Terry Smith, the founder, and CEO of Fundsmith, is a renowned investor known for his sustainable and long-term investment strategy. With a successful career spanning over four decades, Smith's straightforward approach and unwavering principles have earned him widespread respect. Under his leadership, Fundsmith consistently achieves impressive returns by carefully selecting high-quality companies with strong competitive advantages.
Recently, I listened to a podcast that explored Terry Smith's unique investing philosophy, which sets him apart from others in the field. Through this insightful conversation, I discovered five key principles that form the foundation of his stock-picking approach. These principles are invaluable takeaways for any investor:
1. Invest in good companies
Terry Smith emphasizes the importance of investing in high-quality companies that consistently generate returns on their capital higher than their cost of capital. According to him, such companies are rare, and he employs a screening process to identify them while filtering out poor companies. Investing in good companies allows investors to rely on long-term value creation.
As Smith mentioned, "If you are a long-term investor, owning shares in a good company is a much larger determinant of your investment performance."
2. Prioritize simplicity and transparency
Smith strongly believes in the importance of simplicity when it comes to investing. He firmly advocates for straightforward business models that are not only easy to understand but also transparent in their operations.
To achieve his investment goals, Smith diligently avoids complex or opaque investment instruments. He recognizes that such instruments can often be difficult to comprehend and can carry hidden risks. Instead, he focuses on identifying businesses that have clear and understandable revenue streams. By doing so, Smith ensures that he can accurately evaluate the potential risks and returns associated with an investment.
Furthermore, Smith is cautious about unnecessary complexity and excessive reliance on financial engineering. He understands that some investment opportunities may appear attractive due to their intricate structures or sophisticated strategies. However, he remains cautious and prefers investments that rely on fundamental principles rather than complex financial manoeuvres.
3. Avoid overpaying
Smith cautions against overpaying for stocks and highlights the risks associated with buying cheap stocks in the hope of a price increase. While some value fund managers pursue this strategy, Smith argues that it is not a reliable approach for achieving outperformance. Instead, he focuses on selecting companies that offer long-term value, even if they appear relatively expensive in the short term. He believes that predicting differential rates of compounding is challenging for investors and that quality companies can consistently compound value over time.
4. Practice patience and maintain a long-term perspective
Smith's investment philosophy revolves around taking a long-term view and refraining from unnecessary trading. He believes that if good companies are selected correctly, there is no need to constantly seek new companies to invest in. By avoiding unnecessary trading and maintaining a concentrated portfolio of high-quality companies, investors can reduce the costs associated with portfolio management. Smith also acknowledges that periods of underperformance are inevitable and advises against solely focusing on short-term results.
He uses Alphabet as an example, acknowledging the cyclical nature of the advertising market in which Google operates. However, he believes that the digital advertising space will continue to grow in the long run, and Google's dominant position will enable it to capture a significant share of that growth. Smith advises investors to focus on a company's long-term potential rather than its short-term challenges.
5. Be mindful of fees and investment costs
Smith is a vocal critic of high investment fees and the detrimental impact they can have on long-term returns. He strongly believes that investors should be aware of the potential negative consequences of excessive fees and actively seek out low-cost investment options.
Smith expresses concern about the widely adopted "two and 20" fee model in hedge funds, which typically charges investors 2% of their assets annually along with 20% of any profits earned. He compares this fee structure to "highway robbery," highlighting the significant portion of returns that can be eroded over time due to these fees. Smith emphasizes the compounding effect of fees, illustrating how even seemingly small percentages can have a substantial impact on investment gains when compounded over the long term.
To mitigate the negative impact of fees, Smith advises investors to opt for low-cost investment alternatives, especially when considering passive funds. He advocates for investing in funds that have minimal management fees and expense ratios, allowing investors to retain a larger portion of their investment returns.
Furthermore, Smith stresses the importance of focusing on a company's total return potential rather than solely relying on dividend yield or short-term gains. He encourages investors to consider the overall growth prospects of a business, considering factors such as revenue growth, market share, and competitive advantage. By adopting this approach, investors can align their investment strategy with long-term wealth accumulation rather than being swayed by short-term fluctuations.
Conclusion
Terry Smith's investing philosophy offers valuable insights for investors seeking long-term, sustainable success. By focusing on high-quality companies, simplicity, and transparency, avoiding overpaying, maintaining patience and a long-term perspective, and being mindful of fees and costs, investors can enhance their chances of achieving favourable returns. Smith's principles emphasize the importance of thorough research, a clear understanding of business fundamentals, and a disciplined approach to investing. By incorporating these principles into their strategies, investors can navigate the complex world of finance with confidence and increase their potential for long-term financial growth.
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