Investment insight

The New Warren Buffet

The former chief executive of Tullett Prebon launched ‘Fundsmith Equity Fund’ in response to excessive fees and poor performance within the investment management industry.

In his own words, he wanted to give “fat and complacent” fund managers a bloody nose. Today the performance of Fundsmith has been exemplary; appreciating by more than 100% since inception (November 2010).

Below is a summary of Terry’s investment philosophy:

He’s a long-term, buy and hold investor. He laments fund managers for being too active, because unnecessary trading damages performance and raises management costs (difference between the bid-offer spread and commission). Renowned investor Warren Buffet eloquently said that “Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases”.

Avoids over diversification, they highlight research which shows that around 20 to 30 stocks are required for optimal diversification. The more stocks you own, the less you know about each one – its called ‘diworsification’. As Warren Buffett said: ‘Wide diversification is only required when investors do not understand what they are doing’. Terry Smith article on why ‘Too many stocks can spoil a portfolio’.

Invests in resilient businesses; they avoid industries that are subject to technological innovation. New technologies create value for some investors while destroying value for many others. Example: internet destroying the media industry. Moreover he will invest in good quality business only when the valuation is attractive.

Invests in businesses with a sustainable high return on capital employed (this measures the efficiency and profitability of a company’s invested capital). Companies that typically fit this bill are non-cyclical consumer businesses (food and toiletries) with repeat purchases.

Buys companies with ‘intangible assets’ that are difficult to replicate. By this he’s referring to brands, licenses, patents, dominant market shares etc.

Avoids market timing, studies show that the most successful fund managers avoid market timing. Stocks are a ‘giffen good’, this means that demand paradoxically rises as prices increase. Driven by greed and fear, most investors end up buying high and selling low.

Avoid companies that require leverage – They only invest in companies that generate high returns on invested capital on an unleveraged basis. This is why they won’t invest in companies which require borrowed money to function or survive –  such as banks.

Terry and his investment team are ‘global investors’. With a global perspective the fund is able to ‘contrast and compare growth rates and valuations across different geographies’. They also believe that the proliferation of ‘national’ and ‘regional’ funds are anachronisms, this approach leads investors to being overweight in a one market and underweight in another.

You’ll also notice that the name ‘Fundsmith Equity Fund’ doesn’t say whether its a Growth or Income Fund, he regard this distinction as artificial and a marketing ploy.

Interesting read: The Fundsmith Owners Manual.

Fundsmith Emerging Equities Trust (FEET)

On the back of a successful global equity fund, Terry launched an emerging market fund in June 2014 – raising £192.9 million at launch. The fund was set up as an ‘investment trust’ to address the low liquidity of emerging market stocks.

Fund Characteristics

FEET will use the same strategy of its flagship global fund (Fundsmith equity fund), but have the majority of their operations in and revenue derived from the developing economies. They will invest almost exclusively in consumer stocks and provide direct exposures to the rise of the consumer classes in emerging economies.

More specifically he will identify companies which deliver most of their profits as cash, have predictable revenues, low capital intensity and high returns on capital. He believes this combination will bring compound growth in shareholder return over the long-term.

Investable Universe

Using the same successful investment process as Fundsmith global fund, Smith has identified 139 companies within the FEET’s investable universe. Once fully invested, he anticipates investing in between 35 – 55 of them.

Backtesting the performance of FEET’s investable universe shows a return of 298% over five years to 31 march 2014, compared with 69% for the benchmark MSCI Emerging Markets index. Performance over 10 years is more marked, increasing by 1187% against 188% for the MSCI EM index.

Update: Following the placing and offer, the trust raised £193 million, including £5 million from Terry Smith himself.

Fundsmith Emerging Equities Trust (‘FEET’) website –

And the Fundsmith Emerging Market Equities Trust PLC – Owner’s Manual

All told – Terry Smith is an investment manager of exceptional calibre, a plain-speaking and outspoken maverick. Along with Nick Train and Neil Woodford, he’s one of the few fund managers I hold in high esteem.


