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The Telegraph - Why it is safe to pay up for quality

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Warren Buffett, the legendary investor, has described compound interest as the eighth wonder of the world. Understanding its effects is essential to success in investment. Yet it remains a mystery for many people.

The simplest illustration of this is to ask how long it takes to double your capital at 10pc a year compound return.

The whole point is that we are talking about compound returns in which the gains are added to the capital sum to which each successive period's rate of return is applied. Consequently, the answer is seven years. It only takes a compound return of 7pc per annum to double your money in 10 years.

How about this example: starting with £1,000, what is the difference in final capital from 30 years of investment at 10pc a year compound versus 30 years at 12.5pc a year? I ask this because it may represent a reasonable range of outcomes from an investment lifetime in which a person saves for 30 years before retiring then trying to live on the income from investments. The answer, rather surprisingly, is that the extra 2.5pc of compound return would double the final sum – so £1,000 invested would become £34,243 at 12.5pc as opposed to £17,449 at 10pc.

At Fundsmith, we only invest in companies which make high returns on capital employed; convert most or all of their profits into cash; have high profit margins; and which have proved resilient to economic cycles over many decades.

But the valuation of such companies has become a subject of concern to investors. Their valuations have risen through the financial crisis and the "Great Recession" which has followed. This is because they produce consistent performance from the provision of our everyday necessities and luxuries, and have an ability to grow in a world in which there has been little or no economic growth in contrast to most other sectors of the market.

Since the rise in their share prices has outpaced the rise in the companies' profits or cash flows in recent years, they are certainly more highly rated than they were, but that is not the same as being overvalued. While I accept that they are not as attractively valued as they were before this recent rise, I would suggest a study of compounding should perhaps give reason to pause before moving swiftly on to the presumption that as a result they should be sold or even avoided.

We don't often look at price to earnings (p/e) ratios, the traditional measure of value, at Fundsmith as we prefer to look at cash flows, but since almost everybody else uses them it is the simplest way of expressing the relative valuation of our portfolio, which currently has a p/e about two points higher than the market – the Fundsmith stocks are on about 21 times forecast earnings and the MSCI World Index is on about 19 times.

In judging what this implies there are a number of things which you should also be aware of, namely that not all earnings (the "e" in that ratio) are of equal value. The shares in the Fundsmith portfolio produce their earnings with significantly less capital intensity (hence their higher return on capital) than the market in general, and they deliver more of their earnings in cash, which is more valuable. Their earnings are also more predictable, which brings me back to compounding.

I have taken a look at how much you could have paid for some of these companies over the 30-year period between 1979 and 2009. In particular, I looked at Coca-Cola and Colgate Palmolive. In 1979 they had about the same rating as the market – 10 times earnings. But what could you have paid for them at that time in terms of p/e and still equalled the performance of the market over the next 30 years? The answer rather surprisingly is about 40 times earnings. Why? Because these companies' total returns grew at about 5pc a year faster than the market over this period, and rather like the earlier illustration of a 2.5pc differential in compound growth, this 5pc differential multiplied the final capital sum represented by their share prices four times faster than the market rose.

Of course, the next 30 years may be different. However, if I had to guess how it would affect this calculation it would be that companies like Coke and Colgate will fare even better in terms of growth given that cyclical stocks are unlikely to get a repetition of the growth that was stimulated by the credit bubble. It is also fair to point out that quality stocks may indeed not be expensive relative to the rest of the market but that both will prove to be expensive, particularly when interest rates rise. But even so, I suggest you consider how you might have reacted if someone had suggested you invest in Coca-Cola or Colgate at, say, twice the market p/e in 1979. In rejecting that idea you would have missed the chance to make twice as much money as an investment in the market indices over that period.

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Terry Smith

The Daily Telegraph