Investors in the Fundsmith Equity fund did not miss out on much of the value recovery, according to manager Terry Smith, who says the rotation from high-growth stocks to unloved companies has been “rather underwhelming”.
In his interim letter to shareholders, the manager explained that the fund’s underperformance was due to inflation and subsequent need to raise interest rates. This has prompted investors to move away from Smith’s preferred quality-growth companies and into value stocks.
This defining narrative of the year so far had caused Fundsmith Equity to underperform the MSCI World index by 6.5 percentage points in the first half of 2022, although this has widened slightly since, as the year-to-date graph below shows.
Total return of fund vs sector and MSCI World index in 2022
Source: FE Analytics
However, he pointed out that while in the US the S&P Value index did significantly outperform its growth counterpart and the main tech index, it still fell 12% versus a 28% decline for the S&P Growth index and a 30% decline in the Nasdaq.
“Falling less than others when times are tough has obvious merit but still isn’t a sufficient payback for the long preceding wait during which value stocks underperformed massively,” he said.
In fact, the manager said that not owning traditional value sectors “didn’t do us any harm” in the first half of the year, with the S&P Banks index down 25%, the S&P Airlines index falling 22% and even the S&P Metals & Mining index down in absolute terms.
“The one sector in the ‘we’ll never own’ category that did cost us by our absence was energy. In the US, the S&P Energy index increased 29% in the first half while in the UK, BP shares rose 17% and Shell 34%,” Smith said.
“For those regretting the absence of energy stocks from our portfolio, these increases have only taken the S&P Energy index back to a level it first reached in 2008 or the two UK stocks reached in the 1990s.”
Now, however, he said that the highly rated tech sector has been “turned on its head”, with the free cash flow yield of the 78 technology stocks in the S&P 500 at 4.6%, while the equivalent 36 consumer staples stocks are 3.8%, meaning tech is cheaper than consumer goods companies.
Smith pointed out that while some tech remains expensive (highlighting the ARK Investment Management’s ETFs as examples), his technology stocks – Microsoft, Adobe, Alphabet, Visa, ADP, Intuit, PayPal and Meta – trade on a price-to-earnings ratio of 24x, although Amazon is an outlier.
He added that the portfolio’s holdings delivered “decent underlying business performance” in the first half of 2022, but acknowledged that this may be “little source of comfort” to investors at the current moment.
Smith also shared his view on other asset classes, pointing out that in inflationary periods the acronym TINA (there is no alternative) is used in relation to equities.
On the topic, he said that bonds were “certainly not the place to be in these conditions” while real estate was “a notoriously local market with poor liquidity and high frictional trading costs”.
Commodities, which have done well over the past 18 months on the back of restricted supply, “have had a day in the sun”, he argued. While this may continue, Smith said it relies on the investing thesis of ‘greater fool theory’: selling to someone willing to pay more than you did.
Finally, while some may wish to try and sell equities into cash (which will avoid further falls), he noted that “we can safely say you missed the top”.
“Getting the other side of the trade roughly right will almost certainly mean buying back into equities when economic conditions are at their most bleak. This is a skill which few, if any, possess. Meanwhile, time spent in cash whilst waiting is hardly a good bolt hole from inflation,” said Smith.
He also used this as a rationale not to disinvest from Fundsmith Equity in favour of value equities, pointing out that this would be a subset of the market timing approach.
Smith argued that value stocks, while seemingly flavour of the month so far this year, will not hold up well in a recession, which some commentators have already suggested will take place later this year.
This would take us back to the 1970s, the last time the world suffered high inflation along with recession. In this scenario, brought about by rising interest rates – which he called a “blunt tool” that will “do nothing to correct the continuing supply problems” – the Fundsmith Equity manager argued that his stocks should hold up better than the market.
“The best defence against this inflation is a high gross margin,” he said, which he defined as the difference between sales revenue and the cost of goods sold. On average, his companies have a margin of 60%, while the market is around 40%.
“It is too early in the development of this inflationary economic cycle to be sanguine about this and the next few quarterly earnings seasons are unlikely to be overly exciting. Nonetheless, the structure of our companies’ profitability gives us considerable comfort,” he said.
“From a fundamental perspective, which is what we seek to focus on, we are therefore confident that our portfolio companies will perform relatively well over an inflationary and recessionary cycle.”