Fundsmith Equity Fund 2019 ASM notes

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The Annual Shareholders' Meeting (ASM) for the Fundsmith Equity Fund is a unique event. I am not aware of any other open-ended funds that offer a similar meeting. The wit and wisdom of Fundsmith is worth listening to in the flesh.

Mr Smith and his colleagues achieve an impressive feat: making the world of fund management interesting.  The event took place on 25th February 2019.

The Fundsmith Equity Fund ASM is not on the same scale as Warren Buffett’s annual meeting. But it does deliver a number of lessons on business, investing and life in general.

A video of the event has now been posted to YouTube.  Fundsmith has also released the short-form report for 2018.

The notes I made after attending the ASM are below.

A low-quality ASM photo (thanks iPhone 6s)

The host    

The host of the ASM, Jeff Randall, used to present Sky Business News. He is friendly while also asking tough questions i.e. without Paxman-style aggressiveness.

Mr Randall joked that the fund had better perform well as his daughter’s wedding was not going to be cheap.  He hosted the event for free and has the bulk of his personal wealth (outside of property) in the Fundsmith Equity Fund.

This was the last year that Mr Randall would host the event and Smith ensured he received farewell applause.

In my view, the current format for the meeting works well. A power point presentation, by contrast, is much less interesting.

Terry Smith and Jeff Randall prepare ahead of the ASM

ASM key takeaways: 

Below are some of my takeaways from the meeting. I have hopefully captured the mood and comments accurately. Apologies to Fundsmith if I have not done so.

I also did a fairly long report on Fundsmith here and there are a number of Brewin Dolphin podcasts with Smith and Julian Robins (Head of Research) here.

ASM Quotes

One of the best quotes from the discussion was this:

Better a painful end than pain without end.

My notes don’t tell me what this referred to (torture?)

On valuation:

Things are not cheap or expensive [in isolation]. They are only cheap or expensive relative to other things.

Below is a theme that Smith has talked about in an FT article. It is worth repeating:

Equities are the only asset class where part of the return is invested for you.

Two great Smith quotes on growth/quality:

Growth without quality: a busy fool

Quality without growth: Kraft Heinz

Smith or Julian Robins repeated the Charlie Munger quote: 

There was no trade on the markets today with everyone happy with what they had.

Another Munger quote referenced was:

Show me the incentives and I’ll show you the outcome.

I'm not sure which of the below quotes Smith used.  We will have to wait until the video is released to find out.

The plural of anecdote isn't data

The plural of anecdote is data.

Fundsmith Equity Fund performance in 2018

When Terry Smith took the stage he noted that the Fundsmith Equity Fund posted its third-best relative performance to date in 2018. The fund is defensive in nature and does best when “there are problems.”

There are apparently 2,592 mutual funds in the UK and 92% of them posted a negative return in 2018. The Fundsmith Equity Fund posted a positive 2.2% return in 2018, which put it in the 3rd or 4th percentile of fund performance.

Fundsmith was handsomely beaten by a Canadian marijuana fund.  Terry jokingly (I think) said he wished he had invested in it.  The Fundsmith return in 2019 year-to-date was 11% at the time of the ASM.

The Fundsmith Equity Fund ran down cash towards the end of 2018 due to market weakness i.e. buying when markets fell back.

The Fundsmith portfolio generated 8% growth in free cash flow in 2018 versus 13% in 2017.  The free cash flow yield of the portfolio, therefore, increased from 3.8% at the start of 2018 to 4% at the end of the year.

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Performance since inception on 1 November 2010

Of the large funds in the UK, Fundsmith Equity Fund has done best since inception (1 November 2010) on a risk-adjusted basis, using the Sortino ratio as a guide.  The Sortino ratio measures the return per unit of risk.

The Sortino ratio for the Fundsmith Equity Fund is 1.11 while the next best performing fund in the UK was L&G Global Health and Pharma at 0.87.  Healthcare is defensive and also subject to growing demand.

The saying that "health is wealth" appears to be true in more ways than one.

The next best generalist fund (not sector driven) was the Morgan Stanley Global Brands fund with a Sortino ratio of 0.81.

The L&G Global Health & Pharma fund has also performed well

Source: SharePad

1) FTSE 100 has a load of rubbish in it

This was one of the most interesting comments that Terry Smith made during the event. It is a sentiment that I agree with.

Around 70% of the FTSE 100 is accounted for by the banking, mining and oil and gas sectors. These are cyclical, low return and mature industries. It is no surprise, therefore, that the FTSE 100 has failed to perform well since 2000.

FTSE 100 sectors at 31 January 2019 

Source: SharePad

2) Rotating into value in a late bull market has never worked

Terry Smith addressed a theme that has been pushed by commentators. With markets seemingly overstretched one argument is that we should shift into “value” - cheap shares may be more resilient if markets fall.

