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The Market NZZ - Valuation Is Not as Important as Quality

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Fund manager Terry Smith, founder and CIO of Fundsmith, consistently favors quality companies. In this interview, he talks about the merits of Novo Nordisk, which of the «Magnificent Seven» stocks he likes, and which shares he would buy – if they were cheaper.

Fund manager Terry Smith has seen many a stock market cycle. He has been in the business for around fifty years and founded the London-based asset manager Fundsmith in 2010. As an investment professional, he knows how difficult it is to keep a cool head during bear markets, so he focuses on a small number of high-quality stocks.

He typically holds twenty to thirty stocks in a fund. He generally avoids companies in cyclical industries or sectors that can only generate attractive returns with a lot of leverage. «Most companies are not investable for us,» says the stock market veteran.

In an in-depth conversation with The Market NZZ, Smith reveals how he finds quality stocks, why he currently has no Swiss stocks in his fund and which stocks he has recently bought.

Terry Smith: «We like companies that make money from a large number of everyday, repetitive, relatively predictable events and transactions».

Your aim is to run the best equity fund in the world. How do you pick the stocks that will deliver the best performance?

To be clear, by «best fund» we mean the best risk-adjusted performance. You could undoubtedly do better than us by owning the latest «hot» stock. But the problem with that is that when things go wrong, as they did in 2022, when some stocks lost 30-50%, the level of volatility you inflict on investors can cause you or them to make very bad decisions. For us, it is important to have a reasonably consistent return over time, as well as an above-average return.

And how do you select stocks to achieve this?

We have a very long list of criteria, but I’ll boil it down for you. Firstly, we look for companies with good returns on capital. The companies in our portfolio have an average return on capital of about 30%. So for every franc, dollar, euro or pound of capital that we own in that company, they generate 30 cents of profit. That is probably 70% or 80% above the market average.

What would be another criterion?

We’re also looking for a source of growth, because otherwise there’s nothing to invest the good returns in. If a company just gives it back to shareholders, then what we’ve effectively got is a high-yield bond. High-yield bonds don’t compound. The way that companies compound is that they take some of the equity returns and invest them on your behalf. That’s what retained earnings are. But they need a source of growth – we need both high returns and growth. We don’t want returns without growth or growth without returns. I can find plenty of companies that are growing very, very fast with poor returns.

What else are you looking for in a company?

A degree of predictability. We like companies that make money from a large number of everyday, repetitive, relatively predictable events and transactions. We don’t like companies that make big one-off deals, such as the movie business. Is the movie going to be a hit or not? You don’t know. Another example is big construction projects. We prefer things like toothbrushes, bathroom cleaning products, dog food or medical procedures, or an operating system like Microsoft Windows, where there is a degree of predictability in consumption.

One last important thing for selecting stocks?

Last but not least, we require a degree of management skill when it comes to capital allocation. If you’re sitting at the top of one of these companies with a 30% return on capital, there’s sometimes a tendency to do stupid things – for example, a value-destroying acquisition. So we’re looking for people who are intelligent, responsible and honest about how they allocate our capital.

Given these restrictions, you are likely to discard a large part of the equity universe from the outset.

Indeed, the vast majority of companies are uninvestable to us.

As a consequence, there are many sectors that are not part of your portfolio, such as mining, oil and gas companies...

… utilities, transport, banking, insurance, real estate? Yes, we don’t own any of those things. None of them.

Because they don’t meet your requirements.

The Stern School of Business at New York University does a regular annual survey of thousands of companies and they look at the measure of return on capital employed minus the weighted average cost of capital. I’d say that’s the most important measure of corporate performance. But don’t take my word for it. That’s what Warren Buffett wrote in his 1979 annual letter. If you look at this data set and you look at the companies that are earning a very positive spread over their cost of capital, you’ll find that they’re in the following sectors: consumer staples, consumer discretionary, IT, medical services, IT services, business services and so on. They are earning more than their cost of capital – they are creating value. Then you look at the ones that consistently earn less than their cost of capital...

 Which sectors are these?

Mining and minerals, oil and gas, banking, investment banking, brokerage, real estate, transport. They are a disaster. And look, there comes a time in every economic cycle when mining is doing pretty well, airlines are doing pretty well or banking is making a comeback, but it’s usually one or two years out of ten. Leopards don’t change spots, good companies don’t become bad and bad companies don’t become good. Except for very small sweet spots in a cycle where the big, bad companies have their day in the sun.

So we have a framework for selecting good companies. How do you make sure that you don’t overpay for them?

Valuation is not as important as quality. We looked back over fifty years at the P/E ratios you could have paid for certain companies and still outperformed the S&P 500. For L’Oréal, the starting P/E you could have paid was 281. People are very bad at working out the difference between different compound rates of return. The difference between a 10% return and a 12% return isn’t something we can easily grasp. We think it’s 20%, but it’s not. Owning good companies is more important than owning undervalued companies.