I’ve compiled a list of useful sources when selecting the best investment funds.

They are a community of investors who’s goal is to help ordinary people who want to manage their own wealth become better informed.

They specialise in investment trusts because independent research demonstrates that investment trusts perform better over both short and long term horizons, than open ended funds (Unit trusts and OEICs).

Investment Trust Intelligence

Investment Trust Intelligence is a “library of high quality investment strategy research, fund analysis and useful guides for private investors, all written in-house by experienced analysts on the investment companies team at Kepler Partners”.

The research produced is entirely independent and they do not write paid-for research.

The Wealth 150 – Hargreaves Lansdown

The Wealth 150+ is their selection of the best funds available to UK investors. They offer a combination of excellent performance potential and low management fees.

In addition, their Wealth 150 is a broader selection of funds with excellent long-term prospects but don’t posses the superior characteristics as the plus selection.

A small caveat – their lists don’t cover investment trusts.

IC – Top 100 funds

The Investor Chronicles Top 100 Funds represents what they believe to be the UK’s best actively managed funds across all the major sectors and asset classes.

Citywire Selection

The financial publisher ‘Citywire selection’ is their independent analysis of the funds with the best established track records.

Citywire is an independent financial publisher that has provided news, investment analysis and research for professional and private investors

Bestinvest Premier Selection

Their list of top-rated funds across all major sectors with the potential to deliver superior returns.

Charles Stanley Foundation Fundlist

This is a list of their preferred funds, carefully selected by the Charles Stanley Collectives Research Team.

Money Observer rated funds

The Money Observer Rated Funds consist of actively managed funds and investment trusts that have consistently outperformed their peer groups over the medium term.

P/E ratio

The price-to-earnings ratio compares a company’s share price with its earnings. And in this case, takes an average for the whole stock market.

The FTSE 100 PE ratio presently stands at 15, and the FTSE 350 (an aggregation of the FTSE 100 & FTSE 250) trades on 16 times earnings, matching its long-term average. To put this in perspective, the UK stock market traded at more than 25 times earnings during the dotcom bubble (A speculative bubble in internet-based companies covering 1996–2000).

A more refined version of the PE ratio is the cyclically adjusted price to earnings ratio (CAPE), which smoothes earnings over the course of the business cycle, places the FTSE 100 on 13.5. This is again below its long-term average of 16.

However the cyclical adjusted price-earnings ratio (also known as Shiller price-earnings ratio) is by no means perfect, according to the financial economist and Reuters journalist Anatole Kaletsky. He correctly highlights that…

“Any comparison of valuations covering long periods is meaningless if it fails to take into account vast changes in technology, economic policies, interest rates, social and political structures, and taxes”.

Anatole explains that investors who followed Shiller’s methodology would have missed out on all of the gains within the last 25 years.

The Shiller price-earning ratio showed the stock market to be overvalued 97 percent of the time during these 25 years. Even during the two brief periods when the Shiller ratio was below its long-term average — in early 1990 and from November 2008 to April 200 — it never sent a clear buy signal. Instead, Shiller’s approach suggested that the valuations in 1990 and 2009 were only just below fair value — implying there was very limited upside at the beginning of two great bull markets that saw prices multiply fivefold from 1990 to 2000, and threefold from 2009 to 2014 (so far).

Therefore I would take this statistic with a pinch of salt.

Monetary Policy and Relative valuation

Monetary Policy remains very accommodative, both in Europe and across the Atlantic.

The Bank of England base rate is 0.5% and the European Central bank base rate stands at 0.05%. The Bank of England governor Mark Carney has suggested that a return of rates to the normal 5% remains unlikely in the medium term. In addition, he said that rate rises would be more limited and gradual than in the past and expects them to reach a new normal of 2.5%.