This approach has never worked according to Smith. Value stocks collapse along with everything else when markets decline.

The MSCI European Value index was down 52% in the financial crisis. Smith stated that value does best in a market recovery.

This chimes with a number of key UK investment sectors. Homebuilders and miners were “cheap” in 2007 on a P/E basis but fell by more than the market in 2008/2009. Cyclical stocks are "cheap" at the top of the cycle.

The trouble with the value approach, in my view, is that cheap stocks tend to be cheap for a reason.

3) Colgate: reasons for exiting

Smith revealed why the fund had sold out of Colgate.

The toothpaste maker has apparently been increasing prices to generate revenue growth. According to Smith, this approach never works.

Colgate is an interesting stock and one that Smith has mentioned at earlier ASMs.

He has quipped that half* the world currently doesn't use toothpaste. If they want to form a relationship with the half that does they had better start using it.

*(I don’t recall the exact proportion).

4) Facebook: scope to increase the number of advertisers

Facebook is a hot topic with it having been added to the fund in early 2018. The shares initially rallied and then fell back as a number of scandals hit sentiment.

The funniest part of the ASM was when Jeff Randall asked a question from a Fundsmith shareholder on Facebook.  The question was full of indignation and is well worth watching the video for.  It was something like this:

Terry, Facebook is a disaster.  When can we get shot of the thing?  Management are awful and keep on messing up.  Lets just get rid of it for heavan's sake.

I had a look at Facebook's investment case in January 2019

The rational for buying Facebook was outlined in Fundsmith’s annual shareholder letter. Smith also added a number of interesting points at the ASM.

Facebook has 6 million advertisers on the platform. The small business accounting software group Sage also has 6 million customers.

Sage is largely a European business. The implication is that Facebook has a significant opportunity to increase the number of advertisers.

Smith also compared Facebook to Microsoft at the time the fund established a position. In other words, there is a significant negative sentiment toward Facebook - a high growth and high ROCE company.

The cost of running Facebook has increased from US$27bn in 2017 to US$44bn in 2018 and is expected to hit US$65bn in 2019.

Facebook's overheads have therefore increased by over US$35bn in two years.  This creates a significant barrier to entry.

Facebook will still have a 30% margin after the overhead increase.   Smith said something along the lines of:

To those who say Facebook is in trouble I would ask one question: which competitor is going to take them out?

Fundsmith asks companies like L’Oreal if they are spending less with social media platforms and influencers. The response is that they remain positive on social media advertising.

Terry Smith stated that people have accused Facebook founder Mark Zuckerberg of many things.  But no one has accused him of being stupid.  In other words, Facebook is spending heavily because it is in its interests to do so.

Facebook should be thought of as an advertising platform, according to Smith, rather than just a social network.

5) Fundsmith’s organic growth meter

This was a new one for me. Apparently, Fundsmith has an organic growth meter to measure the underlying growth that its holdings are generating.

This could be something that is worth mimicking. Companies that run out of organic growth often do strange things i.e. high priced acquisitions and price increases etc.

Quality companies are worth a lot less without quality growth opportunities. Anyone can deliver growth, but not everyone can deliver high-return growth.

Organic growth is the key driver of high return-growth. In short, good companies make products that people want to buy more of.

6) The biggest threat to the Fundsmith Equity Fund in 2019

I was surprised that Smith took this question head-on. He started by saying the fund is not run on the basis of economic forecasts.

At the same time, Smith also said that the biggest threat to the Fund is an increase in rates. This makes sense.

Equity market valuations tend to decline when interest rates increase.

7) Market outlook

This was another question that I was surprised Smith was willing to answer. He noted the parallels between markets today and 1997/1998.

A well-developed bull market was underway in 1997/1998.

In December 1996 the Federal Reserve chairman Alan Greenspan questioned whether “irrational exuberance” had taken hold.

The Asian financial crisis and the Long-Term Capital Management debacle then saw the Federal Reserve cut rates.

This led to two more years of the bull market up until 2000.

Smith’s view is that trade tensions and other factors may keep global rates at a low level. This may result in the bull market continuing for another couple of years.

Smith noted that inflation is coming back. If you are looking for work you can apparently earn US$120,000 as a truck driver in the United States.

There are apparently 7 million job openings in the US, which creates inflationary pressure.

8) Scaremongering about Brexit is ludicrous

Smith dismissed Brexit scaremongering as ludicrous.

The UK is less than 3% of world GDP and perhaps accounts for 2% of the revenue generated by the companies in the Fundsmith Equity Fund.

Taking Unilever as an example, the UK accounts for less than 5% of the group’s revenue. Unilever has a policy of not commenting on markets that are less than 5% of revenue.

This made the furore surrounding UK Marmite prices in 2016 largely irrelevant.  It was only one product in a country that generates less than 5% of revenue.

