Skin in the game? Terry Smith is putting £115m where his mouth is

November 2016

Terry Smith is in the news again. Not for being a Brexiteer — though he’s been committed to that cause ever since he stood as a candidate for Jimmy Goldsmith’s Referendum party long ago — nor for his well-known love of boxing, but for investing another £115 million of his own money into the global equity fund he set up six years ago. The money comes from selling shares in Tullett Prebon, the moneybroking firm he ran for eight years. It takes his total holding in the Fundsmith Equity Fund to £200 million.

Back in 2011, the last time The Spectator spoke to him, Smith was setting up Fundsmith and hoping to attract a break-even £250 million of other people’s money. Roll on five years and he has £8 billion under management — and rising. Investors can’t seem to get enough of his fund’s returns, which have compounded at around 20 per cent per annum since launch and comfortably beaten market indices and the vast majority of its peer group.

Still, £115 million is a big cheque to write, even for a man who has had four successful decades in the City as analyst, broker and fund manager. He thinks it’s odd — ‘outrageous, actually’ — that funds in the UK are not required to disclose how much money their managers have personally invested, as they would be in the United States. It’s another example, he says, of how ‘almost anything you suggest to the fund-management industry in this country is met with a desire to maintain its opacity’. Fund investors are entitled to know how much skin their managers have in the game. This is not just about transparency and alignment of interests: the evidence from the US is that funds whose managers have a lot of skin in the game, as Smith does, perform better than those where that is not the case.

But what, if anything, should we read into the timing of his move? Nothing, he insists. ‘I’m taking no view on markets or timing. When I do have a view on those things, I’m inevitably wrong.’ The question, he says, speaks to a general concern that he has with how people make investment decisions. In his experience people typically only ask one side of the question: ‘Is now a good time to buy your fund? Or, is now a good time for consumer staple stocks [which make up about a third of his portfolio]?’

‘To that I always say: compared with what? Given that you’re not going to put the money under the mattress, compared with cash? Bonds? Other equities? In my particular case, the question that I asked myself is: do I want to be in Tullett Prebon, or do I want to be in something else? The something else I’d like to be in being my own fund.’ Would it not make a difference, I say, if you could still get a 5 per cent real return from government bonds, as you could for many years leading up to the global financial crisis; in other words, if there were better alternatives to equities in today’s yield-starved world?

‘Not really for me. The question for me is not about where near-term share prices are going. Since this is not money that I need to spend to live, what I should really be thinking about is whether or not I think fundamentally these companies [that the fund owns] will compound in value at a reasonably superior rate over time. That’s the critical point of my methodology of investment.’

In practice, bonds now yield next to nothing, while low interest rates and QE have pushed up valuations of almost everything, including the stocks in his fund. Yet those stocks — global companies with high compounding returns on capital and strong cash generation are the only kind he likes — still look the better bet to him, as his £115 million cheque suggests. Yes, the cash-flow yield of his portfolio has come down from 6.5 per cent when he launched the fund to 4.4 per cent now, but that still compares favourably with the miserable yields on most competing assets. For a patient investor, the ability to compound returns over long periods is ultimately more important than current valuations.

There are those who say the so-called ‘bond proxy’ stocks — the likes of Procter & Gamble, Nestlé and Unilever, whose shares have become popular for their ability to pay a yield when bonds do not — are overvalued. But they’re guilty of ‘loose thinking’, Smith says. ‘People seem to work more on urban myths than fact. Consumer staples are about a third of our portfolio. So it is far from the only thing that a strategy like ours does, and the amount we have in the sector has come down in recent years. What have tended to grow within our fund over the years have been things like medical devices and equipment and legacy technology companies — businesses that do the payroll, airline reservations and so on. There the valuations don’t look particularly ritzy and they really haven’t had a massive tailwind of the same sort. In fact, to a degree they’ve been neglected.’

But maybe we have reached a turning point in the market cycle, when bond yields start to rise and the stock market de-rates? Smith is doubtful: ‘I don’t do any market timing or attempt to guesstimate inflection points in stocks or markets, but I will say this: for as long as the world continues roughly as it is, which is to say a low-growth, low-interest-rate environment, I think firms which are paying a 3 per cent dividend yield, have paid the dividend for 150 years and put it up by 3-4 per cent per annum, could become incredibly valuable. See Nestlé for details!’

The pundits should also take a look at Japan, which he fears will prove to be a ‘pretty good analogue’ for what the rest of the developed world can look forward to over the next few years — a weak financial system, a big overhang of debt, endless monetary stimulus and an ageing population, leading to an extended era of slow growth (‘27 years and counting’ in Japan’s case).

He’s implying, in other words, that equity valuations could stay high for a long time yet. ‘I don’t know the future. But it wouldn’t surprise me if… we were all dusted and gone before [current conditions] turn around. They’ve certainly gone on, I would suggest, significantly longer than any commentator I know put forward in 2008/9.’

So finally back to Brexit. ‘I obviously wanted the referendum and I was pleased with the outcome. I’m less pleased with the degree of caterwauling and moaning that’s occurred from people since who seem unwilling to accept the result, but… I suppose it was ever thus… I think there’s every likelihood this will be a difficult period. As for the pound depreciation, while it helps export effectiveness, you’ve got to bear in mind that manufacturing in the UK is very hollowed out and it’s not an unalloyed benefit in the way it may have been 50 years ago, under Harold Wilson. It’s a different sort of world now.’

‘I think there’s every likelihood that the EU will prove very difficult about this, in order to discourage others from following the same path. So we may well end up going back to the WTO tariffs … and we will quite possibly lose passporting for businesses such as my own, in terms of selling in Europe. But I do think ultimately we’re either right or wrong about the EU being the least competitive trading bloc in the world. I’m utterly convinced that it is: I can’t see what other major trading bloc in the world is less competitive.’

Anything could happen between now and the time we leave the EU, he says, but it won’t affect the way he invests. He takes comfort from how the chief executive of L’Oréal (whose shares he holds) reacted to Brexit. ‘He said “I would rather it didn’t happen, but it won’t make a blind bit of difference to our business.” And I think that’s generally true. People have managed to cope with far worse things than this.’

 This article first appeared in the Spectator in November 2016. Link here.