Smith’s Fundsmith Equity fund has only just celebrated its three-year anniversary, but has already grown to £1.5bn in size. According to FE Analytics data it is the 11th most-bought fund in the entire IMA universe this year, having been the fifth-best performer in the IMA Global sector since launch.
He says the key to his success is looking for well-established businesses that have proved themselves over the long-term.
"We look for really good companies," he said. "There are probably only 75 worldwide [that we would invest in]. These companies have a long history, more than one economic cycle, so we’re talking decades."
"We do not seek to find tomorrow’s winners, rather to invest in companies which have already won. We invest in large, well established businesses which make their money through a very high volume of relatively small, repeat, predictable everyday events."
"Companies such as Colgate, Unilever and Domino’s Pizza, which have already won dominant positions in their respective sectors. We are encouraged to note that the average company in our portfolio was established in 1901 and has survived two world wars and the Great Depression."
Smith’s perspective coincides with that of FE Alpha Manager Nick Train, who recently told FE Trustnet that the average age of companies in his portfolio is 121 years.
"We accept there’s an element of cyclicality in every business, but the companies we look at even at the bottom of the economic cycle are still making great returns," Smith added.
The manager says there are three key mistakes investors make when buying individual companies. He tells the story of an investor in his fund who tried to create his own portfolio by investing in the top-10 holdings of Fundsmith Equity.
Smith, founder and chief executive of Fundsmith, says the investor was then taking his gains and re-investing them in his flagship fund because he found he had underperformed the manager.
The man’s reasoning, Smith says, was he couldn’t leave the stocks alone.
Smith says this is all too common a problem for investors. He says individuals rarely have the patience to hold on to stocks during dark times and, as a result, miss out on massive outperformance over the long-term.
The manager runs his Fundsmith Equity fund with this principle in mind – buying quality companies that have already proved themselves over the long-term.
The manager has a set of six criteria he strictly adheres to when selecting companies to put into the fund.
The first is high returns on operating capital employed, preferably in cash.
"This approach rules out most businesses that do not sell directly to consumers or that make goods that are not consumed at short and regular intervals," Smith said.
He adds that he looks for returns of 30 per cent or more on capital returns.
The manager explains that while investors ask for the rate of return on bank accounts or bonds, they ignore this clear signal when it comes to investing in companies.
Smith says the rate of return is the single most important indicator a company is a good buy – everything else is just noise.
He also looks for businesses whose advantages are difficult to replicate.
"We seek companies with brand names, trademarks, high market shares, patents, licences, distribution networks, installed bases and client relationships," he said.
"Together these define a company’s franchise and its ability to outperform competitors."
Another key indicator is that companies don’t need to borrow significant amounts to generate returns.
"We won’t buy companies that rely on leverage," Smith said. "We’re looking for companies with a large number of everyday, repeat, predictable transactions, like buying drinks or food."
He looks for companies whose growth is driven from reinvestment of their cash-flows at high rates of return.
The manager also looks for companies that are resilient to change, particularly to technological innovation.
"We will not invest in industries which are exposed to rapid technological innovation and therefore obsolescence," he said.
Finally, they need to be on attractive valuations.
"We estimate the free cash-flow of every company after tax and interest, but before dividends and other distributions, and after adding back any discretionary capital expenditure which is not needed to maintain the business," he said.
"Otherwise we would penalise companies which invest in order to grow. We only buy stocks when they are reasonably priced based upon this cash-flow yield."
Over the last three years, Fundsmith Equity has beaten its peers and the MSCI World index, returning 59.02 per cent since November 2010.
Performance of fund vs sector and index since launch
Source: FE Analytics
However, the manager says investors who are buying into his style of management need to realise short-term outperformance will not always be the case.
"Our fund is a bit like a rider in the Tour de France," he said. "No rider has ever won every stage. What you want is to be excellent at one thing and not bad at the others. We are excellent in bear markets and are not so good in bull markets. Investors in this fund will have to accept there are times you have to look away."
The eroding effect of charges is a key focus for Smith, who believes the industry is still overcharging for investment expertise. He adds that his buy-and-hold strategy can help to reduce fees for underlying investors.
"We seek to minimise portfolio turnover costs, which are excluded from the OCF, by only ever investing in good companies that we would be happy to own indefinitely."
Fundsmith Equity is invested in market-leading companies such as Microsoft, Imperial Tobacco and Intercontinental Hotels Group, which owns brands such as Holiday Inn and Holiday Inn Express.
The fund requires a minimum investment of £1,000 and has ongoing charges of 1.69 per cent.
