Terry Smith's Investment Philosophy

Terry Smith is the founder and chief executive Fundsmith. This post will summarise his investment philosophy as presented in the above video.

Invest in good quality businesses

1. High Return on Capital Employed: Charlie Munger says that "Over the long term, its hard for a stock to earn a higher return than the business which underlies it earns."  This is because companies with a high ROCE (above their cost of capital) are increasing in value over time; meanwhile, businesses with a low ROCE are like melting ice cubes, whose value is being eroded. Thus, instead of investing in companies which seek EPS growth at the expense of ROCE, it is far better to invest in businesses that target high ROCE. The idea is that in the long-term, the company's capital allocation decisions are the only thing that will really matter. Franchisee businesses are great in this respect, as they rely on someone else's capital.

2. Sustainable Growth Resulting from Secular Trends: Companies which are growing can retain earnings and reinvest them at high ROIC. This allows investments to compound in value over time. Smith says that one must invest in businesses with compounding value instead of investing for dividend income. This is why he seeks to invest in businesses which are in sectors experiencing secular growth that results from consumerisation of people in the developing world, or premiumisation of consumers in developed markets. Alternatively, seeking to invest in businesses which can expand into white space, or which will benefit from demographic shifts is also likely to result in compounding value creation.

3. Moat: The high ROCE of a business should revert - eventually - to the mean. A moat (entry barriers), in the form of brand loyalty/trust, distribution and supply chains, and software helps protect the high ROCE of a good quality business. Businesses that make differentiated goods, whose consumption is a legal requirement, are also likely to survive. That being said, some moats are more easily crossed than others: patents expire, tangible moats comprising land or factories, for example, can be overcome easily with debt or cash, and businesses in rapidly changing sectors, are unlikely to have any moat at all. Companies that have operated in a sector for very long periods of time, and have never had to raise money often have sizeable moats.

4. Mr. Smith never invests in a company that needs his money. He looks for big private companies operating in the sector, which have never had to list; this gives him comfort about the profitability of the business.

Try not to overpay.

For Mr. Smith, this is a secondary consideration. He subscribes to the belief that “If a business earns a very high ROCE, even if you pay an expensive looking price, you'll end up with one hell of a result.” This is because a good company, which is growing in value will dig you out with time; meanwhile, a bad company with low ROCE, and negative growth will shrinks in value, burying you over time, even if you pay a seemingly low price. That being said, you still don't want to pay too much as you want a high rate of return. In addition, it is worth remembering that if you overpay for a great business you could lose money, and if you buy a declining business very cheap, you could make a lot of money.

Do Nothing.

It is important for investors to remember that you don’t need activity, you need results. This is because, inactivity often gets the best results, and “it’s awfully hard work doing nothing”.

Don’t try to time the market.

Mr. Smith says that there are two types of people: those who can’t time the market, and those who don’t know they can’t time it. Market timing is a futile exercise. It is better to identify good companies and then make long-term investments at attractive valuations.

Seek long-term returns.

The Tour de France has never been won by someone who won every stage. In fact, it is often won by people who never won a single stage. Investing is like the Tour de France. You are not trying to have the highest return in a given year, but the best return over a lifetime.