Fundsmith Equity Fund
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This is Money - Firms which provide good products or services are key to investing, says Fundsmith boss

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When it comes to generating good returns, the most important thing is quality.

The Fundsmith Equity Fund celebrated its fifth anniversary this week. When we started, it was with the aim of providing the best fund you could invest in with the highest return adjusted for risk.

To attain this we needed to invest only in good companies.

By this I meant businesses that have a long track record of high profitability derived from providing good products or services and strong market positions.

It may sound blindingly obvious to say you only want to own things that are high quality, but in the investment industry it is not, and as the famous investor Sir John Templeton said: ‘If you want to have a better performance than the crowd, you must do things differently from the crowd.’

I remain amazed at the number of people who talk about investment and spend most or all of their time talking about asset allocation, regional allocation, sector weightings, economic forecasts, bonds vs equities, interest rates, currencies, risk controls... but never mention the need to invest in something good.

I naively supposed that the experience of the financial crisis might have taught investors a lesson about the inability to generate good returns from bad assets.

No amount of structuring using CDOs, CLOs and all the other alphabet soup of structured finance could turn sub-prime loans into investable assets.

When things went wrong, even the triple-A tranches of those sub-prime loan structures turned out to be triple-Z. There’s an old saying about silk purses and sow’s ears which encapsulates this.

Similarly, it is hard to make a good return over the long term by investing in poor-quality or even average businesses.

I am not suggesting that investing in high-quality companies is the only way to make money. However, investing in poor-quality companies has a couple of disadvantages.

One is that you are continually faced with the problems of timing and the headwind of their value destruction.

If investors have any coherent reason for such investments, they usually are diversification and/or the belief they can buy them when their fortunes and share prices are depressed and about to improve, and sell them close to or preferably just before they turn down.

Taking the diversification point first, I am also surprised how many investors assume that it is better to be diversified across low-quality investments than to be concentrated in high-quality ones.

With regard to timing, the sale and purchase of shares in poor-quality companies, leaving aside the drag on performance from the dealing costs involved, the performance record of the vast majority of active managers would suggest that there are far more who think they can play the investment and business/economic cycle successfully, and outperform, than can actually do so.

I am fond of saying that when it comes to so-called market timing there are two types of people: those who can’t do it and those who don’t know they can’t do it.

How have we fared? The Investment Association’s Global Sector comprises 270 funds, and my fund is the third best performing over the five-year period, returning 17.2 per cent per annum compound return compared with 9.9 per cent per annum for the MSCI World Index.

I would just point out that the two funds which rank ahead of us are specialist healthcare funds. They have performed well in a period which has seen a boom in M&A activity in biotech companies in particular. But their concentration on a single sector is a risk we would not be willing to take.

We still have the same strategy that we launched with five years ago. We only buy shares in good companies, try not to overpay and then do nothing.

We have made a good start, however, our investment time horizon is indefinite.

We will not waver from this no-nonsense approach and strive to deliver long-term outperformance.

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Terry Smith 

This is Money