Can you elaborate?

There’s a great Buffett quote on it: «It is better to own a great company at a fair price than a fair company at a great price». If you own a fair company at a great price, you hope that the price will adjust to the correct valuation. But after that, that’s the end of your good investment. You have to move on and find something else, whereas a great business is a gift that can keep on giving.

But you cannot simply ignore valuation, can you?

No, we don’t ignore valuations and we have a very simple rule of thumb: We take the free cash flow that a company generates divided by its market value, which is the free cash flow yield, and then we take what we think is the medium-term growth rate. We’re relatively good at estimating that because we invest in fairly predictable businesses. If you put the yield and the growth rate together, you get a rough measure of your expected return. Over very long periods of time, the stock market has delivered returns of around 9% to 10%. If we get a really good company, we can get returns in excess of 10%. If we get a yield of 4% and a growth rate of 10%, we’ll get 14%, which should beat the index. It does not really matter if the yield is 1% and the growth is 13%, or if we get a yield of 4% and growth of 10%.

Given this framework, would you say the pharmaceutical company Novo Nordisk, which has had fantastic growth thanks to its obesity drugs, is still attractive? Based on its P/E ratio, it looks rather expensive.

Compared to what?

Let’s say compared to the market or compared to the sector.

Novo is trading at 45 times earnings. What’s the closest comparable? Eli Lilly. Eli Lilly makes Mounjaro and Zepbound. These are the other weight loss drugs. Lilly trades at a P/E of 74, which might just mean that Eli Lilly is even more expensive. But there’s not much point in comparing Novo Nordisk to the market. I’m not even sure I would compare it to the pharmaceutical sector. It’s got a different approach to drug discovery, which is how it got to this position in the first place. A P/E of 45 may be expensive, but not at the current growth rate, which is well over 20%, probably closer to 30%. So the valuation will come down pretty quickly. In two years’ time, it’ll be at a P/E of around 20, which is in line with the broader equity market.

Can Novo sustain that growth rate?

Well, the company has clearly got a moon shot in terms of the obesity drug and it’s definitely got quite a lot of patent protection. But it’s also got labelling protection. When you develop a drug, you have to go through the FDA approval process and you have to get it approved for the use that you’re testing it for. Ozempic started as a treatment for type 2 diabetes. And then the data clearly showed that it also caused weight loss. But you can’t just go ahead and sell it for weight loss. You have to go back and do a new trial in people, some of whom don’t have type 2 diabetes, to see if it’s effective and safe for weight loss. And right now Novo is several steps ahead of the competition.

And there seem to be other benefits of the drug.

Ozempic also clearly causes a 20 to 25% reduction in major cardiovascular incidents and reduces the risk of heart attack and stroke, whether patients are overweight or not, whether they’re diabetic or not. It’s going to get the same label in due course for liver and kidney problems, and it’s likely to get the same label for autoimmune diseases, arthritis, lupus, gout, and in due course even as a treatment for alcoholism. And Novo is way ahead of the competition and it’s hard to catch up. And importantly, we did not invest in Novo because of its weight-loss drug. We invested because of their superior drug discovery process and I would not bet a lot of money against these guys coming up with something else. Having said all that, none of this could be right. There are a lot of things that could go wrong.

Aside from the hype around anti-obesity drugs, the Magnificent Seven are also very popular. You own Alphabet, Meta and Microsoft in your fund. Why these three?

Technically, we have four because we have a small stake in Apple. But let’s start with Tesla. Tesla is not going to meet any of the requirements I’ve just talked about - it’s a car company! Even the best car companies in the world, Toyota, BMW and Volkswagen, don’t make adequate returns. It is a really bad business to be in. Ford earns a 3% return on capital, a couple of points below US Treasuries!

What about the Magnificent 7 that you like?

Alphabet has a P/E ratio of 25. So it’s very close to the market, maybe 10% more, and we’re talking about a company that has a duopoly in online advertising with Meta. So unless it does something to disrupt that, it is a pretty good business and there is no sign at the moment of any development that could disrupt that. People are talking about it, but there’s nothing happening.

And Meta?

Meta is even cheaper, trading at 24 times earnings. Not bad for a duopoly in online advertising with the aforementioned Alphabet. Meta has two billion daily users and is still growing. People complain that the growth rate is only 3-4%. But Meta has two billion customers – what growth rate do you expect?

What about Microsoft?

Microsoft is the world leader in business software and it has a near duopoly in cloud computing with Amazon Web Services. And it has the world’s leading operating system, about 99.9% of the world’s ATMs run on Microsoft. It has a great position in games with Activision, although it lost the mobile battle to Apple and Samsung. They have been quite successful with the Surface tablets. It’s a very good business and I think Satya Nadella has proven to be an outstanding CEO. Admittedly, it’s the most expensive of the group with a P/E of around 35.

