Lessons From Fundsmith's 2018 Shareholder Letter

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Includes: BRK.A, BRK.B, CL, CLX, FB, IMBBF, IMBBY, MCD, PM
by: Steven Chen
Summary

Making a smaller loss could be more significant than delivering larger gains.

A long-term focus is crucial to investing success but is often in shortage among investors.

Seemingly low valuations could always go lower.

Traditional value investing is not superior.

Having a contrarian view based on facts is not only important but also sometimes necessary.

Background

With the launch of the Smithson Investment Trust to focus on smaller caps last October, Fundsmith, a London-based asset management firm, now operates three funds - the other two including the flagship open-ended Fundsmith Equity Fund and the closed-ended Fundsmith Emerging Equities Trust. Fundsmith Equity Fund claims to be "the No.1 performer since its inception in the Investment Association Global sector by a cumulative margin of 13 percentage points over the second best fund and 188 percentage points above the average for the sector which has delivered +81.9% over the same timeframe."

The mastermind behind the investment fund, Terry Smith, who often has been referred to as "the English Warren Buffett,” spells out his stock-picking strategy as simple as "ODD":

  1. Only invest in good companies;
  2. Don't overpay;
  3. Do nothing.

For those who are interested in learning more about his approach and philosophy but have not done so, feel free to check out my previous article: My Encounter With Fundsmith And Underrated Lessons To Reiterate

In my view, Terry Smith's ways of investing are quite close to that of Warren Buffett, and they are simple, understandable, actionable, and most importantly, makes quite some logical sense. The annual shareholder letter from Terry Smith is certainly on my radar (just like the one from Warren Buffett), and here we go - his 2018 letter just came out (check this link).

As usual, I expect some things for me to take away even from a short letter like such, and below are the lessons I would like to share with the SA community.

Lesson #1

There are 2,592 mutual funds in the Investment Association (‘IA’)universe in the UK. In 2018, 2,377 or 92% of these produced a negative return. 13 posted a return of exactly 0%. Just 202 had a positive return. Our Fund was in the 4th percentile — only 3% of funds performed better. Ironically, 2018 was not a great year for our absolute returns but it was actually our second best year relative to all IA mutual funds. 2011 when the market also fell was our best, probably not coincidentally.

Fundsmith Equity Fund tends to outperform especially during market downturns. This is the point reconfirming my own investment experiences so far, although it is not proved by any research: in order to beat the benchmark for the long run, making a smaller loss may be more significant than delivering larger gains. How a portfolio reacts to bear markets and recessions appears to be a more determinant factor to its long-term success. By coincidence, Warren Buffett often mentioned this same thing when discussing the characteristics of business performance at Berkshire Hathaway (BRK.A) (BRK.B).

From a simple mathematical perspective, a hypothetical portfolio experiencing a 50% loss in value would need a 100% gain to get back to the pre-loss level; however, if the loss was just half of that 50% (i.e., 25%), then it would just need a 33.33% gain to break-even - only 1/3 of that 100% should be more than enough now.

Lesson #2

Tumultuous, turmoiled or turbulent Black Monday may have been, but did it really matter? Take a look at the chart below of the Dow Jones and see if you can spot Black Monday. You will need good eyesight or reading glasses to do so.

Source: Fundsmith Annual Letter 2018.

A long-term focus is important to investing results, while human nature tends to produce a shorter attention span. Real investors, in my dictionary, are those concentrated on the long run, thinking about products, customers, business models, competitive landscapes in 5, 10 and even more years.

When you look back at the 1987 Black Monday crash, many of you would certainly have a contrasting opinion as if you were within the post-crash period. Volatility is your friend; let the market serve you but not guide you. Maxims like such are easy to tell but hard to act upon. This is where emotional intelligence would play its role, as well as the fun (and challenging) part of investing. This is a world full of a great number of smart people, but how about wisdom?

Lesson #3

A ‘value’ stock like Imperial Brands (formerly Imperial Tobacco) was on a historic P/E of 8.1x at the end of 2000 in a bear market. It is now on a historic P/E of 16.5x. An aim for a value investor might be to buy ‘value’ stocks in a downturn when their yield is higher than the P/E.

Terry Smith is not a fan of the traditionally defined value stock strategy (I do not think that Warren Buffett is a value investor per the traditional definition, either), even though he is seeing value stocks would come back into fashion sooner or later.

