I didn’t start investing until my late 20s. What followed was a steep learning curve, albeit helped by following the thoughts and dealings of some of the best money managers in the business. One in particular — Fundsmith Equity‘s Terry Smith — has probably served a bigger role in my education than any other.
Terry Smith on quality
Terry Smith looks for winners. In practice, this means surveying the market for companies that already possess a strong/leading share of their market and can be depended on to protect it. This is why many of the stocks that make up the Fundsmith Equity portfolio have been around for many decades. Past performance might not be a guide to future returns but it can help when looking for resilient businesses that have consistently managed to grow revenue and profit.
These days, I’ve a penchant for smaller companies flying under the radar. That said, I’m still applying a quality criterion like Terry Smith. Aside from the characteristics already mentioned, I’m on the hunt for businesses generating high returns on capital and big margins. This means I now steer clear of capital-intensive businesses like airlines (which Smith labels “machines for losing money“).
Like Smith, it also means I’m very selective about what makes it into my ISA portfolio these days. Only 29 holdings make up Fundsmith Equity right now. So long as I’ve picked well, operating a concentrated portfolio can turbocharge my returns. Of course, the opposite is also possible!
Price matters…to a point
‘Buy low, sell high’: that’s the rule that every investor tacitly learns on entering the market.
Terry Smith doesn’t go against the grain here. However, the UK fund manager has frequently pointed out that focusing too much on valuation can prove detrimental to returns. For Smith, a stock’s price is of secondary importance to how good a company is (see above). A cheap stock can always stay cheap while a more expensive stock can go on increasing in value. In other words, contrarians/value hunters don’t always prosper. This is why Smith picked up stocks like Nike and Starbucks in the 2020 market crash rather than buying ‘bargain’ travel stocks.
As an investor, I’ve come around to the idea that simply trying not to overpay is preferable to buying what’s cheap. This is also why I’m wary of unprofitable, flavour-of-the-month companies such as cybersecurity firm Darktrace even when its prospects look undoubtedly solid. So long as I’m paying a not unreasonable price, I know the risk/reward should theoretically be (more) in my favour.
No gimmicks
A final thing I like about Smith is his no-nonsense approach. He picks stocks that he expects to generate a better return for holders than the market. He doesn’t short (bet against) any companies. Nor does he use derivatives or get involved in any creative financial practices like some managers might.
Most importantly, Smith has taught me that investing is as much about what you don’t do as what you do. In practice, this means buying stocks with the intention of holding for years rather than attempting to ‘time the market’.
Not only is predicting the short-term movement of a share price very difficult, it only guarantees fees. As Smith frequently highlights, Fundsmith has very low turnover, meaning that investors ultimately get to keep more of the profits made.
Paul Summers owns shares in Fundsmith Equity. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
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