Terry Smith, serving as the founder and CEO since 2010, leads Fundsmith, an investment management company based in London. As of 2022, Fundsmith has successfully managed assets totaling 35 billion GBP.

He is known for his fierce competitiveness, a trait that extends beyond his professional life into activities like cycling uphill in the French Alps and kickboxing. His career in financial services spans over four decades, during which he has been known for his principled stands and formidable success. Smith has a reputation for being as formidable as “Smokin’ Joe” in outperforming competitors. He is particularly critical of those he perceives as guilty of incompetence, obfuscation, or misleading investors through sophisticated marketing or creative accounting. Smith champions the concept of “quality” in investments, which he believes is synonymous with true value. In this article, I will share some of his most interesting and insightful letters from 2010.

“Share buybacks — friend or foe?”

Terry Smith’s commentary on share buybacks in the context of company performance and shareholder value is quite insightful and critical. He points out several key issues and suggests necessary changes:

• Impact on Earnings Per Share (EPS): Smith highlights that companies often use share buybacks to artificially inflate their EPS. This practice can mislead investors into believing that the company has created value when it may not have. The reduction in the number of shares outstanding increases EPS, but this doesn’t necessarily reflect an improvement in the company’s fundamental performance.

• Understanding and Analysis of Share Buybacks: He notes that both investors and company management may not fully understand the implications of share buybacks. This lack of understanding can lead to poor capital allocation decisions, which are crucial for shareholder value.

• Value Creation Criteria: Smith emphasizes that share buybacks only create value if the repurchased shares are trading below their intrinsic value, and there are no better alternatives for using the cash. Unfortunately, he observes that most share buybacks do not meet this criterion and end up destroying value for the remaining shareholders.

• Accounting Practices and Transparency: The current accounting treatment of share buybacks, according to Smith, obscures their true impact. This lack of transparency allows management to conduct buybacks without adequately justifying them.

• Proposed Changes: (1) Management should be required to justify buybacks by comparing the price paid and the implied return with other potential uses of the cash. (2) Share buybacks should be analyzed with the same rigor as if the company were investing in another company’s shares. (3) Instead of just looking at EPS, investors and commentators should use return on equity to assess the impact of share buybacks. (4) Extra scrutiny is warranted for buybacks conducted by companies whose management’s incentives are tied to EPS growth. (5) He suggests a change in accounting for buybacks, proposing that repurchased shares should remain part of shareholders’ equity and be considered an equity-accounted asset on the balance sheet.

Overall, Smith calls for a more nuanced and critical approach towards share buybacks, emphasizing the need for better understanding, analysis, and transparency to ensure that they genuinely contribute to creating shareholder value.

”Exchange-traded funds are worse than I thought”

Smith begins by evaluating the performance of the Fundsmith Equity Fund. From November to December 2010, the fund rose by 6.14%, underperforming the MSCI index but outperforming the MSCI EAFE and FTSE 100. He notes that benchmarks are useful for measuring performance over long periods, but problems arise when fund managers use them for portfolio construction. He emphasizes that Fundsmith does not track any index or minimize tracking error, indicating a clear stance against passive investment strategies that closely follow market indices.

He highlights the success of specific investments, such as Del Monte Foods, to illustrate the type of products Fundsmith invests in — small-ticket consumer non-durables like pet food, which show resilience and consistent demand. This investment approach emphasizes understanding the business and its market rather than short-term market trends.

The main critique in the letter is directed at ETFs. Smith raises concerns about the rise of ETFs, particularly the misunderstanding and misuse of them. He points out that while some ETFs are similar to index funds, many are not, leading to potential misunderstandings among investors. He is particularly critical of synthetic ETFs, which use swap agreements instead of directly holding assets. The risk of counterparty default, as seen during the Credit Crisis, is a significant concern with such ETFs. Additionally, Smith is wary of the performance divergence in synthetic ETFs when they are used to access inaccessible markets or those with poor liquidity.