But that’s still attractive in your view.

How does it compare to its peers? Nvidia, another member of the Magnificent 7, trades on a P/E of 75, so even Novo looks quite cheap in comparison. And there are other companies that have benefited from the AI hype. Adobe and Intuit, for example, have seen their share prices rise by 70% in the last year or so on the back of AI hype. Even though I can’t see how they’re going to make money from AI. Even if they can build it into their graphics software and accounting software - they don’t have a Large Language Model, do they? Aren’t they just going to pay a lot of money to the vendor? Intuit trades at a P/E of 64, Adobe at 38. By comparison, Microsoft looks pretty cheap. Of course, the Magnificent 7 are not uniform. We invest in the ones that are cheaper and more predictable.

What do you think of the argument that we don’t need to know the winners of the AI revolution if we can buy the proverbial shovel manufacturer, i.e. Nvidia, which makes the chips needed to run the big language models?

I don’t think the exponential growth in demand for Nvidia’s GPUs is certain to continue. They’re doing great now and they’re delivering a lot of shovels. But if nobody strikes gold, I don’t think you’re going to need any more picks and shovels. Also, there is competition, and Nvidia has gone through two transformations in its life - admittedly very successful ones - and in the course of those transitions the stock has had two drawdowns of 80%.

You are also invested in the tobacco company Philip Morris. Is this company really growing?

Sales have been growing at around 10% per annum for the past few years. The reason we’re keeping Philip Morris is because it’s the world leader in reduced-risk products, the heat-not-burn tobacco products. You get a thing called an iQOS device - it stands for I Quit Ordinary Smoking, by the way - you put in a HEET stick, which looks like a little cigarette, and you puff away and it heats the tobacco. It doesn’t burn it, there’s no smoke. The Food and Drug Administration, who are no friends of big tobacco, say they reduce the harm you get from using tobacco by at least 95%. And unlike vaping, it doesn’t attract young people because it tastes like tobacco. In fact, the people it’s aimed at are smokers. It’s a way of switching smokers to another, safer tobacco product. It’s also the world leader in oral products with Zyn, the Swedish match product, which is a nicotine pouch. There’s no tobacco in it at all. It’s a nicotine product, but it’s growing at maybe 75% per annum. So there is growth at Philip Morris even though the traditional cigarette business is not growing very much in volume terms.

You don’t have any Swiss companies in your fund. Are they too expensive?

There are a number of Swiss companies we are interested in, but we don’t own any at the moment. Possible names would be Nestlé, Schindler, Sonova, SGS, Geberit, and our mid-cap colleagues are looking at things like Inficon and VAT.

Is Schindler not attractive enough?

We owned Schindler but we switched to Otis because I think Schindler had lost its way a little bit. If you compare it to its competitors, Otis or Kone, it has had a relatively poor performance over time and we saw that coming, while the management didn’t seem to have a good grasp of it.

What about Nestlé?

The same goes for Nestlé. We’re sceptical about the current wellness push simply because it hasn’t really delivered free cash flow growth. Call us old-fashioned, but we’d like to see some real results. I am not against owning Nestlé, but there are other stocks we prefer at the moment, such as Unilever. But Nestlé is not written off forever.

Your turnover is extremely low. What was the last «buy» in your fund?

We have bought two things this year. We haven’t named one of them because we’re still buying. The other is Fortinet, the Internet security business. If you’ve got a firewall on, there’s about a one in two chance that there’s a Fortinet router that you’re using to give you security. And it’s really a bit of a two-way race between them and Palo Alto Networks in terms of security. Cyber security is obviously a big growth area. The company went through a long period where it was growing 20% a year. And then, when everyone was working from home during the pandemic, it jumped to 40% annual growth and the stock went through the roof. After that spike, it fell back to 10% sales and the market ran away from the ship, even though there was nothing wrong with the underlying business.

Is there a great company that’s on your radar screen that just hasn’t met your valuation criteria yet?

The short answer is: Hermès. It’s a very good business. It doesn’t have as wide a spread of luxury brands as LVMH, but it’s extremely well positioned.

In your Janaury letter to shareholders you wrote that the stock that causes the most critical comments from clients is usually the best one. Which company received the most negative comments this time?

Interestingly, the feedback has been much more muted this time. We haven’t had the usual wave of criticism and complaints about our shares this year that we had with Meta or even Microsoft before.

Terry Smith

Terry Smith is the founder and managing director of the asset manager Fundsmith. He is the portfolio manager of the largest active equity fund in the UK, the Fundsmith Equity Fund, as well as the Fundsmith Sustainable Equity Fund. Due to his investment style and his focus on a manageable number of shares, he has also been described as the ‹English Warren Buffett›. Terry Smith has worked for Barclays Bank and UBS, among others, during his career. He is the author of the books «Accounting for Growth» and «Investing for Growth».