Terry Smith is ignoring all talk of a bear market and sticking by his investment process despite his Fundsmith Equity fund experiencing its weakest annual returns since inception. 
In his annual letter to investors, the FE Alpha Manager (pictured) said “it would not be surprising” if investors were worried about last year’s returns.
In 2018, the five FE Crown-rated Fundsmith Equity fund was up by just 2.2 per cent although it outperformed the MSCI World index benchmark, which was down by 3 per cent, as well as its average IA Global peer’s fall of 5.72 per cent.
Annual performance of fund since launch
Source: FE Analytics
After a relatively benign market environment in 2017, volatility returned with a vengeance last year and made it much more difficult for equity managers to outperform given a backdrop of increased uncertainty.
Smith noted that markets had fallen significantly in October and December due to “considerable anxiety from some market participants” over issues such as the Federal Reserve’s rate-hiking programme, Brexit and the growing threat of a trade war between the US and China, among other issues.
“Despite the hysterical headlines this, in my opinion, falls well short of turmoil – a word frequently used to describe these event,” he noted, adding that “October has been a notoriously bad month for stock markets in recent decades”.
One of the most famous Octobers in recent memory was the Black Monday on 19 October 1987, said Smith, when the Dow Jones Industrial Average fell by 22.6 per cent in one day.
“I can only imagine with some amusement how some of the commentators, ‘investors’ and market participants who are reeling from the events of this October and December would have performed in October 1987,” he said.
Looking back the sell-off is hard to recognise, said Smith, and did not really matter.
Yet, that has not stopped advisers and commentators from predicting crashes and bear markets or from suggesting investors take preventative action by rotating into different styles or selling everything to hold cash, according to the manager.
As such, Smith said he continued to stand by his principles for dealing with such events and predictions.
Firstly, that nobody can predict market downturns “with any useful level of reliability”. Secondly, that even if predictions do prove correct, investors would have foregone any gains that would far outweigh losses in a downturn had they listened to their advice.
The manager said that talk of the bull market coming to an end more recently also seemed premature, as bull runds are generally ended by a particular event rather than having gone on too long.
“A bear market will occur at some point,” he added. “We may indeed already be in one.
“The best stance is to ignore it since you can’t predict it or position yourself effectively to avoid it without impoverishing yourself by forgoing gains. But you have to possess the emotional and financial stability to stick to this stance when it strikes.”
Smith said any such rotation into value stocks may also be premature as the growth story may have further to run, particularly as bull markets often climb a ‘wall of worry’.
“As for buying so-called value stocks, if you wish to pursue this strategy it is best done after the bear market has struck, not before,” he added.
Performance of indices over 10yrs
Source: FE Analytics
Indeed, the manager said that the distinction between growth or quality investing and value investing is “somewhat superficial”, adding that the two approaches should be used together.
“Most investment strategies require some regard for the valuation of the stocks purchased or held – even strategies like ours which focus on high quality companies,” he said. “The rate of growth of a company is a critical component of its valuation.”
The Fundsmith Equity manager said value investing has been out of fashion in recent years as persistently low interest rates have driven the value of almost all stocks “beyond the reach of true value investors”.
“Nonetheless value investing has its merits and will surely have its day when stocks of the sort which attract value investors perform well,” he explained.
However, Smith said he will not be changing tack and pursuing a more value-focused strategy despite his belief that the stocks could eventually come back into fashion.
“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,” he said.
“One is that whilst the value investor waits for the event 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.”
He added: “Our strategy has the merit that inactivity is a benefit. If we have correctly identified the good companies whose stock can compound in value, we can hope to hold them indefinitely and still derive good investment performance from them with lower transaction costs.”
Performance of fund vs sector & benchmark since launch
Source: FE Analytics
Since launching in November 2010, the Fundsmith Equity fund has made a total return of 281.55 per cent compared with gain of 140.12 per cent for the benchmark and a 97.72 per cent return for the average peer.
The £16.4bn fund has an ongoing charges figure (OCF) of 1.05 per cent.