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The Spectator - This time he's playing for keeps

May 04, 2011

For the outspoken Terry Smith, successful investing means never having to say ‘sell’

Terry Smith’s office is high up in Tower 42, formerly the NatWest tower, in Old Broad Street. It has a sweeping view over Docklands towards Essex, the neck of the woods with which he seems to be associated in the popular mind. This high-profile City figure’s image is that of a bruiser with attitude, who made good in the money markets through a series of ballsy deals and likes nothing better than a good scrap.

On his new blog, Straight Talking, you can read his denunciations of Labour spending and the ‘myths’ about Osborne’s cuts, particularly as reported by the BBC. While Smith wins friends and enemies in equal numbers with his forthright opinions, his saving grace in the financial markets is that he does not flinch from facing reality. He first made his name in the 1980s as the only banking analyst in London who dared put out a sell note on his own employer’s shares, and then wrote a book which exposed the accounting sleight of hand employed by some of his next employer’s best clients. Unsurprisingly that got him the sack, but it proved to be the making of his career.

Twenty-five years on, he turns out to be a trim, genial bloke in his fifties who bears more than a passing resemblance to the comedian Frank Skinner, but talks at about three times the speed. We meet shortly after the publication of Warren Buffett’s latest annual letter to his shareholders: Smith is a long-standing fan, and has modelled his latest venture, Fundsmith, on many of the principles which Buffett has espoused in his even longer career as professional investor and wiseacre. ‘I’ve been reading his letter since 1980 and one of the things I’ve noticed is that it’s easier to be humorous the richer you become. You start with the serious stuff and later you just tell jokes, and they love you for it.’

Having made a fortune from his broking businesses, Smith is wealthy enough to put £25 million of his own into his new fund, and is now inviting others to join him. Fundsmith is a simple global equity fund, consisting of just 20 to 25 stocks selected on Buffett-like principles. This means buying stocks with the intention of keeping them, rather than trying to ride the wave of the stock market. So he is looking for well-established self-financing businesses with high returns on equity and durable competitive advantages.

Smith opens his confident marketing pitch by pointing out that the pension fund at Tullett Prebon, the money-broking business where he is chairman, has been invested for the last few years in exactly the same way that Fundsmith will be run. With his advice, it has returned 14 per cent compound per annum, moving from a hefty deficit to a substantial surplus as a result, and comfortably outpacing the stock market.

The second part of his pitch, equally characteristic, is that virtually everyone else in fund management is doing it wrong. In his view, the sector is ‘broken and not fit for purpose’. He runs through a familiar charge sheet; most actively managed funds underperform the market; most fund managers ‘hug the index’ to avoid the risk of losing their jobs; and in the majority of cases the fees charged are way too high to justify the indifferent results.

And why are their charges all the same, he asks? ‘Bit suspicious, wouldn’t you say? Clearly there are elements of a complex cartel at work here.’ Valid though these strictures are, many others have tried to break the mould in fund management and come up short. Smith’s fund has taken in £77 million, including his own money, since its launch last November. It needs around £250 million, he reckons, to break even. His own annual management fee is a cartel-like one per cent per annum — the same as most other funds, once you exclude commission payments to financial advisers. Smith says he might bring that figure down once the fund gets bigger, but he’s careful not to make any promises.

Much depends therefore on the results the Fundsmith Global Fund can deliver. In an hour’s conversation about stock-picking, we talk at length about the ideal kind of business to invest in. Smith nominates pet food. Why? Because pet food is a classic example of a low-price, high-margin consumer business where the market is controlled by a small number of dominant suppliers and in which consumers ‘have no opportunity to renegotiate the price at the point of sale’. These are companies which are strong enough to earn consistent profits through the ups and downs of the business cycle, rarely if ever need to dun shareholders for extra capital, and are not threatened by technological change.

Smith has three of the owners of the world’s top five pet food brands, Nestlé, Colgate-Palmolive and Procter & Gamble, in his 23-stock portfolio, and did have four until Del Monte was bought by the private equity group KKR. ‘Resilient’ hardly does justice to the robustness of their profits: research shows, he points out, that pet owners ‘would stop feeding their children before they stopped feeding their pets’. Another business Smith likes is elevators and escalators, in which two companies, Otis and Schindler, dominate the market. They are good examples of companies whose economic value is not so much in their products as in the steady cashflow generated by repeat service and repair business. Medical equipment suppliers fall into the same category.

The rationale for the fund is that proven earners such as these, as well as making consistently high profits, remain relatively cheap, with an average free cash flow yield of more than 7 per cent. That’s well above the return on a medium-term government bond, the standard non-equity alternative, and the shares offer the promise of growth as well. They would still look cheap even if you allowed for the fact that bond yields have been artificially held down by recent hefty purchases by central banks — the policy of quantitative easing, the latest bout of which Smith regards as an expensive and pointless failure.

The last time large-cap quality stocks like those Smith favours were expensive was back in the 1990s. In Smith’s opinion, the market is pricing them incorrectly. Really great companies go on churning out profits for generations longer than the market expects. ‘The average company in my portfolio,’ he says with glee, ‘was founded in 1883. The great beauty of owning them is that you rarely need to sell them… The urge for me to fiddle with the portfolio is quite low.’

The Tullett Prebon portfolio has changed on average just one stock in its 25-stock portfolio each year. That keeps transaction costs to a minimum, and the new fund promises to do the same — which makes charging one per cent a year for minding the store what Arthur Daley might call ‘a nice little earner’. That said, don’t be surprised to see the fund outperform most of its competitors.

Jonathan Davis is the founder of Independent Investor

Jonathan Davis

The Spectator

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