Terry Smith recently released a new book to mark the tenth anniversary since the launch of his flagship ‘Fundsmith Equity Fund’. Titled ‘Investing for Growth’, it’s a compilation of articles and annual shareholder letters written between September 2010 to August 2020, the book contains a wealth of insights into one of the most successful fund managers of his time.
Since inception (November 2010) the fund has returned 420% (to 30 October 2020), far ahead of its benchmark (MSCI World Index), which returned 183% over the same period. I have no doubt the book will become a best seller, however its worth asking if this marks peak Fundsmith?
Having seen countless fund managers fail to sustain market alpha, I’m skeptical as to whether this outperformance can continue. The reasons are many, but below are a few of the key ones:
Valuation
Their marketing strapline is “buy good companies, don’t overpay and do nothing”, sounds easy right? The problem is the sort of quality companies Terry Smith looks for are significantly overpriced, reducing their future expected returns. Using their preferred valuation metric of free cash flow (FCF) yield, the average FCF yield of the portfolio stood at 7% in 2010, where as it was 3.4% in 2019, by comparison the year-end medium FCF yield of the S&P 500 stood at 4.2%.
Commentators have been warning that the shares of the sort Fundsmith invest in are highly rated; these concerns were first raised back in 2012. I realize that had you followed their advice and sold the fund you would have foregone enormous gains; over the eight period from the first warning you would have missed out on a 350% of gain. But the iron law of investing is mean reversion; valuations can only stretch so far before the rubber band snaps back.
Size
Questions about size are frequently raised during the annual shareholder meetings and each time Terry Smith’s answer is broadly the same. The companies they invest in have an average market capitalization of £131bn, with a fund size of £21bn and 30 holdings – the fund will hold approximately 1% of each company, he argues this is hardly an illiquid holding.
However this answer misses a few key points, one being that Terry has admitted that the creation of ‘Smithson Investment Trust’, a global equity fund devoted to small and medium size companies was because of the fact that many of these companies which fit their quality criteria are too illiquid for their larger main fund. Moreover he has openly admitted that Fundsmith is now too big to hold Dominoes Pizza, one of their most successful stocks held during the early years.
The Fidelity Magellan fund’s Achilles heel – Size
Legendary fund manager Peter Lynch ran the Magellan Fund from 1977 to 1990; during this period he generated a 29% annual return, an astonishing feat. However there is a big caveat, which is that the fund was closed to the public until mid-1981. And the funds best returns came during those early years when it had a low amount of assets under management (AUM), just $18 million.
From mid-1981 to 1990 the fund generated a lower return of 22.5% per year vs. 16.5% for the S&P 500. The AUM ballooned to $14 billion in 1990 and then to a high of $105 billion in 1999, this staggering growth in assets coincided with a deterioration in performance.
For example during the early years the fund outpaced the S&P 500 by an astonishing 10% per annum.
After the fund’s assets hit $1 billion in 1983, it continued to outperform the benchmark, albeit at a lower rate of 3.5% per year until the fund hit $30 billion AUM in 1993.
From 1994 to 1999 the fund grew to a record high of $105 billion AUM. This is where performance failed to persist; it underperformed the benchmark by 2.5% over the same period, the fund’s underperformance continued after the turn of the century.
Berkshire Hathaway’s Achilles’ heel – Size
Another example is Warren Buffett’s Berkshire Hathaway – from when he took over in 1965 to the end of 2019; he made an annual compound return of 20.3% Vs. 10% for the S&P 500 over the same period.
A closer inspection of the performance data exposes the same pattern as the Magellan fund, which is that the greatest outperformance came during the early years when they were a much smaller company.
In the 1960’s they outperformed the S&P 500 by 23.3% per annum, outperformance dropped to 21.7% in the 1980’s, then to 6.8% in the 2000’s, and over the last decade they have underperformed the benchmark.
Buffett has been warning for some time that returns would decline as the firm got bigger, during a Businessweek interview in 1999, he famously said:
“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
The conclusion is that scale undermines performance, today Berkshire Hathaway sits at a market capitalization of $542 billion, and the opportunities for growth are much smaller now than they were in the past.
Seeds of destruction
Fundsmith is the best selling actively managed fund within the UK, hoovering up the lion’s share of fund inflows, but these very flows are eliminating their excess returns.
They now face a shrinking universe of investable stocks due to liquidity constraints, couple that with a high TER of nearly 0.95% for I class shares and lower future expected returns due to lofty valuations, the appeal of Fundsmith is not what it was during the early years. While it is still too early to tell, previous studies have shown that a fund’s outperformance will shrink (as assets pour in) until it converges with that of an index fund.
S&P Dow Jones is well known for their ‘active vs. passive’ scorecards, but they also have a ‘persistence scorecard’, which measures how well a manager can sustain superior performance. The results are a harbinger of Fundsmith’s fate – few fund managers’ can consistently outperform. The results from the December 2019 persistence scorecard show that less than 1% of equity funds maintained their top quartile performance at the end of the five-year measurement period. Fundsmith is unusual in that its maintained top quartile performance for a decade, as time goes on this will get increasingly difficult.
All told, Terry Smith has been very public about his winning formula, and with copycat funds providing similar offerings, and size reaching uncharted territory, has his edge been competed away? Past examples don’t inspire confidence.
Disclosure: I hold Fundsmith Equity Fund at present. I am monitoring the fund closely to see if returns converge with that of their respective benchmark – the MSCI world index.
The Astute Investor 