I recently finished reading Investing for Growth by Terry Smith. Mr Smith is sometimes called the “English Warren Buffet”, with an amazing track record that continues to impress.
Up until 2021, his Fundsmith Equity fund returned 18.4% per year since its inception in 2010. That’s …some performance vs the 12.8% of MSCI world index.
Why is a passive investor like myself interested in individual stocks or active management? That’s a good question.
After all, my lazy portfolio has performed really well, it’s super cheap (0.2% average annual cost) and takes zero time to maintain.
Despite that, I am hungry for learning and curious to understand how companies work and where returns come from. As the amounts grow and the bull market continues I become more concerned about keeping the wealth I have built. Rather than looking at the MSCI World Index ETF as a black box, I want to dig a bit deeper:
- Is the bull market trend sustainable?
- How do successful managers with skin-in-the-game think of the markets and stocks?
- How come some active managers consistently outperform?
- What makes a great company a great investment?
- Where do returns come from?
- Are stocks better than real estate?
Curious investors will find the answers to these questions enlightening.
Two things struck a chord with me after reading this book.
- Great companies can make good use of capital
- Why seeking income (dividends) from great companies can hurt investor returns
Buying Quality companies
To make money in the stock market you don’t necessarily need to bet on great companies. In fact, many people have become ultra-rich by taking sides in failing companies making a comeback or even shorting them (Bill Ackman, George Soros).
But investing in such companies makes it harder to make money because time works against you. Time is on your side in a profitable company with a healthy balance sheet.
If there’s one focus in Terry’s mind is finding quality companies and buying them at a fair price.
Great companies have growing earnings and growing Earnings Per Share (EPS). But because investors focus too much on EPS together with the Price to Earnings ratio, companies can inflate it. Such are the corporate shenanigans that are exposed with examples (I’m looking at you, Tesco 2014).
Also, earnings can grow but at what cost? Earnings don’t account for the capital used to produce them.
If the cost of capital is higher than the return on the capital then the company is destroying value for the shareholders.
For example, you can grow the EPS by borrowing much more and make the numbers look good while also paying dividends. But over time, if you can’t make more than the costs you’re hurting the investors and the company.
Great management makes good use of the money (equity, debt etc). This is what Return on Capital Employed is all about. ROCE together with how profitable the company is, Free Cash Flow yield are two top metrics when assessing companies.
If you’re curious about ROCE and other return ratios then you should read this fantastic thread by 10kdiver.
Finding great companies is one thing, buying them at fair prices is another! 😉
Not overpaying is equally important too.
Companies with a high return on capital don’t pay out dividends. They consider it a ‘waste’ to pay shareholders instead of investing the money themselves for much higher returns. Why is that? After all, I could just take the dividend and re-invest it in the same company, isn’t it the same?
Avoid Dividends to Boost Returns
Income is really hard to find these days. The UK bonds pay less than 1% per year and banks pay nothing.
We live in a negative interest rate world if you factor in inflation. Our money loses buying power in bonds. It’s even worse when sitting idle in the bank.
Property investing offers better cashflow. But Buy to Let struggles to produce a decent income after fees, maintenance and (recent) taxes at personal ownership. So what should investors do if they are desperate for income?
Why investors should prefer to skip the dividend
Profitable companies pay out some of their earnings to shareholders. This rewards them for holding shares. Every year, we receive a payment that is much more stable than the stock price itself. Even in times of crisis, like in 2008, companies only cut their dividends by 25%.
We know that dividends are part of the reason stock markets have done well. Simply reinvesting those dividends back into the stocks allows for higher returns and better compounding.
John Bogle, the Vanguard founder, calculated that reinvested dividends income accounted for ~95% of the compounded long-term return earned during 1926-2007. Investing $10,000 at 1926 inception would have grown to $33.1m with dividends reinvested. The final amount with NO reinvestment would be just a paltry $1.2m! A 32m difference!
We knew dividends are important for compounding. But what surprised me is the following new (to me) fact.
The reason stocks have done so well is not the outperformance thanks to dividends paid out.
It’s the dividends re-invested in a very “profitable engine” that makes a big difference.
Companies should pay out dividends when they cannot re-invest the capital in a more productive way (R&D, new products etc).
When we re-invest those dividends, the share buy has to happen at the market price by definition. You first receive the dividend and then re-invest it by buying more shares in your broker account. Yes, even ‘accumulation funds’ work the same way, they just do it automatically on your behalf.
Here comes the catch. The company share price is typically higher than the actual value of the company. Shares typically trade at a multiple of ‘book value’.
As a result, if high-returning companies did not pay out a dividend but retained the profits and invested in their projects, this would make for a much cheaper way to build wealth for the end investor.