He also notes the risks associated with leveraged and inverse ETFs, which have their returns compounded daily. Smith presents tables to illustrate how in volatile markets, these ETFs can result in significant losses, even if the underlying index’s performance is positive or neutral. This issue is exacerbated in leveraged inverse ETFs, which can lead to even more significant losses.

”Return-free risk — why boring is best”

Smith plays on the phrase “risk-free return” to challenge conventional investment wisdom. He notes that before the financial crisis, the idea of “risk-free return” was commonly associated with sovereign debt in developed countries, reflecting a belief that such investments were secure and free from risk to the principal amount.

Smith then critiques the efficient-market hypothesis (EMH), which claims that financial markets are efficient in the sense that higher returns can only be obtained by taking on more risk. He presents evidence contradicting this view, citing research by Robert Haugen and Nardin Baker which found that the least volatile stocks achieved better annual returns compared to the most volatile ones. This challenges the EMH’s risk-return principle. Further, a study by Goldman Sachs on fundamental quality, measured as cash return on cash invested (CROCI), showed that portfolios based on CROCI performance tended to yield higher market returns, suggesting that fundamentally strong companies can be better investments.

”Ten golden rules of investment”

Smith outlines ten golden rules of investment that provide valuable insights for individual investors. These rules are designed to help investors avoid common pitfalls and leverage their unique advantages over larger institutional investors. With that said, I will highlight 5 rules that Smith discusses in-depth about.

Market timing: don’t try this at home

In his letter, Terry Smith provides a detailed explanation of market timing, highlighting its complexities and the common misconceptions surrounding it. He defines market timing as the strategy of buying assets at their lowest price points and selling them at their peak, applicable to both individual stocks and the broader market. While this approach might seem advantageous, Smith points out that it is extremely difficult to execute successfully. He notes that most investors, including professionals, tend to invest when markets have already risen and withdraw when they have fallen, effectively doing the opposite of what effective market timing requires.

Smith delves into the psychological challenges inherent in market timing, emphasizing the difficulty of making contrarian investment decisions. Selling when the market is optimistic and buying during pessimistic phases requires a rare combination of conviction and flexibility. He illustrates the potential pitfalls of market timing with an example from the S&P 500 Index, showing how missing just a few of the market’s best days can significantly diminish investment returns. This underscores the risk associated with attempting to predict market movements and the improbability of consistently identifying optimal investment days.

He categorizes investors into two groups: those who acknowledge the futility of trying to profit from market timing, and those who haven’t yet realized its impracticality. He advocates for a focus on investing in high-quality companies, suggesting that for such investments, the timing is less critical than the quality of the assets.

Sorting the wheat from the chaff

Terry Smith’s discussion on Return on Capital Employed (ROCE) sheds light on an often-overlooked yet crucial metric in evaluating “good companies.” He emphasizes that while investment research typically focuses on earnings growth or earnings per share valuations,

ROCE, which is the cash operating profit divided by the sum of shareholders’ equity and long-term liabilities, does not receive the attention it deserves. This neglect is significant because ROCE offers a comprehensive view of a company’s operational efficiency and profitability, unlike metrics solely focused on profit or earnings growth. Smith argues that understanding the returns a company generates on its capital (ROCE) is crucial for investors, akin to knowing the expected rate of return on any other investment like a fund, bond, or bank account.

Companies with a ROCE higher than their cost of capital are creating value for shareholders, while those with a ROCE lower than their cost of capital are destroying value. This distinction is vital for assessing whether a company is genuinely creating value or just appearing profitable. Despite the challenges in assessing ROCE, such as determining the cost of equity capital, Smith asserts that investors should focus on companies whose ROCE significantly exceeds any feasible estimate of their cost of capital. He critiques fund managers who invest in industries with historically poor returns, using the airline industry as an example where the overall ROCE often falls below the cost of capital, leading to value destruction.

Investing in companies with high ROCE means that time works in the investor’s favor, as these companies are growing their intrinsic value almost daily, independent of market cycles or external events. Smith also references Warren Buffett, who highlighted ROCE as the primary performance metric in his 1979 letter to Berkshire Hathaway shareholders, expressing surprise at how such advice from a successful investor is often ignored in the investment community.