This translates into negative real interest on cash (where inflation exceeds nominal interest rates) and meagre gains on government and corporate bonds. Therefore on a relative basis, equities look attractive.

Elsewhere, inflation remains subdued and economic growth continues to pick up speed – this is good news for corporate profits. Earnings is one of two key drivers of share prices over the long-term, the other being the attractiveness of alternative asset classes.

Yield Gap

The yield gap is a common yardstick to assess whether a market is over or under valued. It is the average dividend yield in a market compared with the yield of a long-term government bond.

In this case, the FTSE 100 yields 3.4% and the FTSE 350 (aggregation of FTSE 100 and FTSE 200) yields 3.3%. By comparison the 10 year gilt year is 2.64%, this would imply that shares are undervalued. However critics would rightly point out that this method is distorted by quantitative easing and low interest rates.

Market sentiment

Finally, there is the ‘sentiment indicator’. FT investment writer John Auther’s rightly stated, “Bears need to capitulate, journalists need to stop writing articles about corrections and sentiment surveys need to grow unequivocally bullish. This is not happening yet, as this column indicates. This rally continues to be hated and distrusted, and retail investors continue to be heavily in cash”.

It reminds me of the old stockmarket maxim, ‘stockmarkets climb a wall of worry’.

This leads me to the conclusion that while the UK and developed markets are richly valued, they are not a bubble. If anything, I believe there’s a ‘bubble in the prediction of bubbles’ and many journalists make a comfortable living out of it!.


CAPE (or Shiller PE): The ‘cyclically adjusted price to earnings’ ratio is calculated by taking an average of earnings per share (EPS) over 10 years and dividing it by the current level of the stock market.

Interesting reads

Anatole Kaletsky – Time for a ‘melt-up’: the coming global boom” November 14, 2014

Anatole Kaletsky – ‘Here’s what it will take to trigger the next stock market correction’ August 21, 2014

Anatole Kaletsky – ‘Exuberance is not always irrational July 25, 2014

Jeremy Siegel – Don’t put faith in Cape crusaders” August 19, 2013

The business media is awash with financial jargon, perpetuating the myth that the stock market is hideously complex and therefore best left to the professionals.

Instead, successful investing requires a basic understanding of the financial markets and the application of sound investment principles.

Stock Market Terminology

What is a Share? Also known as ‘Equities’ or ‘Stocks’, they represent part-ownership of a company. As a shareholder, you have a right to say in the decision making (through annual meetings) and are entitled to a share of the profits through the payments of dividends.

Board of Directors – A group of elected or appointed members who run the day-to-day affairs of that company. They are elected by the shareholders to represent their interest.

Initial Public Offering – When a company raises money by issuing shares to the public for the first time. Also referred to as ‘Flotation’ or ‘coming to the market’.

Rights Issue – When a company issues new shares to existing shareholders in order to raise money.

Market Makers – Individuals or stock brokers who guarantee to buy and sell shares in a particular company, in order to maintain liquidity. They create markets in illiquid shares, ensuring there’s always a buyer and seller.

Bid-ask spread – This is the difference between the purchase price and the sales price, it is maintained by the market maker.

Liquidity – The number of buyers and sellers in a particular market. It impacts the degree to which an asset can be sold quickly and easily, with little or no change in asset value. Property is an example of an illiquid asset.

The Big Bang (October 27, 1986) – The day in which the London Stock Market was deregulated. Changes included a shift from open outcry to an electronic system and the abolition of fixed commissions.

Short-Selling – The practise of betting that a share price will decrease. It is the act of selling a borrowed asset with the intention of buying it back at a lower price and returning it back to the owner, pocketing the difference.

Moral Hazard – The incentive to take greater risks, because someone else will bear the costs if things turn badly.

Securities – The general name given to shares, bonds and similar investments that are often traded on the stock exchange

Blue chips – These are large, nationally recognized and well-established businesses. Examples include Royal Dutch Shell and Vodafone Group.

