a share, its FCF yield would be 5%, hence, becoming a lot more attractive as an investment. 

3. Do Nothing 

Is unit trust a long-term investment? 

The answer lies in the unit trust fund’s portfolio turnover ratio (PTR). Essentially speaking, a fund that has a low PTR is one which holds more of the investments in its portfolio for the long-term. Such a fund would buy or sell investments less frequently. The opposite is for a fund that has a high PTR. Such a fund would be more active in buying and selling investments, thus, is more like a trading fund. 

Investing success isn’t so much about the frequency in buying or selling stocks. 

More activities (buy and sell) don’t necessarily bring returns. But rather, activity costs money such as brokerage fees, stamp duties and bid-offer spreads. So, it’s more expensive (less cost efficient) to invest in funds that trade very actively. To Smith, he focuses on cost-efficiency by holding good businesses and trade less. 

For instance, Fundsmith has been a shareholder of Microsoft for 13+ years. The thing is – If Fundsmith is correct about Microsoft and Microsoft has delivered to shareholders consistent growth in net income (as shown below), it is in the best interest for Fundsmith’s unitholders to keep Microsoft in its portfolio. Such also includes bad times like COVID-19, trade wars, interest rate hikes, … and all sorts of macroeconomic factors.

Fortunately for its unitholders, Fundsmith did just that. 

Back in 2011, Microsoft was trading at US$ 25.96 a share. As the company grew its earnings, so did the stock price of Microsoft. Its stock price grew significantly to as much as US$ 466.25 a share. That is almost 18x from 2011. Brilliant. Could you tell me a unit trust fund that just focuses on accumulating good businesses, don’t overpay for them and boom! 18x capital in 13+ years? Plus, how about its quarterly dividends throughout this period? 

Source: Google Finance

Therefore, activity is not the key. Rather, the essence is to buy right and hold on (sit tight and do nothing) for the long-term. That is how wealth is compounded. For Fundsmith, such culture of “do nothing” is evident in its PTR as follows: 

Note: 
Notice that Fundsmith has some “negative” years when it comes to PTR. Such is a case when the cash inflow received by Fundsmith exceeded its lower figure of purchased / sold stocks during that year. 

Conclusion: 

Here is a takeaway. Let’s assume that I’m interested in beating the stock market
by investing in equities via unit trust funds. How do I choose such funds? Well, I learnt from Fundsmith that if I want to do so, the unit trust funds must invest in stocks that: 

1. Earn more gross profits than most stocks in the market. 
2. Earn more operating profits than most stocks in the market. 
3. Deliver more ROCE than most stocks in the market. 
4. Generate more free cash flows than most stocks in the market. 
5. Have higher interest cover than most stocks in the market. 

Also, these stocks must be purchased at attractive valuation (FCF yield) and also be held for the long-term. Apart from being cost-efficient, this could compound wealth significantly over the long-term. 

As an independent investor, where I am my own fund manager, these principles do apply. It isn’t just for Smith who’s running a £20+ billion fund, but also for all of us whose capital is significantly lesser ($2k, $20k, $200k, $2m, or $20m). This is not about capital size but rather the principles and philosophies in investing. 

Resources: Fundsmith

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