However, for traditional value investors, he gave a very rough guideline of valuation that can be regarded as "cheap" - a P/E ratio of less than 10x. This is just a general view, which does not or should not apply to all industries, but the threshold here is expected to remind investors of the overpricing of stocks compared with their historical lows (the real value entry points). Again, because of the normally shorter attention span, those attractive pricings probably have been long since forgotten by Mr. Market. Imperial Brands (OTCQX:IMBBF) (OTCQX:IMBBY) is just one of many examples. Checking other staple names like McDonald's (MCD), Clorox (CLX), Colgate-Palmolive (CL), you would observe similar deviations from their 2008/2009 levels in terms of price multiples (see below).

Source: Morningstar; data as of 2/18/2019.

Source: Morningstar; data as of 2/18/2019.

Source: Morningstar; data as of 2/18/2019.

This means that seemingly low valuations compared with "recent" historical averages and overall or industry-specific levels could go even a lot lower than you think.

Lesson #4

Unlike our strategy which is to seek such stocks and hold onto them, letting the returns which the company generates from this reinvestment produce good share price performance, value investing suffers from two handicaps. One is that whilst the value investor waits for the event(s) which will crystallise a rise in the share price to the intrinsic value that has been identified, the company is unlikely to be compounding in value in the same way as the stocks we seek. In fact, it is quite likely to be destroying value. Moreover, it is a much more active strategy. Even when the value investor succeeds in reaping gains from a rise in the share price to reflect the intrinsic value he identified, he or she needs to find a replacement value stock, and as events of the past few years have demonstrated, this is far from easy. Moreover, this activity has a transaction cost.

This describes the traditional definition of value investing - buy stocks at low price multiples and then sell them at high ones. The real question is whether those low and high price entry points can be found and how frequent those would emerge. For example, even if a value investor buys stocks at low multiples throughout 2009 and sells at high multiples after six years of a bull market afterwards, s/he would probably have stayed in cash since 2016 till now, missing the second leg of the bull.

Another issue with the traditional value play is that time is often the enemy of your holdings as many cheap businesses do not generate adequate free cash flow on capital or keep reinvesting at a high rate of return, therefore very likely "destroying value." On the contrary, time is a friend of wonderful businesses.

Lesson #5

Undeniably, 2018 was not a good year for either the tobacco industry or social media, due to regulatory concerns. This is the case impacting Fundsmith's two major holdings: Philip Morris (PM) and Facebook (FB).

Philip Morris:

Philip Morris was caught up in the noise and uncertainty which surrounds the new reduced-risk products — vaping and heat-not-burn technology — where Philip Morris has a market leading product in iQOS. I suspect we can tell that the company is on the right track not just in terms of introducing products which wean smokers off cigarettes and so make their consumption safer and give a new leg to its business but also by the number of regulators and commentators who oppose them.

Philip Morris International only targets ex-US markets, where regulations are loose relatively to the US, but seems to be unfairly punished by the concerns originating from a series of FDA actions and commentaries.

Facebook:

I strongly suspect that most people’s judgement of Facebook is based upon their personal experience and prejudices. But 69% of Facebook’s DAU and 73% of its MAU are outside the United States and Europe. How much do you think they care about allegations of misuse of data in a US election? Not much I would suggest which seems to be borne out by the fact that in the third quarter the number of DAU grew by 9% and MAU by 10%.

The majority of Facebook users are based outside of the zones with tightening regulations, and therefore, it may not be justified for the company to trade at this all-time-low valuation (see below - P/E at the end of 2018 was even below 20x).

Source: Morningstar; data as of 2/18/2019.

Regardless of the market pessimism against Tobacco companies, like Philip Morris, and social media giant Facebook, the businesses themselves are relatively solid with potential to grow. Investors should stay objective, have the contrarian view, when needed, based on facts, and hopefully take advantage of Mr. Market, who would likely offer to sell at cheap prices. In the end, his loss will be your gain.

Summary

Investing is the domain in need of continuous learning. I enjoy reading shareholder letters from professionals who I resonate with, such as Terry Smith and Warren Buffett. There are always new lessons expected to be learned, as successful investors are learning machines themselves.

I hope that you enjoyed reading this article. If you find anything missing but valuable from the 2018 Annual Letter, feel free to comment below. Meanwhile, I will be at Fundsmith's annual meeting later this month in London and will share more thoughts if any.

Disclosure: I am/we are long MOST OF THE STOCKS MENTIONED. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.