FTSE 100 – An index composed of the 100 largest companies listed on the LSE (London Stock Exchange). It measures the value of the top 100 companies and acts as a barometer of the British economy. Although most of the FTSE 100’s revenue are now derived internationally (more than 70%).

AIM (Alternative Investment Market) – It’s the London Stock Exchange’s market for small, high-growth companies wishing to raise finance without the onerous regulations of the main market.

S & P 500 – The Standard and Poor 500 is a stockmarket index made up of 500 of the largest and most widely held companies on the NYSE (New York Stock Exchange).

Both the FTSE 100 and S & P 500 are weighted by the market capitalization of each stock, meaning larger companies account for a greater portion of the index.

Dividend Aristocrats – A selection of companies in the S&P 500 companies which have increased their dividends for 25 consecutive years. Dividend aristocrats comprise 51 blue-chip companies, predominantly within Consumer staples, industrials, consumer discretionary and healthcare. The S&P 500 Dividend Aristocrats index has a dividend yield of 2.41% (April 28, 2017).

Bear Market – A prolonged period of declining asset prices, fuelled by investor pessimism and lack of confidence. It is characterised by stockmarket declines of 20% or more. Stock market corrections are historical norms, they happen roughly once a year in the 10% range and two to three times a decade within the 20% range.

By contrast, bull markets occur when financial markets have appreciated by at least 20%.

J.P. Morgan table of Bear and Bull markets.

Beta – This measures the sensitivity of a stock’s price relative to the overall market. If a stock has a beta of 1, it indicates a level of volatility equal to the stock market.

Alpha – This is the excess return of an investment relative to the benchmark. A positive alpha means the investment has outperformed its benchmark, and a negative alpha means it’s underperformed the benchmark.

Volatility – Indicates the speed and amount by which an investment changes in value. For example established blue-chip stocks tend to have a stable prices, making them less volatility.

Free Float – Is the portion of shares that are available to the public to trade. Certain exchanges have free float requirements. For example the FTSE (stock market index compiler) requires companies to have publicly available shares of 25%.

Core Tier 1 capital – A measure of a bank’s financial strength. This consists of shareholder equity (capital directly invested by shareholders) and retained earnings (profits not paid out as dividends).

Definitions of A-Shares, B-Shares and H-Shares in China

A-Shares – Shares of mainland China based companies traded on the Shanghai and Shenzhen Stock Exchanges. They are denominated in Renminbi and mainly available for domestic Chinese investors.

B-Shares – Shares of mainland China based companies traded in Shanghai and quoted in US Dollars or traded in Shenzhen and quoted in Honk Kong Dollars (open to foreign ownership).

H-Shares – Shares of a companies incorporated in mainland China that are listed on the Hong Kong Stock Exchange


Opportunity cost – Defined by investopedia as “What a person sacrifices when they choose one option over another”. In other words, it’s the benefits you could have received by taking an alternative action

Example – The opportunity cost of going to university is the money you could have earned from working instead.

Economies of scale – Are the cost advantages that a business can exploit by expanding their scale of production (definition from Tutor2u). As their output increases, they can achieve lower costs per unit.

What is the European Union (EU)?

A political and economic union between 28 European countries.  The EU was created in the aftermath of world war 2 to foster greater economic interdependence and put an end to centuries of warfare. Today, the EU has a population of more than 500 million people.

The EU’s greatest achievement is the creation of the single market (also known as internal market) – this allows the free movement of people, goods, services and capital.

Purpose of EU

The fundamental aims of the European Union are to promote greater social, political and economic harmony among member states.

Eurozone – A monetary union consisting of 19 European Union Countries which have adopted the Euro. Interest rates within the euro area are set by the European Central Bank (ECB), whose principal task is to keep inflation under control.

Financial Conduct Authority (FCA)

The body which regulates the financial services industry within the UK. Their aim is to protect consumers, ensure the industry remains stable and promote healthy competition.