Never invest just to avoid tax

In his commentary, Terry Smith addresses a critical issue in investment strategies, particularly focusing on the temptation to invest primarily for tax relief rather than genuine interest in the underlying assets. He highlights the use of investment “wrappers” like individual savings accounts (ISAs) and self-invested personal pensions (SIPPs), which offer significant tax benefits such as no tax on capital gains or dividends in ISAs, and tax relief on SIPP contributions. These vehicles allow for a range of investments, including stocks, cash, mutual funds, and commercial property. However, Smith warns against the tendency to invest mainly for tax advantages, especially in enterprise investment schemes (EISs), film finance schemes, and venture capital trusts (VCTs). He notes that these schemes often attract investors more interested in avoiding or deferring tax than in the highly specialized investments they entail.

Smith further questions the prudence of investing in certain assets just for tax benefits, like unquoted companies with less than £15m of gross assets (required for EIS or VCT qualification) or even in the film industry, citing Disney’s significant loss on the movie “John Carter” as an example. He argues that the allure of tax avoidance can lead investors to overlook other critical factors, such as high fees associated with these investments. He found that EISs and VCTs could have initial fees ranging from 2% to 7.5%, annual charges of 2 to 3%, and performance fees of about 20% on any gains.

Moreover, Smith highlights a common misconception promoted by managers of tax-based investments. They often encourage investors to focus on the returns after tax relief, like the effective return on the 70p of each £1 invested after a 30% income tax relief, without considering that the tax relief is from the taxman, not the investment manager. Smith points out that the manager had the full £1 to invest before fees, emphasizing that the tax relief shouldn’t distract from the actual performance of the investment.

Too many stocks spoil the portfolio

Smith’s commentary on portfolio diversification provides a critical analysis of the concept, especially in the context of modern portfolio theory. He acknowledges the intuitive and theoretical appeal of diversification, which is grounded in the idea that a collection of investment assets carries lower risk than any individual asset. This reduced risk is possible because different types of assets often change in value in opposite or different ways.

However, Smith argues that portfolio diversification requires more than a superficial examination to avoid unintended or poor results. He introduces the concept of covariance, a measure of how returns on assets move in relation to each other. A positive covariance indicates that returns move together, while a negative one means they move inversely. The lower the covariance number, the less risk there is in the portfolio. He notes that the covariance of a portfolio of FTSE 100 stocks decreases as the number of stocks in the portfolio increases. However, this reduction in risk does not happen linearly. The risk reduction is significant when a portfolio increases from one stock to about 20 to 30 stocks, but beyond this range, most of the achievable risk reduction has already been realized.

Smith highlights a critical flaw in over-diversification, terming it “diworsification,” a concept coined by Peter Lynch. This occurs when a portfolio is excessively diversified, leading to a dilution of quality and knowledge about each investment. Over-diversification can cause the performance of a portfolio to merely match that of the benchmark or index it is composed of, negating the benefits of active portfolio management. This situation is particularly problematic when considering the high fees associated with active management. He questions why many fund managers maintain portfolios with far more stocks than necessary for optimal diversification, citing a study that showed the average mutual fund manager owned a portfolio of 90 stocks, with the top 20% most diversified managers owning an average of 228 stocks. Smith suggests that this trend among fund managers is more about aligning with peers and avoiding criticism rather than optimizing investment performance.

Keep a lid on costs to protect your investment

This time he provides valuable insights into the fundamentals of investment, with a primary focus on the critical role of cost control in achieving successful returns. Smith emphasizes the need to abandon market timing in favor of a long-term investment strategy centered on acquiring shares in high-quality companies and holding them. He cautions against making investment decisions primarily to minimize taxes, urging investors to prioritize building portfolios that maximize potential gains.

Smith also warns against over-diversification, highlighting that spreading investments too thin can be counterproductive. Instead, he advocates for concentrating on quality holdings. The core message of the letter revolves around the impact of investment costs on returns. Smith breaks down the various fees and expenses that investors may encounter, including financial advisor fees, platform costs, annual management charges for mutual funds, and hidden costs related to trading within the fund.

