Fundsmith Equity Fund research update

• Terry Smith seeks companies he is confident can meet or exceed their expected earnings, where this has not already been reflected in the share price
• Pharmaceutical business Novo-Nordisk is a recent addition to the fund
• Performance since launch has been strong, although more recent performance has been lacklustre

Our view

The Fundsmith Equity Fund, managed by Terry Smith, does not currently feature on the Wealth 150 list of our favourite funds across the major sectors. The list is reserved for managers we feel are exceptional and have long track records – preferably one that includes a full economic or stock market cycle. While the fund’s performance since launch in November 2010 has been very good, Terry Smith's track record is relatively short and he is as yet untested in an environment of prolonged falling share prices. We will continue to monitor the fund and inform investors if our views change.

Performance

The fund has grown 200.4%* since launch compared with 120% for the FTSE World Index and 83.1% for the average fund in the IA Global sector. Although please note past performance is not a guide to the future.

Terry Smith seeks to invest in high-quality companies, with low levels of debt, which are difficult to replicate (often because they operate in a niche area, have an innovative product or a loyal customer following). ‘Defensive’ characteristics such as these have been highly prized by investors over the past few years, which has boosted share prices of such companies. When other types of business are preferred by investors, the fund is likely to struggle. Performance over the past few months, for example, has been lacklustre as investors have shunned defensive businesses in favour of more economically-sensitive companies.

The nature of the companies the manager invests in, and his investment style, means the fund will perform differently to peers and the index. Terry Smith would typically expect the fund to offer an element of shelter from falling markets and lag a strongly rising market due to his focus on defensive businesses. The strongly rising market in recent years has unusually been led by defensive companies to the benefit of the fund and periods of underperformance should therefore be expected when his style is out of favour, as seen in recent months.

Past performance is not a guide to future returns. Source: Lipper IM * to 31/01/17

Fund update

Share prices of stable, ‘defensive’ businesses have been very popular with investors over the past few years causing share prices to rise strongly. Typically, company earnings drive share prices over the long term, but in many cases the earnings potential of these companies has remained relatively flat. Investors have been prepared to pay higher share prices for these more defensive companies providing they perceive their future earnings to be relatively secure, regardless of whether they expect them to rise, and this has pushed their valuations higher.

As a long-term investor, the manager is happy to buy highly-valued companies where he feels a strong track record of earnings growth will eventually justify the premium price. However, he prefers to invest in companies he is confident will meet or exceed their expected earnings; where this is not already reflected in the share price; and where the earnings potential has been underestimated by other investors.

He also uses temporary periods of weaker performance to add to favoured holdings. The manager increased the fund’s exposure to IDEXX Laboratories (which manufactures animal healthcare products), for example, in early 2015. A large shareholder in the business was forced to sell shares, causing the price to fall, which Terry Smith saw as a temporary issue and a chance to buy shares at a reduced price. The company went on to be the best-performing stock in the portfolio in 2016.

The businesses he likes often sell large quantities of everyday, low priced items that are repeatedly purchased in a predictable manner. This includes businesses such as Colgate Palmolive, which Terry Smith likes for its oral health division. As growth in emerging markets (a key area of expansion for the business) has been sluggish, investors’ have become less positive on the company’s prospects and the share price has fallen. Terry Smith feels this will reverse when the outlook for emerging markets improves and is confident the long-term outlook for the business is robust.

Elsewhere Novo Nordisk (a pharmaceutical business with a diabetes focus) is a recent addition to the portfolio. Terry Smith has liked the business since launch of the fund, and views the healthcare sector as an area of growth; however, he felt the company was previously valued too high relative to the earnings he expected the business to generate. Novo Nordisk has experienced a number of problems over the past few years around drug pricing, and the share price has been hurt as a result. This weakness meant the share price now better reflects the business’s earning potential, in the manager’s view. As he feels the company’s recent troubles are temporary, he took this as an opportunity to add this investment to the portfolio. The fund is concentrated at around 30 holdings which allows each to have a greater impact on performance but is a higher-risk approach.

Find out more about this fund including how to invest

Please read the key features/key investor information document in addition to the information above.