Apparently, Unilever’s UK price increase for Marmite just after the Brexit vote was opportunistic: the key ingredients are sourced from Burton-upon-Trent.

Unilever survived World War II with one HQ in the UK and one in the Netherlands.  If they can survive that they can survive Brexit.

9) Fundsmith Equity Fund’s technology exposure

Technology is the largest sector exposure in the Fundsmith Equity Fund. In the words of the host Jeff Randall:

Fundsmith has shifted towards gadgets and gizmos and away from dog food and toothpaste.

Fundsmith generally owns mundane technology rather than the "sex and violence" (exciting) spectrum of technology companies.

The tech companies that Fundsmith own are pretty defensive. They have increased revenue in every year since the financial crisis with the exception of one company.

The shift away from consumer staples has in part been driven by forced sales (takeovers).  The latest of these was the takeover of Dr Pepper Snapple.

10) Fundsmith Equity Fund owns defensive stuff

Apparently, a portfolio similar to the Fundsmith Equity Fund would have increased by 12% in the post-dotcom bust. It would have declined by 12% in the 2007/2008 financial crisis.

These are similar to the returns of the pension fund Smith was managing during the financial crisis.  Fundsmith Equity Fund should generate its strongest relative performance when markets head south.

11) Which holdings are you most excited about in 2019?

My notes tell me that the answers are Facebook and Phillip Morris. This reflects weak share price performances for both companies during the last 12 months.

Julian noted that stocks in the Fundsmith portfolio don’t tend to experience weak share price performances for more than two consecutive years.

On this basis, the outlook for  Phillip Morris is positive.

12) Phillip Morris in focus

Philip Morris may have been the worst performing holding for the Fundsmith Equity Fund in 2018. The shares were trading at over US$122 in mid-2017 and hit a low of US$66 towards the end of 2018.

The tobacco group is the leader in next-generation products with US$6bn spend on the development of its IQOS stick. The product is apparently selling like hotcakes where it has been introduced.

I think Terry Smith referred to the IQOS product as "cool."  Smith remained sanguine on tobacco stating that things often get better when governments clamp down.

The reason is pretty clear in the case of tobacco: government intervention has reduced costs (advertising) and made it impossible for new competitors to come into the market.

Julian Robins' son has put forward a question at the last two ASM's.  This time around he highlighted the poor share price performance of Phillip Morris.

Julian also revealed that his son had topped up the fund in the Autumn - just before the equity market sell-off.

13) Why is L’Oreal not a top ten holding?

At the previous year’s ASM, Julian and Terry were both asked which stock they would hold if they could only hold one stock. They both replied L’Oreal.

A question this year was on this basis why isn't L’Oreal a top-ten holding for the fund. The explanation is that L’Oreal and Estee Lauder would jointly be the largest holding in the fund.

When Fundsmith is not able to find a "perfect company" they buy two businesses. Another example of this is the fund's shareholding in Intuit and Sage.

When choosing only one stock to hold forever you need to avoid companies that can be disrupted.  L’Oreal is not at significant risk of disruption according to Robins i.e. it has the smallest existential threat.

2018 was the best year for cosmetics spending in 20 years.

14) Errors of omission (stocks Fundsmith could have owned)

These included exiting Domino’s Pizza Inc, not owning Mastercard and not owning Church (& Dwight?). However, Fundsmith owns Visa, which is in the same segment as Mastercard.

Fundsmith has apparently been frustrated by a lack of engagement from Johnson & Johnson.  The US pharma giant hasn't been willing to explain why some of its business segments are underperforming rivals.

15) Impact of stock selection from the Investment Universe

The Fundsmith approach is to identify an investment universe (IU) of companies that meet its criteria. The fund then invests in around 28 of the most attractive companies in this universe.

Someone asked what impact stock selection from the investment universe had had on the fund's performance.  The answer was a 46% return improvement since inception.

Stocks from the IU had increased by 224% since inception in November 2010 while the Fundsmith Equity Fund is up 270%.

16) Does Fundsmith worry about inequality and high levels of pay

Fundsmith would prefer to own a company like Costco where the lowest paid works are reasonably paid. This is preferable to the policy of Walmart, which pays the minimum wage to its staff.

The Costco model is more sustainable in the view of Julian Robins.

17) Diversity

It is good to see Fundsmith tackle questions like this.  They repeated the mantra that they always want the best person for the job.  They generally like people to apply directly to Fundsmith rather than have to pay headhunters.

Smith noted that they have had only one female portfolio manager apply to work at Fundsmith to date.

18) Is Smithson taking up too much of Terry and Julian's time?

Apparently, Smithson was a fair amount of work to get going with Terry and Julian involved in the research process.  However, the managers of Smithson have only asked the opinion of Terry/Julian once since the fund's inception.

