This Time He’s Playing for Keeps

Terry Smith’s office is high up on the 37th floor of Tower 42, formerly the NatWest Tower, from where there is a floor to ceiling view over Docklands and out toward Essex, a neck of the woods with which he seems to be associated in the popular mind. The public image of this high profile City figure is that of a pugnacious bruiser, someone with attitude who has made good in the money markets through a series of ballsy deals, and who likes nothing better than a good verbal scrap.

On his new blog, Straight Talking, you can read his denunciations of Labour’s public spending record and the myths about George Osborne’s cuts. (“There are violent protests and the BBC engages in daily hysteria about ‘huge cuts’ when government expenditure has in fact risen every month since the coalition government took office and no absolute cuts are planned. The attitude of the BBC reminds me of George Orwell’s 1984 in which there was a Ministry of Truth, which only told lies”).

While Smith wins friends and enemies in equal numbers with his forthright opinions and litigiousness, his saving grace in the financial markets, where bullshit has always been a well rewarded commodity, is that he does not flinch from facing reality. He first made his name in the 1980s as the only banking analyst in London who dared to put out a sell note on his own employer’s shares, and then wrote a book which criticised the accounting sleight of hand employed by some of his next employer’s most prestigious clients. Unsurprisingly that got him the sack, but proved to be the making of his career.

Meeting him now, twenty five years on, is to meet a trim and genial bloke in his 50s who bears more than a passing physical resemblance to the comedian Frank Skinner, but talks at about three times the speed and laughs a good deal. The day we meet is shortly after the publication of Warren Buffett’s latest annual letter to his shareholders. Smith is a longstanding fan, and indeed has modelled his latest venture, the fund management business we have met to talk about, on many of the principles which Buffett has espoused in his even longer career as professional investor and wiseacre.

Buffett is 80 now and starting to talk vaguely about handing over to a successor, but his track record as an investor remains unrivalled. He continues to command a huge and faithful following, among whom Smith is happy to be counted. “I have been reading his letter since 1980 and one of the things I have noticed is that it is easier to become humorous the richer you become. You start with the serious stuff and later you just tell jokes, and they love you for it”.

Having made a substantial fortune from his stockbroking and moneybroking businesses, Smith is wealthy enough to put £25m of his own money into his new fund, and is now inviting others to join him in investing the same way. The fund is a simple global equity fund, consisting of just 20-25 stocks, selected on Buffett-like principles, which means buying (and holding) mainly well-established self-financing businesses with high returns on equity and durable competitive advantages. The Sage of Omaha is quoted liberally in the fund literature and those who invest receive an Owner’s Manual telling them how it will operate, another Buffett concept.

Smith’s marketing pitch for his fund is a variant on the old one-two. Part one is, naturally enough, a confident claim that his fund should perform well. The pension fund at Tullett Prebon, the moneybroking business where is chairman, has, he points out, been invested for the last few years exactly the same way as the new fund will be run.  With his advice, it has returned 14% compound per annum since then, moving from a hefty deficit to a substantial surplus as a result, and comfortably outpacing the stock market as a whole.

The second part of his pitch, equally characteristic, is that virtually everyone else in fund management is doing it all wrong. In his view, the fund management business is “broken and not fit for purpose”.  The industry “has badly served its customer base in a number of ways”. He runs through the familiar charge sheet; most actively managed funds underperform the market; most fund managers “hug the index” to avoid the risk of losing their jobs; and in the majority of cases the fees funds charge are way too high to justify the indifferent results that they in practice  deliver.

Why are their charges all the same, he asks? “The fact is that there is a cartel. Why has everyone got the same management fee? If you were a competition regulator, God forbid that you were, wouldn’t you start by noting how everyone is charging the same? Bit suspicious, wouldn’t you say? Clearly there are elements of a complex cartel at work here”. His “latest rant” is about the fact that the industry is now busy promoting a new breed of exchange-traded funds as low cost passive index funds, when many of them are nothing of the sort.

The way fund managers distribute their products, which is mostly through intermediaries, means that they really have no idea who their customers are. Doing his market research, Smith looked at the websites of all the main fund providers and was startled to find that there was barely one whose fund you could invest in directly online. On his website, investors can put in up to £400,000 with a single debit card payment. “The truth is that fund management is the only area of human endeavour where the Internet has introduced an extra layer of intermediation between the end user and the product” he says. “I find that incredible”. The handsome fees which are paid to distributors of fund products come straight out of the pockets of investors, although many continue to believe, mistakenly, in Smith’s view, that they are somehow getting things cheaper as a result of being able to subscribe online.

Valid though these strictures are, many others have tried to break the mould in fund management in the past, but come up short. Smith’s fund has taken in £77m, including his own money, since its launch last November. It needs around £250m in assets, he reckons, to break even (and rather more, I suppose, before he earns the right to tell his investors old jokes, Buffett-style). His own annual management fee is a cartel-like 1% per annum, the same as most other funds, once you exclude the commission payments to financial advisers. While Smith says that he might bring that figure down once the fund gets bigger, he is careful not to make any promises. His fund, he emphasises, as well as being a personal interest, is a business to make money.

Much will depend therefore on the results the Fundsmith Global Fund can deliver. In an hour’s conversation about stockpicking, we talk at length about the ideal kind of business to invest in. Smith nominates pet food. Why? Because pet food is a classic example of a low price, high margin consumer durable business where the market is controlled by a number of dominant suppliers and in which consumers, in Smith’s words, “have no opportunity to renegotiate the price at the point of sale”. These are companies which are strong enough to earn consistent profits throughout the ups and downs of the business cycle, as a result rarely if ever need to dun shareholders for extra capital, and aren’t threatened by losing their franchise to technological change.

Smith has three of the owners of the world’s top five pet food companies, Nestle, Colgate-Palmolive and Proctor & Gamble, in his 23 stock portfolio, and did have four until Del Monte was bought by the private equity group KKR. “Resilient” hardly does justice to the robustness of their profits: research shows, he points out, that pet owners “would stop feeding their children before they stopped feeding their pets”.  Another business that Smith likes Is elevators and escalators, where two companies, Otis and Schindler’s, dominate the market. They are good examples of companies whose economic value is not so much in their products, as in the steady and consistent cash flow generated by the repeat business of servicing and repairing what they make. Medical equipment suppliers are another in the same category.

The rationale for the fund is that proven earners such as these, as well as making consistently high profits, remain relatively cheap, with an average free cash flow yield of more than 7%. That is well above the return on a medium term government bond, the standard non-equity alternative, and they offer the promise of growth as well. These stocks would still look cheap even if you allowed for the fact that bond yields have been artificially held down by the recent hefty purchases of central banks, the policy of “quantitative easing”, the latest bout of which Smith regards as an expensive and pointless failure (although it has helped to push up equity prices).

The last time large cap quality stocks Smith favours were expensive was back in the 1990s. In Smith’s opinion, the market is pricing them incorrectly. The really great companies simply go on churning out profits for one generation after another, longer than the market expects. “The average company in my portfolio” he says with glee “was founded in 1883. The great beauty of owning them is that you rarely need to sell them”. In addition, “as I have a day job, the urge for me to fiddle with the portfolio is quite low”.

The Tullet Prebon portfolio has changed on average just one stock in its 23 portfolio each year. That keeps transaction costs to a minimum, and the new fund promises to do the same – which makes charging 1% a year for minding the store what Arthur Daley might call “a nice little earner”. That said, don’t be surprised to see the fund outperform most of its competitors, as the Buffett-like strategy is a proven winner most of the time, and Smith’s track record as an analyst, before he moved into corporate life, was outstanding.