Lessons From A Master Manager

18 February 2019 | AJ Cilliers
 


First Published on Sharenet - 2016-01-05

If you had invested in Terry Smith’s Fundsmith Global Equity fund in November of 2014, you would have been 18.7% better off by the end of October 2016. This put Fundsmith in fifth place out of 293 UK funds, with a return just one percentage point below the top performing fund. What is more, Fundsmith has more than doubled in value over the past five years, making Terry Smith one of the UK’s most respected fund managers.

Smith is generous when it comes to explaining his successes, and strongly critical of the majority of the UK’s fund managers. From his various writings and comments on the subject, here are five lessons and observations that might help you to become a better investor:

1. Avoid the unknowable

Smith is amazed by the obsession that most fund managers have with issues such as macroeconomics, interest rates, quantitative easing, asset allocation, currencies, emerging markets versus developed markets, and so on. According to Smith, these factors are unknowable, largely irrelevant, or both. 

He is equally surprised by how few fund managers mention the need to invest in good companies, such as those with good products or services, strong market share, good profitability, cash flow and product development. Smith once claimed that there are only 65 companies in the world that he would consider investing in - and below he explains why. 

2. Only the best is good enough

If you’re not investing in good companies, you’re probably buying into average or poor companies. This is problematical, because over time such businesses tend to destroy shareholder value so that a buy-and-hold strategy is not going to work.

A more active strategy also has its drawbacks. Apart from the negative effect of trading costs, the performance of most funds shows that few active managers are able to buy shares in weaker companies when the share price is down and performance is depressed, and then sell them when they peak.

Buy good companies, however, and you are likely to be rewarded with good returns for long periods of time. Smith is a strong believer in a long-term buy-and-hold strategy, but only if you buy good companies in the first place. 

Good companies will often surprise you on the upside, and seldom on the downside. Apart from the attributes mentioned under Point 1, strong well-run companies have experienced and capable management teams. They not only run their own businesses well, they will often acquire under-achieving firms cheaply and turn them into winners. 

Strong management teams also tend to be conservative in their forecasting and ruthlessly efficient in controlling their costs. All of this results in actual performances that often exceed expectations, with a correspondingly positive effect on the share price.

Smith notes that shares in quality companies are often said to be too expensively rated. While this may often be true, he insists that for a long-term investor, owning shares in a good company is a far greater determinant of investment performance than whether the shares were cheap when you bought them.

3. Let your winners run

Smith provides a fascinating example of how investors tend to shoot themselves in the foot. He notes that, between 2000 and 2010, the best performing US fund was the CGM Focus fund, which delivered annualised returns of 18pc a year.

This is very impressive, and one would imagine that investors in the fund were overjoyed. However, during the above-mentioned period the average investor in the fund lost 11 percent a year. Investors showed an uncanny ability to buy into the fund at its peak and sell out when it bottomed.

This highlights the oft-quoted fact that most of us are terrible at "market timing", where we try to sell at or close to market peaks and buy at market lows. All the evidence suggests that we are fooling ourselves, and as illustrated by the CGM experience, at considerable cost. The wisest investors are those who have realised the futility of trying to time the market and have given up the practice.

The other major fault that most investors have, whether private or professional, is to deal too much. All dealing activity has a cost, much of which is hidden. We are taught that to be successful investors we need up-to-the-minute information and the ability to deal instantaneously. This is not the case - in fact, over-trading is far more likely to take us down the rocky road to poor returns.

4. It doesn’t have to be high tech

According to Terry Smith, people often assume that a successful investment must be highly sophisticated, difficult to understand, and unknown to the majority of investors. However, quite often the best investments are everyday products - such as Domino’s Pizza.

Smith’s fund bought into Domino’s five years ago, and to date has earned over 600 percent on this investment. Understanding why gives an insight into Smith’s ability to spot good companies:

  • Domino’s meets Smith’s prime criteria of making its money from a large number of everyday repeat transactions, and having a large base of loyal customers who rely on its services.
  • Domino’s is a franchise business. Fundsmith bought into the holding company, which earns all of its revenue from franchise royalty fees. The benefit is that the holding company did not put up the capital for its various franchises - the franchisees did. So with a minimum investment of its own, Domino’s is effectively earning high returns on other people’s capital.
  • Domino’s has focused on the most important item for success in its sector - the food. This is in contrast to other fast-food providers such as McDonalds, which are struggling.
  • Domino’s is primarily a delivery business, allowing it to operate from ’unattractive’ premises in cheaper areas. This is a much cheaper option than that of the city centre fast food merchants, who operate out of far more expensive premises.
  • Businesses such as Domino’s, which sell their products on a cash basis and have strong positive cash flows, can afford higher levels of debt financing.  As debt is cheaper than equity (because interest is deductible for tax purposes), returns to equity holders are enhanced.

5. Dare to be different

Smith believes that, collectively, fund managers ignore Sir John Templeton’s axiom that "If you do what everyone else does, you will get what everyone else gets".  Most managers don’t see the biggest threat to their career as being the loss of investors’ money or the risk of performing badly. Their biggest fear is being different from their peers.

They don’t appear concerned that they and their fellow fund managers produce poor results for investors, as long as they all perform roughly the same. If they can manage this, they are unlikely to experience large disinvestments by clients or the loss of their jobs. This leads the majority of "long-only" fund managers (those who don’t use the sophisticated techniques of "short-selling") to buy so many shares that they pretty much replicate the performance of whatever index they are measured against.

However, even if a fund manager owns enough shares to roughly track an index - and this is only about 25 randomly chosen shares in most markets - their fund will underperform the index once the fund manager’s fees and the cost of his or her dealing activity have been taken into account. This, Smith suggests, is as inevitable as it is poor.

Conclusions

As investors, we often focus on macroeconomic factors that we can’t predict anyway. Too many of us follow the crowd and indulge in ’groupthink’, and so we get the same below-par returns that everyone else does. We buy cheap companies rather than good ones, and trade too often. We also think that high-tech and high complexity equal high returns, when often the simplest businesses are the best.

Change our thought patterns and our behaviours, and who knows - perhaps we too could enjoy the enviable success that Terry Smith has achieved.

First Published on Sharenet - 2016-01-05

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aj

AJ Cillers

AJ is an academic and a freelance financial journalist who has written for Sharenet for some 15 years. He spent 25 years as an accountant and financial manager in various South African companies before moving into academia. He has a broad range of interests, including all aspects of business and stock market investing. Apart from a bachelor’s degree in Accounting, AJ holds a Master’s degree in Financial Management. He is also a Fellow of the Chartered Institute of Management Accountants.


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