Investors should expect slowing growth from tech companies that have grown so large they are now cyclically tied to the wider economy, according to renowned fund manager Terry Smith.
In his semi-annual letter to shareholders, the Fundsmith Equity fund manager said he expected some of his largest holdings in the sector to have down years, but was confident over the long term.
“Large technology companies have in a sense become victims of their own success. Their growth over the past decade means that they are now such a large part of the economies in which they operate that they have become inevitably more cyclical,” said Smith.
At the time of the 2008-2009 recession, Apple, Microsoft, Alphabet and Meta had combined sales of $125bn. Today, Apple alone generates three times that sum and the combined sales of these four companies are around $1trn.
“As a result, the economic slowdown means that where Microsoft grew sales at 18% last year, we are looking at more like 7% this year. Meta is growing at about 8% where growth was previously well over 20%. Apple and Alphabet will almost certainly have down years in 2023 but we expect a decent bounce back in 2024,” the Fundsmith Equity manager noted.
Despite this backdrop, Meta was the £22.2bn fund’s best performer in the first half of the year, contributing 3.1 percentage points to its total return.
Performance of fund vs sector and benchmark in H1 2023
Source: FE Analytics
A year ago, Smith wrote: “Meta’s stock now trades on a FCF yield of 8.7%. At this level it is either cheap or a so-called value trap. We will let you know which when we find out, but we are inclined to believe it is the former.”
Since then, Meta's shares are up around 70% having tumbled towards the end of 2021 but remain 23% down from their peak in September 2021.
Despite being “too paranoid to ever declare victory” Smith said that while Meta's share price performance has been volatile, its fundamental performance had been less so.
Microsoft was the fund’s second best performer, contributing 2.6 percentage points to the overall return despite slowing revenue growth.
Top contributors to Fundsmith Equity’s performance in H1 2023
Laboratory instruments firm Waters was the biggest detractor for the year so far, contributing a loss of 1.2 percentage points to the fund’s overall performance this year as a slowdown in procedures since the pandemic continues to hamper returns.
Meanwhile, it was a mixed bag for the portfolio’s consumer stocks. While L’Oréal and LVMH were among the best performers, Estée Lauder was one of the worst.
Smith said the latter’s performance “concerns us”, after it was forced to write down stock it had built up in expectation lifting travel restrictions following harsh lockdowns in the country.
“Whilst domestic travel has returned, it seems that Chinese consumers are buying watches, handbags, and other luxury goods first which it was harder to shop for online during the lockdown. It has revealed some severe weakness in Estée Lauder’s supply chain with no manufacturing capability in Asia,” the Fundsmith Equity manager said.
“Our consumer companies in the main continue to generate decent top line growth, albeit mostly price led. Estée Lauder was unfortunately the exception with sales down 8% in its most recent report.”
Top detractors from Fundsmith Equity’s performance in H1 2023
LVMH, which grew 17%, PepsiCo (14%) and L’Oréal (13%) performed better, but he added that but rising input costs have put pressure on margins.
While his companies’ gross margins are “way above those of the market average which means their bottom lines are better protected”, Smith warned that “they cannot completely offset these headwinds”.
Overall, the veteran manager said “conditions are tougher and our companies are mostly having to cope with slower revenue growth and/or higher input costs”.
“However, that’s what happens from time to time so we are mostly sanguine about it. We have a few more worries as a result but not a wholesale concern about what is happening,” he concluded.
Smith also explained his rationale for dumping Amazon and Adobe – two stocks that he had bought and sold in quick succession.
The former was first bought in July 2021, while the latter was added in 2022, but both have been removed from the portfolio – an anomaly for Smith’s buy-and-hold strategy.
Smith said in his shareholder letter that he bought Amazon after its chief executive outlined new parameters for future investment projects. These were that they must deliver good returns on capital, be in a market that is underserved, provide a different approach to competitors and be where Amazon could acquire the “competence” to execute the strategy.
Smith said: “It is always easier to talk the talk than it is to walk the walk and the CEO’s pronouncement that he wanted Amazon to seek routes to get bigger in grocery retail ran counter to all these principles. In our view grocery retail has none of these characteristics and Amazon has already stubbed its toe in this sector with the Whole Foods acquisition.”
The manager noted that in discussions with companies, the majority ignore his suggestions and so he is “likely to be more active in exiting such situations where we disagree with the manner in which our investors’ capital is being allocated”. There was a similar rationale behind his decision to sell Adobe, he added.
The sale of Amazon was the key reason behind the fund’s 6.2% turnover in the first half of the year, Smith said.