Noted fund manager Terry Smith says one of his biggest mistakes is not to have invested in Apple (AAPL:NASDAQ) and Amazon (AMZN:NASDAQ) on the day of launching his Fundsmith Equity Fund (B41YBW7) in 2010. While both stocks now feature in his portfolio, he only invested in Apple in late 2022 and Amazon a year earlier.

In an exclusive interview, Smith says there was a turning point with Apple that made him realise it had all the right qualities for the Fundsmith investment strategy. That lightbulb moment was down to two factors, one was the rapid growth in recurring revenue from its services arm, and the other was a sell-off in the share price which made the stock’s valuation more attractive.

‘The thing that’s changed about the story, and I was dismissive about but I’m now growing convinced it is a reality, is the services part of the business,’ he says.

‘This is now getting on for a third of the revenue, it has 70% gross margins which is twice what you get in the handsets, tablets and devices part of the business, and it’s growing at about twice the rate of the remaining business.’

Why is Fundsmith sticking with its investment in Meta Platforms?

While Meta’s (META:NASDAQ) shares are up 20% year-to-date, they had a miserable time in 2022, falling 64%. It’s a similar story with PayPal (PYPL:NASDAQ) which was recently jettisoned from Fundsmith’s portfolio. Why ditch one and not the other?

Terry Smith has previously talked about PayPal’s lack of engagement with new customers, costs that seemed out of control and value-destructive acquisitions. Meta also comes with its own unique set of problems, but Smith is prepared to sit and wait.

On the plus side, Meta’s Facebook platform has 1.8 billion daily users and 12 million businesses advertising on the social network, bringing in significant revenue.

On the downside, it no longer has a duopoly with Alphabet on digital advertising, with names like Amazon and Apple now also big in this space. Digital advertising has proven to be more cyclical than previously thought, and Meta has regulatory problems.

There is also the elephant in the room – big spending on the metaverse and no idea when there will be any payback.

‘The attempt to regulate advertising worries me quite a bit,’ says Smith. ‘With the metaverse, I’m convinced something real is going to emerge, it’s just difficult to envisage because it doesn’t currently exist. But you only have to go back 10 years and see people who are pretty knowledgeable poo-pooing the concept of the cloud.

‘If I was looking for a single event to get us from the point of “it’s a bit of mystery and they’re spending a lot of money on it and we don’t know how it works” to “that’s interesting”, it will be the first person to sell some glasses that start to deploy what this is. I suspect that is going to be Apple. That still doesn’t mean Meta is going to be the winner or a winner, there are still levels of uncertainty here that I
don’t like.’

Smith has already shown a fondness of companies that sell services based upon an installed base of equipment. Until recently Fundsmith held a stake in Finnish group Kone (KNEBV:HEL) – in addition to making and selling elevators, escalators and automatic building doors, it provides maintenance solutions to keep them working. This theme extends to UK testing and certification business Intertek (ITRK) which has previously featured in the Fundsmith portfolio, generating a constant stream of revenue by checking products contain what’s on the label.

Apple also plays to this theme. It has created an ecosystem that starts with someone buying one of its electronic devices and then subscribing to its content across films, fitness and more, as well as using its payment services. ‘It’s got to the point where I think Apple TV, Apple Music, Apple Pay is real and it’s going to keep coming,’ says Smith.

By waiting 12 years to put Apple in Fundsmith’s portfolio, Smith has missed out on approximately 1,350% total return (share price and dividends reinvested) from the iPhone maker. A cynic might even suggest he’s far too late to the party because all the easy money has been made from the stock. In Smith’s view, there are still plenty of future rewards to be had.

The Fundsmith boss is a dab hand at remembering classic investment-related quotes to help illustrate a situation. He recalls something Warren Buffett wrote in the 1993 letter to Berkshire Hathaway (BRK.A:NYSE) shareholders, citing a remark from a 1938 issue of Fortune magazine: ‘Several times every year a waiting and serious investor looks long and with profound respect at Coca-Cola’s (KO:NYSE) record but comes regretfully to the conclusion that he is looking too late. The spectres of saturation and competition rise before him.’

The value of Coca-Cola has risen significantly since 1938, suggesting that it’s never too late to back an exceptional company. And Smith certainly seems to think that’s true with Apple.

‘Me buying into Apple at $125 or whatever we paid for it to start a holding in November clearly isn’t as good as buying it at $6, but equally if we think there is value in here and it is a very good business, looking in the rear-view mirror isn’t going to help you. We have to think about the future.’

NEXT STEPS FOR UNILEVER

Smith is not short of an opinion on any stock in his portfolio and Unilever (ULVR) has been on the receiving end of some choice words in recent years. The fund manager has criticised the FTSE 100 company’s management for spending too much time on ESG (environmental, social and governance) matters and not enough on the day-to-day running of the business. He’s also attacked strategy plans and accused the company of ignoring his request for an audience despite being a long-time shareholder.

Unilever has just appointed Hein Schumacher as its new chief executive, replacing Alan Jope. What are the key priorities for the new boss, in Smith’s opinion?

‘I hope the new chief executive will stop the process of playing what Warren Buffett characterises as Gin Rummy management. You’ve got a set of cards; you keep discarding one and picking up a new one. “Let’s get out of spreads and tea and buy Glaxo’s consumer healthcare product business.” No, stop it.

‘I think the first thing the new Unilever chief executive should do is make each of the business segments it has – food, household cleaning products, wellbeing and beauty products, and ice cream – why don’t you make each of them the best you can in terms of organic sales growth, profitability and returns on capital. Let’s get it all working properly first, then think about whether we want to make any changes.’

FOCUS ON WHAT YOU DO BEST

Smith objects to companies which stray too far away from their core business. He says for innovation to work and deliver value to investors it ‘almost always’ must be within an existing franchise. Here, staff already have knowledge and the means to bring the product or service to market. Just consider how Reckitt (RKT) launched the Cillit Bang cleaning product in 2005 and less than 20 years later it is considered a ‘power brand’ by its owner.

‘When people try to develop outside of the core business, guess what, it doesn’t work very well,’ says the Fundsmith boss. ‘If we take a fast-moving consumer goods business like Procter & Gamble (PG:NYSE) and Unilever which are big in household cleaning and personal care products, they go “It’s only a short step outside that into beauty”. No, it’s not. It’s like Neil Armstrong’s giant leap for mankind.’

Procter & Gamble failed with its attempts at the beauty industry and wisely sold its operations. Unilever also ventured into this space, with limited success. It spent $2.7 billion in 2017 on cosmetics firm Carver Korea which Smith calls a ‘clearly bad’ deal. He has even worse things to say about Unilever’s $1 billion purchase of male grooming brand Dollar Shave Club. ‘That acquisition has basically been buried in an unmarked grave. These are not businesses where they had an existing core franchise.’

The new head of Unilever mustn’t play the blame game, adds Smith. ‘Stop blaming the previous CEOs for everything,’ he says, adding that good companies have seamless changes in management and don’t go around saying the last person did it all wrong.

Given these comments, it’s clear Smith is more sceptical of the management than the business itself. If it was the other way round, the shares would have been sold a long time ago.

DISCLAIMER: The author has a personal investment in Fundsmith Equity Fund

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