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Terry Smith taunts rivals over 'bubble' warnings

Fund managers like Neil Woodford warning of stock market bubbles only 'demonstrate the difficulty in making predictions', says Fundsmith boss.

Terry Smith taunts rivals over 'bubble' warnings

Star fund manager Terry Smith has taken a swipe at rivals such as Neil Woodford who have warned of a stock market bubble, as he delivered another rebuke to critics who argue the stocks he buys are too expensive.

In his annual letter to investors, Smith, manager of the top-performing £13.4 billion Fundsmith Equity fund, said commentators had been predicting underperformance for the sort of stocks he favours, like the consumer staples companies labelled 'expensive defensives' by critics, for the past five years.

'During that time the fund has risen in value by over 175%,' he said.

'The fact that you would have foregone this gain if you had followed their advice will of course be forgotten by them if or when their predictions that our strategy will underperform their "value" strategy of buying cyclicals, financials and assorted junk pays off for a period.'

Smith argued the valuation of his fund's stocks were 'not all that much higher than the market, especially when their relative quality is taken into account'.

'Of course, all this may prove is that everything is expensive or at least highly rated, and there are plenty of pundits and fund managers who have indeed suggested that we are in a so-called "bubble" which will end badly with everything falling a long way,' he added.

'So far, they have only managed to demonstrate the difficulty in making predictions and implementing actions based upon them.'

Fund managers to have warned of elevated markets include Neil Woodford, who said at the end of last year that 'there are so many lights flashing red that I am losing count'.

Woodford's concerns have led to him focusing on one of the few areas of the market he believes is trading at cheap valuations: 'cyclical' companies focused on the UK domestic economy.

The performance of cyclical companies tends to be more affected by the economic backdrop, in contrast to defensive companies, judged to be better placed to withstand downturns.

But Smith argued that fears over a market downturn provided little justification for a move out of defensive stocks.

'Why will a basket of cyclical stocks and financials prove to perform better in these circumstances than a group of companies which are high quality and defensive in terms of supplying everyday consumables and necessities? The events of 2007-9 suggest that the opposite is true,' he said.   

Imperial stake stubbed out

In the letter to shareholders, Smith explained the rationale behind the sale of his stake in Imperial Brands (IMB), the tobacco company he has held since the launch of his flagship fund more than seven years ago.

Smith sold the stake in November last year and said he had become worried about the positioning of the cigarette company, formerly known as Imperial Tobacco.

'We had become increasingly concerned about the company's positioning in terms of its lack of exposure to the developing world and to the next generation reduced risk products such as heat-not-burn devices, all of which has led to volumes falling at a rate it is difficult to cope with,' he said.

'We were even more concerned by the management reaction which we literally could not understand.'

Imperial Brands reported a 4.1% decline in volumes in its 2017 financial year, as it announced small-scale trials of products that heat, rather than burn, tobacco.

But that came too late for Smith, as the company trails rivals such as Philip Morris International (PM.N), a top 10 holding for Fundsmith, whose heat-not-burn product is awaiting approval from the US Food and Drug Administration following successful roll-outs in Japan, Italy and Switzerland.

Smith's sale is all the more significant given his investment philosophy, which emphasises minimal portfolio trading and holding companies for the long term, and his enthusiasm for tobacco companies.

The manager has long argued that increasing government intervention in the sector, including bans on advertising and marketing, had served to strengthen its investment case, by effectively protecting existing companies given the large barriers to entry for new firms.

Smith's stance on Imperial Brands meanwhile puts him at odds with Woodford, another longstanding backer of tobacco companies.

Woodford has sold a number of tobacco companies from his LF Woodford Equity Income fund, such as British American Tobacco (BATS), Philip Morris International (PM.N) and Altria (MO.N), but has kept Imperial Brands as his top holding.

Imperial Brands was one of only two companies in Smith's concentrated portfolio, currently comprising 27 stocks, to lose him money in 2017.

The other was food business JM Smucker (SJM.N), which Smith also sold, in June last year.

'JM Smucker was a disappointment,' Smith said in his letter to shareholders.

'What attracted our interest was when JM Smucker acquired the Big Heart Pet Brands pet food business from private equity. We are keen on businesses which sell to pet owners, such as Idexx (IDXX.O), albeit indirectly, and we had made a very good return on the Big Heart business when it was owned by Del Monte (FDP.N).

'However, the outcome in terms of the margins and returns achieved on the business by JM Smucker proved to be disappointing and we were concerned by the management's reaction to this especially as JM Smucker is a family-controlled company.'

Smith bought one new company during the year: Intuit (INTU.O), a business software provider.

Smith describes his approach to investment as a three-step process: 'buy good companies; don't overpay; do nothing'.

The latter refers to his emphasis on minimising portfolio turnover by backing companies over the long term. Despite the sale of two portfolio companies in 2017, turnover stood at just 5.4% over the year.

Last year's changes to the portfolio are meanwhile in line with the strategy that has been employed in previous years. Since launching the fund in 2010, Smith has bought or sold at least two companies in each of the years he has been running it. 

'Fundamentally better' stocks

In tackling criticism that the stocks he buys are too expensive, Smith cited the free cash flow yield of his portfolio companies, which ended the year at 3.7%, below the average 3.9% for companies on the S&P 500 and 5.6% for FTSE 100 companies.

'Our portfolio consists of companies that are fundamentally a lot better than those in the index and are valued more highly than the average FTSE 100 company and slightly higher than the average S&P 500 company,' he said.

'In the case of the FTSE 100 index this is because the valuation of the index is dominated by what I would regard as uninvestable companies like Anglo American (AAL) and Centrica (CNA) which traded on free cashflow yields of around 15% as at 31 December 2017.'

'They may be lowly rated but that does not mean that they are necessarily cheap given their poor quality.'

He pointed to his portfolio stocks' higher return on capital employed, at 28% last year versus 15% for the S&P 500 and 14% for the FTSE 100, as evidence of their better quality. 

Fundsmith companies meanwhile boasted average operating margins of 26% versus averages of 13% for both S&P 500 and FTSE 100 stocks, and borrowed less, with leverage of 37% versus 52% and 46% for the US and UK indices respectively.

'Moreover, their average level of borrowing is significantly lower than it was when we started the fund. The world at large may not have de-geared much but the companies in our portfolio have,' he said.

Last year saw Smith deliver another sold performance for the fund, which rose 22% versus the 11.8% delivered by the MSCI World index. 

Since its launch in November 2010, the fund has returned 262% to the end of last year, nearly double the 135.5% from global markets.

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Terry Smith
Terry Smith Average Total Return:
11/480 in Equity - Global (Performance over 3 years)
Neil Woodford
Neil Woodford Average Total Return:
91/91 in Equity - UK Equity Income (Performance over 3 years)

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