Smith didn't view his work on Smithson as a waste of time because it improved his "peripheral vision." I.e. it built up an understanding of new areas.

19) Lady luck

Robins noted that the Fundsmith Equity Fund has been accused of being lucky in terms of its starting date.  We have experienced a strong global bull market since March 2009.

Robins noted that Fundsmith had been lucky in one key sense.  With the fund starting after the financial crisis, they could see which companies had been resilient.

This allowed Fundsmith to invest in the highest quality companies available.  Businesses that withstood the financial crisis should be able to weather any future challenges.

20) Smith remains on the ball

One of the most interesting parts of the ASM was when Terry Smith highlights a mistake in one of the Fundsmith slides.  The cash conversion metric for the S&P 500 and the FTSE 100 was the wrong way around (see P7 annual shareholder letter)

I thought the table looked odd.  It put FTSE 100 cash conversion at 96% and S&P 500 cash conversion at 84%.  The FTSE 100 is not meant to be a high-quality market.

It turns out the FTSE 100 cash conversion was 84% and the S&P 500 cash conversion was 96%.  Smith noted that the high figure for the S&P 500 may be due to an accounting anomaly.

The US corporate tax cut created a one-off boost in cash conversion for US-listed companies.

Smith also noted that the leverage ratio in the table may be misleading.  Fundsmith Equity Fund companies don't need much equity capital to operate.

Nine companies in the Fundsmith portfolio operate with net cash and one company doesn't use any capital - I'll have to see if I can figure out which company that is (Kone, Paypal?).

Terry and Julian have worked together for 33 years.  This is probably longer than most marriages.

21) Voting record

Fundsmith votes on all the issues impacting its holdings.  It doesn't engage outside consultants to determine which way to vote.

My notes tell me that Fundsmith has voted against remuneration reports 60% of the time.

22) Latest new stock addition to Fundsmith: McCormick

Fundsmith noted in its January 2019 factsheet that it has started building a new position.  This was revealed to be in the US food group McCormick. (Citywire spotted the purchase in mid-February).

The rationale for buying McCormick (MKC) was that it 1) has the highest returns of any food business and 2) did well buying Reckitt Benckiser's food business (i.e. French's Mustard).

Fundsmith appears to have got in at an attractive level with McCormick's shares experiencing weakness since December 2018.  The food company has outperformed the S&P 500 since 2004 (excluding dividends).

McCormick has two share classes and may, therefore, be controlled by the founding family.  The business was started in 1889, in Baltimore, by Willoughby M. McCormick at the age of 25.

At the current rate, Fundsmith has added one new stock a year.  McCormick is the first new position since Facebook was added in early 2018.

Smith noted that doing nothing is important for two reasons: to minimize costs and to minimize mistakes.  The Fundsmith Equity Fund appears to have made relatively few mistakes since inception.

McCormick & Co and the S&P 500 index (both excluding dividends)

Source: SharePad

Personal comment

These sorts of events are valuable at building trust between investors and fund managers. The crux is this: do you trust the active manager looking after your money.

Interactions like this also help in terms of “behavioural coaching.” I.e. not selling out when markets are at rock bottom.

We tend to pile into markets/funds at the top and exit near the bottom.  This is human nature and is hard to avoid (Smith alludes to this in this presentation.  Also see the book "The Invisible Gorilla")

Unfortunately, we all still cavemen and cavewomen at heart.  We have an innate herding instinct (buy into strong markets) and innate survival instinct (sell at the bottom).

I have been to a number of Fundsmith ASM’s and they have never been disappointing. Questions are researched in advance, which makes the answers thoughtful and insightful.

Smith is a keen student of Buffett and often quotes the 1979 Berkshire Hathaway shareholder letter.  (The paragraph starting: "The primary of managerial economic performance....).

With Fundsmith avoiding banks and other low return sectors you can argue that the approach is: 'more Buffett than Buffett.'  Fundsmith applies Warren Buffett's investing principles in an extremely disciplined manner.

Attending the ASM

To attend the ASM you have to buy at least £1,000 worth of the Fundsmith Equity Fund directly from Fundsmith.  That was the position when I last checked with Fundsmith a year or so ago.

My haul of freebies from Fundsmith Equity Fund ASMs to date

Talking of behavioural biases 

I have tried to persuade a close relation to invest in the Fundsmith Equity Fund for a number of years.  The explanations I get for not doing so are:

If it was that simple everyone would be doing it.

Simplicity refers to the simple three-stage process used by Fundsmith: 1) buy good companies 2) don't overpay 3) do nothing.

Another pushback is the following:

How can you make a lot of money from toilet cleaner and soap?

It is counterintuitive that you can make good money from toilet cleaner and toothpaste. We tend to associate making a fortune with a speculative gold miner.

I have never heard anyone say, "To make your fortune invest your money in companies making toilet cleaner."