He underscores the existence of undisclosed costs associated with trading within mutual funds, which can significantly erode returns. Smith references a study suggesting that these hidden costs could amount to as much as 1.4% annually. He also raises the concern that high charges can absorb more than 100% of the expected income on portfolios, emphasizing the need for cost-conscious investment strategies.

Smith cites John Bogle’s insights on the significance of reinvested dividend income in long-term returns, further underlining the importance of preserving income in an investment strategy. To reduce charges, he recommends minimizing intermediaries between investors and their stocks and considering lower-cost index funds.

”If they use these words, don’t buy their shares”

This letter provides a thought-provoking commentary on the misuse of certain words and phrases within the financial and corporate world. Through his decades of experience in financial analysis, Smith has observed a trend where words are used to either obfuscate problems or inflate the image of companies. He argues that this practice can mislead investors and create a disconnect between the reality of a company’s performance and the language used to describe it.

One of the key points Smith makes is the misuse of the word “leverage.” He points out that while leverage has a legitimate financial meaning related to borrowing, it should not be used to describe borrowing when it is being used in a context where it does not apply. In this case, Walmart’s use of “leverage” to describe learning from Asda’s online grocery delivery experience in the US is seen as an abuse of the term. Smith argues that this misuse of language can be a red flag for investors, especially when it coincides with negative financial results.

Smith categorizes these problematic words and phrases into several groups. The first group comprises words that are used beyond their original purpose. He gives examples such as “runway” and “key,” suggesting that these words should only be used in their literal sense. Using such terms metaphorically can lead to confusion and a lack of clarity in communication.

The second group includes words that are used to sound profound when simpler alternatives exist. Smith points out that terms like “granular data” can often be replaced with the simpler word “detail.” This choice of language might be an attempt to make information sound more sophisticated than it actually is.

Smith also highlights the use of expressions with a pejorative or critical tone, such as referring to a pension fund as a “pot.” He suggests that using such terminology can bias perceptions and lead to negative reactions.

In addition, Smith advises caution when encountering expressions like “reaching out” or “to be honest,” as they may raise questions about honesty and authenticity. He also expresses skepticism about organizations run by “steering committees,” implying that such committees may lead to ineffective decision-making.

One of the most interesting aspects of Smith’s commentary is the concept of “Smith’s Law,” where he argues that expressions should not be used if their opposite is nonsensical. For example, he questions whether anyone would admit to a policy of “indiscriminate acquisitions” when discussing a strategy of “select acquisitions.” This observation highlights the importance of using language that accurately reflects an organization’s intentions and actions.

Smith also touches upon the issue of hyperbole, particularly the overuse of the word “global.” He argues that very few businesses are genuinely global, and using the term in job titles often represents status inflation. This highlights the importance of using language that accurately reflects a company’s scope and reach.

Towards the end of the letter, Smith discusses his investment approach at Fundsmith, emphasizing the importance of focusing on a company’s actual results rather than relying on management’s self-assessment. He highlights Domino’s Pizza as an example of a company that openly acknowledged its shortcomings and used customer feedback as a catalyst for improvement, ultimately leading to a successful turnaround.

”What did you invest in before the war, great-grandpa?”

Smith’s letter reflects on the changes in the constituents of the stock market over the course of a century, particularly focusing on the differences between the Dow Jones Industrial Average in 1914 and its present-day counterpart. This commentary will explore Smith’s observations and conclusions in more depth.

Firstly, Smith highlights the challenge of assessing the transformation of the stock market over a century because most of the major stock market indices were established long after 1914. For instance, the S&P 500 Index, which is now one of the most significant equity benchmarks globally, was introduced in 1923 and has evolved over time. The FTSE 100, a prominent index in the UK, came into existence in 1984, and even the less representative FT 30 share index was not introduced until 1935.

