Being a successful investor involves little more than finding good companies and holding onto them, according to FE Alpha Manager Terry Smith, who says the approach behind his sector-topping performance can be boiled down in the three steps. 
Smith (pictured) launched Fundsmith Equity in November 2010, positioning the fund almost as an antidote to an industry that he views as being “broken” and promising to invest in companies with clearly defined characteristics then not complicate matters by trading around.
“The fund management industry is broken,” he said at the time. “The vast majority of fund investors suffer from punitive fee structures, overtrading, fund proliferation, closet indexing, and over-diversification. The net result is poor performance.”
FE Trustnet has written on a number of occasions about how the average IA Global fund – which is the sector where Fundsmith Equity resides – has found it difficult to outperform indices such as the MSCI World and the FTSE World.
Smith’s fund, on the other hand, has consistently bucked this trend. Since launch, it has made a 152.98 per cent total return compared with a 72.75 per cent rise in its MSCI World benchmark and an average gain of just 48.59 per cent from its peers. This makes it the highest returning member of the sector over this time frame.
Performance of fund vs sector and index since launch
Source: FE Analytics
When it comes to the process behind these numbers, the manager does not claim to have discovered any secrets that other investors cannot apply.
At a recent event hosted by Jupiter Asset Management, he said: “How we manage money at Fundsmith is a type of investment style that I haven't invented, I'm not only person on the planet who does it and we haven't discovered anything new.”
“There is no new methodology in this area of human endeavour, which has been raked over a lot. But it is something I think we can apply successfully and it comprises a very simple three-step process.”
In the following article, we take a closer look at these three steps and why Smith thinks they are so important.
Step 1: Try to only buy shares in good companies
Smith says that if investors only remember on this about his process, it should be this as it is the lynchpin supporting everything else he does.
“You might think it axiomatic that all fund managers try and buy good companies but no they don't. I was a broker for many years and frankly they'll buy any old rubbish,” he said.
“They'll buy bad companies because they are going to be turned around, because the management is going to change, they're going to get taken over, the cycle is going to turn, they bought them lunch and told them it was a good idea. Very few people, in my view, focus on buying good companies.”
While the manager concedes that others have built successful investment careers through buying companies that do not meet his definition of ‘good’, he views this as being the best way of consistently adding value for his unitholders.
When determining which are good companies and which aren’t, Smith focuses on one financial metric: making a high return on capital employed across the business and economic cycle. Put simply, if a business can make returns that are above, say, the rate of any loans then will have surplus cash to re-invest for growth and distribute to shareholders.
“Don't just take my word for it. Warren Buffett in his 1979 annual chairman's letter said: "The primary test of managerial economic performance is a high rate of return on equity capital employed,” Smith added.
“This is probably the man with the greatest investment performance of the past 50 years and since he said that it's been almost universally ignored by the investment industry.”
This isn’t all the five FE Crown-rated Fundsmith Equity fund looks for, however. Another key element of finding good businesses is looking for those that own strong intangible assets and have advantages that are difficult to replicate.
This includes those with brand names, high market shares, patents, licences, distribution networks, installed bases and client relationships. These qualities are clearly on show in Fundsmith Equity’s top holdings.
Source: FE Analytics
Step 2: Try not to overpay
“This is deliberately in second place,” Smith explained.
The manager points out that it is “obvious” that investors will not actively seek to overpay for a stock but says this does not mean they should only pursue value opportunities without regard for if the company is good or not.
He cites another quote from Buffett, this time from his 1989 chairman’s letter: “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
While some investors argue that the biggest determinant of a stock’s return comes from the price you pay for it, Smith maintains that for long-term investors the most important driver is the return on capital the company can generate – even if a high price has been paid.
“We don't seek to overpay but it's a much less important characteristic that a company being 'good', but strangely whenever I talk to people in investment I find they spend far time talking about whether shares are cheap or expensive than whether they are good or bad,” he added.
“For long-term investors, the ‘good’ characteristics of a company are more important than the price you pay.”
Step 3: Do nothing
Smith admits that this is the “really tricky” element of his investment approach.
When launching his fund, Smith said that his ideal holding period is “indefinite”. He also cited figures from the financial regulator that the average fund manager had an 80 per cent annual turnover, which drives up overall costs.
He, on the other hand, wants to keep turnover as low as possible by only buying companies he wants to hold for the very long term.
"Once we have established these positions, we just try to get the hell out of the way and let them perform,” he said. “Last year our portfolio turnover – which was actually the highest in three years – was 2 per cent. We endeavour to do nothing.”
