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Manager Terry Smith has some fascinating things to say about value versus growth investing
Thursday 23 Jan 2020 Author: Daniel Coatsworth

In much the same way Warren Buffett’s annual letter to Berkshire Hathaway investors is eagerly awaited every year for its pearls of investing wisdom, Terry Smith’s letter to Fundsmith Equity (B41YBW7) investors has also become an annual publication worth savouring.

His tenth letter has just been released and it contains some fascinating insights into quality versus value investing.

Most fund managers provide commentary in their annual report on performance as well as the odd snippets into their thinking in monthly factsheets. Both Buffett’s and Smith’s annual letters go one step further by drilling down into the subject matter and letting the authors wax lyrical about certain topics.

I would urge all investors – whether or not you are an investor in the fund like me – to read the latest Fundsmith letter as you could learn a lot from it.

One powerful point in the letter highlights what the fund manager believes to be the flaws of value investing as a strategy. Smith, who likes to invest in companies with high quality characteristics, says most stocks with low valuations attractive to investors are not good businesses.

On the occasion that someone does actually buy a decent company on a low valuation, they may sell that stock when it has re-rated to a fairer valuation and will need to find something else that is undervalued, he argues.

‘This activity obviously incurs dealing costs but value investing is not something which can be pursued with a “buy and hold” strategy,’ Smith says.

‘In investment you “become what you eat” insofar as over the long term the returns on any portfolio which has such an approach will tend to gravitate to the returns generated by the companies themselves, which are low for most value stocks.’

Smith quotes Charlie Munger, Warren Buffett’s business partner, who has previously said it’s hard for a stock over the long term to earn a much better return that earned by the underlying business.

He said: ‘If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return — even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result.’

Celebrating its tenth year this November, Fundsmith certainly seems to be hinting at delivering the potential Munger alluded to. It has delivered 391% total return since it launched in November 2010; a record high achieved this week.

Thanks to its clear communication and easy-to-understand owners’ manual, investors know what they are getting with Fundsmith. It won’t always deliver superior returns, yet anyone with a long-term approach should take comfort in owning this fund.

If you want to pick holes, Fundsmith could consider cutting fees as the fund gets bigger – in line with the strategy adopted by many other funds – and it could also be more transparent on the full portfolio. Those issues aside, it’s fairly easy to see why this is one of the UK’s most popular investment products.

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