The only exception to this timeline is the Dow Jones Industrial Average, created by Charles Dow in 1884, with ten companies in its original composition. By 1914, when World War I began, it had expanded to include ten companies. In contrast, today it comprises 30 companies.

One key insight from Smith’s analysis is the shift in the composition of the Dow constituents over the century. In 1914, the index primarily consisted of heavy industrial companies, particularly manufacturers of basic materials used by other manufacturers. Only one company, General Electric (GE), remained in both the 1914 and contemporary lists, illustrating the radical changes in its business focus over the century. In 1914, GE was primarily involved in basic manufacturing, but today, almost half of its revenues come from aero engines and financial services, sectors that did not exist back then.

Furthermore, Smith highlights that only two of the 1914 companies, Amalgamated Copper and Central Leather, have ceased to exist entirely. The others have faded from prominence and no longer feature in any significant stock market indices, except for US Steel, which has struggled to generate profits since 2008.

In contrast, today’s Dow Jones Industrial Average is dominated by companies from diverse sectors. Financial services, technology (hardware, software, and services), healthcare, and consumer goods have become the prominent sectors. There are also representatives from the oil industry, retail, telecommunications, aerospace, and entertainment sectors. This shift in sector representation reflects the evolution of the US economy, transitioning from an industrial focus to a more diverse, post-industrial economy with a growing reliance on financial services, consumer goods, and healthcare.

Smith concludes with a touch of humor, suggesting that investing for a century is unrealistic, as very little remains unchanged in the world of equity investment over such a prolonged period. The example of the Dow’s constituents from 1914 illustrates this point. Instead, he suggests that investing in companies that have risen to the top of the Dow in terms of market capitalization would have been more profitable over time, even if some of these companies expanded partly by issuing large amounts of equity with inadequate returns.

”Shareholder value is an outcome, not an objective”

He begins by defining shareholder value as the ability of a company to generate a sustained return on capital employed (ROCE) above its cost of capital. Smith then delves into the common practices of activist shareholders and their impact on long-term investors.

Smith outlines the typical modus operandi of activist shareholders, which involves acquiring a stake in a company, campaigning for change, and subsequently profiting from the share price increase resulting from their actions. He argues that this approach may be beneficial for activists but can be detrimental to long-term investors who seek to own shares that appreciate in value over time. The problems stem from the confusion between creating shareholder value and merely increasing the share price.

The core issue Smith raises is that short-term share price movements often become the primary objective for many activists, leading to future problems for the business and its long-term shareholders. This observation highlights the potential misalignment of interests between activists and traditional long-term investors. Activists prioritize actions that lead to immediate share price gains, while long-term investors may suffer from fragmented businesses, changes in management, increased leverage, and complex financial statements.

Smith’s critique extends beyond activist shareholders. He highlights that even proponents of shareholder value, who share his perspective on how to measure it, can fall into the trap of prioritizing financial ratios like ROCE as objectives rather than outcomes. Executives may focus solely on improving ROCE by increasing operating profit (potentially at the expense of market share), cutting costs (which may hinder growth), and reducing investments in research, development, and marketing (leading to long-term detriment).

Another problematic target, according to Smith, is the fixation on earnings per share (EPS). He criticizes the prevailing trend of share buybacks driven by a desire to boost EPS, even when it doesn’t necessarily make the shrunken share base more valuable. Smith emphasizes that EPS doesn’t consider the capital required to generate it or the return on that capital, making it an incomplete metric for assessing true shareholder value.

Smith uses IBM as an example of misconceived actions aimed at boosting shareholder value metrics. IBM set an EPS target of $20 per share by 2015 but fell far short, with earnings of only $10.76 in the first three quarters of 2014. Smith questions the wisdom of such goals, pointing out that EPS targets can be misleading because they don’t account for capital efficiency or return on investment.

He highlights that IBM’s strategy included revenue growth, cost-cutting, and share buybacks, but these actions are not high-quality sources of growth, particularly as cost-cutting and share buybacks have limits. Smith ultimately argues that the creation of shareholder value should be an outcome rather than an objective, emphasizing the importance of focusing on sustainable business practices that generate long-term returns.

