Fundsmith Equity: July 2022 fund update

• Terry Smith is a seasoned investor
• He uses an established three rule process: Buy good companies, don't overpay and do nothing
• The fund’s performance has been strong since launch in November 2010, but has faced headwinds so far in 2022
• The fund does not currently feature on the Wealth Shortlist of funds chosen by our analysts for their long-term performance potential

How it fits in a portfolio

Fundsmith Equity aims to deliver long-term growth by investing in high-quality companies from around the world. Terry Smith, the fund’s manager, focuses on larger businesses from developed markets, which means the fund could complement others investing more in higher-risk emerging markets or smaller companies. A quality growth focus means it could also work well alongside those investing in unloved companies with recovery potential.

Manager

Smith has had a long and esteemed financial services career, working his way from bank analyst to chief executive of broker Tullett Prebon. He was also previously adviser to the Tullett Prebon pension fund, and appointed Andy Brown of Cedar Rock Capital to manage the investments. Inspired by Brown’s investment philosophy and process, Smith launched Fundsmith Equity in 2010. He initially ran it part-time as he was still chief executive of Tullett Prebon, before leaving the business in 2014 to focus full-time on the fund.

Smith’s been the sole manager ever since but has the support of a small team that has worked closely with him for many years. He also manages a sustainable version of this fund and is Chief Executive and Chief Investment Officer of the Fundsmith business. As both his funds are similar and the business is focused on a small number of portfolios, we think he’s able to devote enough time to managing the fund.

Given how long Smith has been in the industry, questions around his retirement are natural. Over the years he has made hires and surrounded himself with a tight knit team. Plans for his succession are in place but for the moment he remains integral to Fundsmith. Head of Research Julian Robins, a long-term colleague and friend, was named ‘the first line of defence’ as and when Smith does eventually decide to step back.

Smith has built an impressive long-term track record and we believe he uses a simple and straightforward investment approach. The fund doesn’t currently feature on the Wealth Shortlist though. To conduct our analysis, we require regular access to the fund manager and up-to-date, monthly portfolio data, which some fund groups, including Fundsmith, choose not to disclose. We can’t, however, make an exception to our process, so we won’t be considering the fund for the list as things stand.

Process

Fundsmith Equity follows three simple rules. Rule number one is to ‘buy good companies’. Smith hunts for high-quality businesses which can dominate within their market niche. Companies with intangible assets are favoured, such as brand power, intellectual property, or a product or service that customers can’t do without and would struggle to replace, even when times are tough. His focus on sustainable growth means he avoids companies whose prospects are closely tied to the fate of the economy like airlines and property developers.

Smith looks closely at a company’s profits and pricing power – the ability to mark-up prices even during tough times without impacting consumer demand. Companies must also be in a strong financial position, so companies that require lots of debt to function such as banks and real estate are avoided.

Smith mainly invests in companies from developed markets with almost three quarters of the fund invested in the US and the remainder in European countries like the UK, France, and Denmark. Consumer-focused companies make up the largest part of the fund, and Smith also invests a significant amount in technology and healthcare.

The second rule is ‘don’t overpay’. Smith only invests in companies he believes he can buy at a fair share price. Whilst some of these companies may be considered ‘expensive’ on today’s metrics, Smith believes their ability to grow faster and stronger is worth the premium price.

Smith is a long-term investor and once he invests in a company, he uses rule number three – ‘do nothing’. He aims to hold onto companies for the long term, which helps to benefit from compound growth. Trading less also helps keep dealing costs down and increases performance potential.

The process results in a portfolio of 20-30 companies, and currently there are 28. This means each holding can have a significant impact on performance, both positively and negatively, which can increase risk.

In keeping with the manager’s process, only a few changes have been made so far this year. This includes the addition of software company Adobe and Mettler Toledo, which manufactures precision instruments for use in laboratories and manufacturing. Pharmaceutical firm Johnson & Johnson and coffee company Starbucks have been sold from the fund.

Culture

Fundsmith is a boutique fund group with offices in Mauritius, London and the US. It was founded by Terry Smith in 2010 with the launch of Fundsmith Equity and has expanded to include a small stable of funds and investment trusts, most of which are run along the same lines. This dedication to the founding investment philosophy is attractive.

The business is employee-owned, with Smith owning the largest stake, and managers all investing significantly in the funds. This means both the business and the funds are run with the long term in mind, and managers’ interests are aligned with investors.

Investors should note we have not conducted full due diligence on the group’s risk and governance oversight as the group’s funds do not feature on the Wealth Shortlist or any of our other investment solutions.

ESG integration

Managers at Fundsmith typically invest in companies with good ESG (Environmental, Social and Governance) credentials. While this fund does not follow a strict ESG approach, the manager does not invest in areas including autos, energy, utilities, banking, and mining.

Corporate governance and engagement are a key part of the investment process, which includes analysing a company’s ownership structure and the way management is compensated. Fundsmith has been a signatory to the UN PRI (United Nations Principles for Responsible Investment), which promotes responsible investment through six Principles for incorporating ESG into investment practice, since 2017.

Cost

The fund is available for an annual ongoing charge of 0.94%. This is higher than many other funds in the Global sector, and means the manager has a higher hurdle to deliver a positive return. We recognise the long-term value that Smith has added over and above these charges, although there’s no guarantee of that in the future. The HL platform fee of up to 0.45% per year also applies.

Performance

The fund has performed significantly better than its peers in the IA Global sector since launch in November 2010. Over this time the fund has returned 457.96%* compared with 178.61% for the sector average. Remember past performance isn’t a guide to the future. Investments can fall as well as rise in value and you may not get back as much as you originally invest.

While the quality growth style has helped, our analysis suggests that Smith’s stock selection has been the primary driver of returns. His focus on quality has helped the fund hold up relatively well when markets are falling. The fund has also tended to outperform during rising markets.

That said, over the past 12 months the fund has lagged the peer group and fallen 11.13% compared with a loss of 8.71% for the IA Global sector. Broadly, growth investing has suffered so far this year. This style of investing focuses on companies with high growth prospects or the potential for higher earnings in future years. Rising interest rates and inflation are typically a headwind for this style, as it reduces the value of future cashflows, and this has dampened the fund’s performance. Some of this year’s weakest performers include online payment provider Paypal and Meta Platform (previously Facebook).

Investors have instead turned to out-of-favour ‘value’ companies over this time. Commodity-related areas including energy have performed particularly well but Smith has tended to avoid these companies.

Investments that have recently performed well include US tobacco company Philip Morris and Danish Pharmaceutical company Novo Nordisk. We believe Smith has the potential to deliver good performance over the long run, though there are no guarantees.

Past performance is not a guide to the future. Source: *Lipper IM to 30/06/2022.

Find out more about Fundsmith Equity, including charges

Fundsmith Equity Key Investor Information