After a year of “two halves”, Fundsmith founder Terry Smith says the Fundsmith Equity fund was hurt by market rotation in the latter half of 2016 but he remains committed to its trademark investment approach.
The fund was up 28.16 per cent in 2016, narrowly underpeforming the 28.24 per cent gain for its MSCI World index benchmark. The fund was still in the second quartile of the IA Global sector, where the average member was up 23.33 per cent.
Performance of fund vs sector and benchmark during 2016
Source: FE Analytics
In his annual letter to investors, Smith explained that sectors favoured by the fund fell out of favour and saw their share prices decline.
Cyclical stocks performed better as analysts anticipated a rise in economic growth following the election of Donald Trump as US president, while the quality growth areas favoured by Smith - such as consumer staples - lagged for the first time in several years.
He said: “I have no way of knowing whether this ’rotation’ will continue but then again neither do any of the analysts or commentators who are involved in opining on the matter.”
Smith highlighted four years of market commentary suggesting that the strategy of the fund would underperform but had instead risen by around 100 per cent in value. The fund is the best performing member of its sector over three- and five-year periods.
Describing the analyst commentary as “simplistic”, Smith noted that the small interest rate rise by the Federal Reserve did not justify the sell-off in ‘bond proxy’ stocks seen more recently.
Smith warns that a switch to cyclical stocks - as suggested by market analysts - could pose further risks if the global economy does not grow as predicted.
A move into cyclical stocks would suggest that investors have spotted a buying opportunity rather than a long-term value proposition.
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
Indeed, the fund manager says he does not subscribe to the ‘Greater Fool Theory’, “in which you hope to buy from a seller who is less competent than you at spotting this opportunity and when the time comes you need to sell to a buyer who is similarly ill informed”.
The FE Alpha Manager says he remains amazed by the number of managers, investors and analysts “obsessed with trying to predict macro events on which to base their investment decisions”.
Smith highlights the election of Trump and the EU referendum result in the UK as a failure of analysts to predict events.
He said: “I spend little time worrying about the macro trends and even less time trying to apply predictions about them in order to manage our portfolios.”
OutlinIng almost a dozen macro challenges for 2017, the fund manager says even accurate predictions and timing would not produce a basis for investment decisions.
He added: “Markets are a so-called second-order system - to usefully employ your predictions you would not only have to make mostly correct predictions but you would also need to gauge what the markets expected to occur in order to predict how they would react. Good luck with that.”
The manager says instead - like companies he most admires - he concentrates on things he can control such as stock selection.
“The companies in our portfolio have significantly higher returns on capital and better profit margins than the average for the indices,” he explained.
“They convert more of their profits into cash and achieve this with a much lower level of borrowing than the average company.
“Nor is this a one off - they have been achieving these superior results for many years. The average year of foundation of our portfolio companies at the year-end was 1912.”
The manager also seeks high returns on capital and a source of growth.
He said: “So how did our companies fare in that respect in 2016?
“The weighted average free cash flow... grew by just over 11 per cent in 2016.
“We regard this as a rather good result given the generally lacklustre growth which the world is experiencing and which led to earnings falling on the FTSE 100 and S&P 500 companies in the past year.”
The fund’s top five contributors performance were: IDEXX Laboratories, Stryker, CR Bard, InterContinental Hotels and Johnson & Johnson.
“The largest contributor, IDEXX, is a company which we began buying in 2015,” said Smith. “It is the world’s largest maker of veterinary testing equipment.
“In contrast, we have held stakes in Stryker, InterContinental Hotels and Johnson & Johnson since inception.”
Performance of IDEXX Laboratories over 2016
Source: Google Finance
He added: “You may note that out of the five worst contributors to our performance last year, four were consumer stocks and at least three are regularly cited as ’bond proxies’.
“It seems strange to be accused of having benefitted from the popularity of these stocks when in fact they have underperformed.”