In summary, Terry Smith’s commentary raises essential questions about the pursuit of shareholder value, the role of activists, and the potential pitfalls associated with specific metrics like ROCE and EPS. His perspective challenges conventional thinking and encourages a more holistic approach to assessing a company’s long-term value creation.

”Three steps to heaven”

Terry Smith’s investment philosophy, as outlined in his letter, provides valuable insights into the principles that guide the Fundsmith Equity Fund. Smith’s approach to investing is built on three core principles: invest in good companies, don’t overpay, and do nothing. Each of these principles carries important implications for investors and serves as a solid foundation for long-term investment success.

Invest in Good Companies

Smith’s first principle emphasizes the importance of investing in companies that consistently create value for their shareholders by generating returns on capital significantly above their cost of capital. Return on capital is a key metric that measures a company’s ability to generate profits relative to the amount of capital invested in the business. The cost of capital is the hurdle rate that a company must exceed to create value for its shareholders.

Smith correctly points out that not all companies are capable of achieving returns above their cost of capital. Some industries, like the airline industry, have a history of struggling to generate adequate returns. The lesson here is that investors should be selective in choosing companies for their portfolio and focus on those with a proven track record of creating value.

Moreover, Smith highlights that many fund managers invest in underperforming companies with the hope that they will turn around. However, this waiting game can erode shareholder value over time as these companies continue to underperform. This emphasizes the importance of investing in companies with a strong competitive advantage and a history of profitability.

Don’t Overpay

Smith’s second principle is a reminder that buying shares in good companies is not enough; investors must also be mindful of the price they pay. While the goal of investing is often described as buying low and selling high, Smith argues that if you are investing in fundamentally sound companies with a long-term perspective, the emphasis should be on buying quality rather than timing the market.

He cautions against adopting the “greater fool theory,” where investors knowingly overpay for shares, hoping that someone else will buy them at a higher price later. This approach can be risky, as it relies on finding a greater fool willing to pay an even higher price. Smith’s approach instead encourages investors to focus on the intrinsic value of a company and only invest when the price represents a reasonable valuation.

Do Nothing

The third and perhaps the most challenging principle in Smith’s philosophy is the idea of “doing nothing.” In an industry where activity and trading are often seen as indicators of a fund manager’s expertise, Smith advocates for a more passive approach. He suggests that investors should resist the urge to trade frequently, as such activity can incur costs in terms of commissions, bid-offer spreads, and other transaction fees.

”Who needs income?”

This letter delves into the allure of dividend income in the realm of investing and the tendency for investors to abandon common sense or be encouraged to do so by the investment industry. He begins by questioning the widely held notion that the majority of returns from equity investments come from reinvesting dividends, arguing that retained profits, not reinvested dividends, generate the most value for shareholders. Smith then highlights the tax implications of dividends and the fact that reinvesting dividends often results in acquiring additional shares at market prices, which can be disadvantageous.

In contrast, retained earnings remain untaxed and contribute to a company’s capital at book value, leading to more favorable returns for shareholders through compounding. He uses Warren Buffett’s Berkshire Hathaway as an example of the benefits of retaining earnings over paying dividends. Smith emphasizes that equities have a unique advantage in allowing automatic reinvestment of company-generated returns, which is not present in other asset classes.

Smith also questions the popularity of income funds, which focus on delivering dividend income, despite potential disadvantages. He criticizes the criteria for inclusion in the Investment Association’s Equity Income sector, where funds only need to exceed the FTSE All-Share Index yield by any amount over a three-year period to qualify, allowing funds to retain the “income” label even when their strategies may not prioritize long-term growth.

He advocates for an alternative approach where investors prioritize maximizing total return and redeem units as needed during retirement, citing the MSCI World Index’s outperformance over the High Dividend Yield (HDY) subset as evidence that high-yield stocks may not always be the best choice for long-term growth. Smith observes that the fear of reducing the capital sum often leads investors to favor high-yield stocks, potentially resulting in suboptimal investment decisions.