The outperformance of the Smithson Investment Trust in 2021 highlighted the folly of blindly following the prevalent narrative rather than analysing stocks on a case-by-case basis, according to its manager Simon Barnard.
As part of the Fundsmith stable, Smithson only holds quality companies, including a number of fast-growing companies that have higher ratings than the market average.
Barnard said this meant that in a year when US 10-year Treasury yields increased from 0.91% to 1.51%, the trust should have underperformed the broader index.
“This is because high interest rates reduce the value of the future earnings of these companies once discounted back at the higher rates,” he explained.
The slower growing companies in the index are less affected by this phenomenon, which is why many commentators have been discussing a rotation into value stocks
Yet the trust’s returns of 18.1% last year meant it narrowly beat the MSCI World SMID Cap index and put it well ahead of the IT Global Smaller Companies average of 10.6%.
Performance of trust vs sector and index in 2021
Source: FE Analytics
Barnard attributed this outperformance to a number of holdings performing well for individual reasons, and the fact that financial theory often proves to be just that: “A theory which doesn’t actually play out perfectly in financial markets, driven as they are by millions of fallible, emotional people.
“Our highest-rated company was one of the best performers last year, up over 30%,” he added. “This also serves to remind us that ‘highly rated’ does not automatically equate to ‘expensive’ – it always depends on what you are getting for the price.”
However, he admitted he was still fortunate to have outperformed in this environment, warning that if interest rate expectations continued to increase, he may not be so lucky.
Yet Barnard said that he would not be changing his strategy, despite the presumption that value would outperform in the short term, as he argued that making money from buying cheap stocks that can rebound was easier said than done.
“You cannot hold value companies for the long term if all you are doing is owning a poor quality company at a low price, which you hope will re‐rate in the future,” he explained.
“If this does happen (there is no guarantee), you then have to sell the company to find another such investment, and so on.
“This means that time is not your friend, because the longer you are holding the company and waiting for it to re‐rate, the lower your annualised returns become, and if you’re particularly unlucky, the worse the company becomes.”
He contrasted this with his approach, where it doesn’t matter if it takes longer for the market to appreciate the value of his holdings, as the highest-quality companies tend to get better, “or at the very least bigger, owing to their growth”. As a result, he said that once he has found the right companies, all he has to do is wait.
Inflation has also been cited as a threat to a quality-growth approach, but Barnard said he was not unduly concerned about this risk. He pointed out that the companies he owns have high gross margins and therefore low raw material costs. They also tended to have low capital requirements, which allowed them to generate high returns on that capital.
"Quality" metrics of trust vs index
Data for the MSCI World SMID Cap Index is shown ex-financials, with weightings as at 31.12.2020.
Data for MSCI World SMID Cap Index is on a weighted average basis, using last available reported financial year figures as at 31.12.20.
Data for Smithson is on a weighted average basis, ex-cash, using last available reported financial year figures as at 31.12.20.
Interest cover (EBIT ÷ net interest) data for Smithson and MSCI SMID is done on a median average basis.
“As inflation affects both the cost of raw materials and the cost of plant and equipment, those that spend less as a proportion of revenue on these items will be relatively less impacted by cost inflation,” he continued.
“On top of this, the market structure and competitive positioning of many of our companies mean that they would also be in a position to raise the prices charged to their customers should the costs of the business increase.”
Barnard said this wasn’t necessarily a desirable outcome, as when a market leader raises prices, it can create an ‘umbrella’ under which competitors can flourish by charging less while still maintaining a good margin.
“But if inflation is creating a cost issue for the whole industry, it is comforting to know that our companies have the market power to increase prices should it become necessary,” he added.
Barnard finished by referring to the recent bout of volatility that has hit markets, saying it is at times like these it’s worth returning to your original investment goals.
The manager accepted it was always tempting to take profits on your best performers to lock in the gains when everything is falling. However, he warned against this tactic, saying long-term consistent compounders were difficult to replace.
“It makes no sense to sell a rare investment in which you still have confidence regarding the long-term outcome, to avoid a short-term decline which you cannot be confident in,” he said.
“Ultimately, we believe that whatever the macroeconomic environment, the secret to investment success is always to focus patiently on the long-term result. Because after all, that’s what you end up with.”
Data from FE Analytics shows Smithson Investment Trust has made 66.4% since launch in October 2018, compared with gains of 47.6% from the IT Global Smaller Companies sector and 37% from the MSCI World SMID Cap index.
Performance of trust vs sector and index since launch
Source: FE Analytics
The trust is on a premium of 1.4%, down from its one- and three-year averages of 2.1 and 2.3%.
It has ongoing charges of 1%.