Retained earnings -> Products/Innovation/Sales -> Higher share price
It is the reinvestment of retained earnings, not dividends, which accounts for the majority of the growth in the value of equities.
This is the reason Google, Amazon or Berkshire Hathaway have not paid a dividend in the past 50 years.
They can re-invest the earnings at book value rather than pay it out (plus they reinvest in a very profitable engine automatically over time).
As you would expect, blindly re-investing those retained earnings is no panacea. Companies that can make good use of capital (high ROCE) can benefit much more from that than companies in low growth mode.
As I’m writing this post, the UK index FTSE 100 has a price to book of 1.85. This means that for every pound of earnings companies retain they currently create 1.85 of market value!
So what can we learn from this? The way I see it, the higher the rates of return on the capital invested, the fewer dividends it should pay. It’s the total return that matters after all (share return + dividends).
Not to mention dividend taxes which makes things even worse. Even inside an ISA, the US tax office withholds 15% of the dividend. That’s thanks to a UK-US treaty, otherwise, this would be 30%!
The reinvestment of retained earnings is also a unique aspect of equities investing compared to bonds or even property. If you have a profitable property (high return on capital employed!) you can’t just re-invest the rent into it and benefit from the compounding.
Best case you will probably gather enough rent and buy a similar one later on if you can.
After reading this book, I am less worried about the lack of income in my portfolio. Earnings can be re-invested cheaply at a much higher return on capital.
Psychologically, selling a small chunk of the portfolio to manufacture a ‘yield’ does not feel great. But it’s a fine strategy if I look at the bigger picture.
Should I trust Terry Smith with my Money?
It is very tempting to invest in Fundsmith equity fund after understanding their thinking process, ethics and values.
Speaking of ethics, for example, they never commented on the Neil Woodford situation, when his business was deteriorating. They are very transparent and communicate directly with retail investors.
You should definitely read the book and understand his thinking before doing so.
We all know the financial independence values which I also support: Keep costs and taxes low by only investing in passive index funds.
It’s not that active managers are bad investors. It’s that they typically own too many stocks, hug the index and produce similar results but with much higher fees. This -on average- will result in worse returns for the end investor.
To succeed away from the passive investing universe, you either need to be an above-average investor or pick one who is. Both are hard tasks!
Plus we all know the phrase Past performance does not guarantee future results and all that.
Not all managers are made equal though.
Like in Tour de France, some riders are trained for climbing the mountain and others for the flat race. You can’t find one who can win every stage of the tour.
Terry Smith describes the fund’s investment style in 3 points:
- Invest in great companies
- Don’t overpay
- Do nothing
The fund invests mainly in quality companies in tech, consumer staples, and healthcare. Popular names include PayPal, Microsoft, L’Oreal, Philip Morris and previously Dominos and P&G.
Quality companies have more predictable returns, are closely monitored (but not ‘activist managed’) which gives me some confidence they should outperform in a downturn (despite the current excellent performance in the good times!).
For the finance geeks out there, the fund’s Sortino and Sharpe ratios are better than the MSCI world index since inception.
10 years is definitely a somewhat decent fund age and of course, Terry Smith has been around for much longer than that.
What about Fundsmith fees?
The annual ongoing charge figure (OCF) is 0.75%. I appreciate Smith’s honesty by highlighting that the OCF charge is only what investors see in the industry.
The OCF does not include the fund trading fees and bid-ask spread or stamp duty taxes. Then we wonder why the investment industry gets a bad rep…..
To give a good example of how the industry should operate, Smith has reported all numbers since the beginning. Trading very infrequently and keeping a “passive active fund” approach if you know what I mean, keeps costs low. The total charge in Fundsmith Equity fund including all charges is about 1 to 1.10% every year.
Investing for Growth was only released in 2020 and it is more of a collection of essays by Terry Smith rather than an actual book.
As expected, if you want to understand the values of their Fundsmith equity fund and its profile, the book is a must-read. But for me, it was more about understanding the thinking behind successful managers and ultimately getting a better understanding of how companies work.
They are run by humans and act like them from time to time… Like presenting better forecasts when an activist investor puts pressure on them. Well, why didn’t you tell us in the first place you plan on growing more 😄
We can’t predict the future so none of this is any advice to invest (or not) in Smith’s fund.
As we enter 2022 I wish you all a Happy, Healthy and Prosperous 2022.
If you are a company owner with idle money earning zero interest, have a look at the Company Investing Course.
We can’t predict the future but we can focus on things we can control. Our investment strategy, our tax structures, choosing decent and affordable investment platforms and never stop learning.
The course starts on the 17th of January and there are still a few places left before it’s sold out. Join us!