Financial Services Compensation Scheme (FSCS)

The FSCS is the UK’s compensation fund of last resort for customers of authorised financial services firms. They pay compensation if a firm has stopped trading or being declared default.

The scheme protect depositors up to £85,000 per person per firm.

Investments are covered up to £50,000 per person per firm (for claims against firms declared in default from 1 January 2010).

About FSCS:

Peer-To-Peer Lending (also known as Crowd-Funding)

It is the practise of financing a business venture, by raising small amounts of money from a large number of people. This is done through internet platforms such as Zopa, Ratesetter and Funding Circle, which bring together borrowers and lenders. As a caveat, Peer-to-peer lending is not covered by the financial services compensation scheme.

What is Bitcoin?

Bitcoin is a digital currency which allows individuals to buy goods and services, without the need of third parties (i.e. banks). The users can store and send bitcoins via a ‘bitcoin wallet’, which is stored on your mobile or computer device. And details of every single transaction are stored on a ‘block chain’, a public record of all financial transactions.

Drawbacks –

Each transaction is completely anonymous, there are fears this will fuel illegal operations (drugs and firearms).

In addition, the supposedly clever design feature means there will only ever be 21 million bitcoins in circulation. This finite supply has turned bitcoin into a speculative investment, rather than a means of payment.

Ben Dyson from Positive Money on the ‘Three Fatal Flaws of Bitcoin’.

A short Bitcoin video: All the Facts

Financial Statements

Income Statement

Also known as the ‘Profit and Loss’ account, it shows the revenues less expenses over a given period.

Balance Sheet

This summarises the assets and liabilities of a business at a particular point in time – financial year end. Assets could include cash, property or machinery. And liabilities include everything the company owes.

Cash flow

This records the cash entering and leaving the company. A key difference between the income and balance sheet is that it doesn’t include the amount of future incoming and outgoing cash that has been recorded on credit (arrangement to pay later).

Investment Management Terminology

Actively Managed Funds – The investment manager will actively try to beat the market by using his judgement, experience and forecasts in making investment decisions.

Passive Funds – A fund which mimics the market index, rather than trying to beat it.

Closet-Index funds – An investment fund which more or less tracks a benchmark, although it claims to be actively managed. Closet indexing exists because fund managers believe it is safer to track benchmark indices.

Hedge Fund – A pooled investment vehicle available to wealthy and sophisticated investors. They are aggressively managed, and use leverage (borrowed money), derivatives, longs and shorts to generate superior returns.

Exchange Traded Funds – Investment funds traded on stock exchanges, which track the performance of a particular market or index such as the FTSE 100.

Options – A contract which gives the buyer the right, but not the obligation to buy or sell the underlying asset, at a specified price on or before a certain date. This is a type of derivative, and they are used to speculate and hedge risk.

Financial Instability Hypothesis – American economist Hyman Minksy believed that ‘Stability begets instability’. This is because long periods of economic stability encourages financial institutions and firms to become complacent. As a result they take on greater risks and more leverage – sowing the seeds of the next crisis.

Minksy Moment – The moment when the financial system moves from stability to instability. Over-indebted borrowers begin to sell assets in order to meet debt repayments, triggering sharp falls in asset values and a loss of confidence. At this point, the whole house of cards falls down.

Capital Employed – The capital investment required for a business to function.  Equation = Total Assets – Current Liabilities.

This is used to calculate ‘Return on Capital‘ – which is the operating profit (excluding taxes and debt interest) of a business divided by the capital employed, expressed as a percentage.

Tobins Q ratio – A measure of firm assets in relation to its market value.

The formula for Tobin’s Q: Total market value of firm / Total asset value of firm

Tobin’s premise is that a firm’s market value should be equal to their total asset value.

A low Tobin Q ratio (between 0 and 1) means that the cost to replace a firm’s assets is greater than the value of its stock. This implies that the stock is undervalued. Conversely, a high Q (greater than 1) implies that a firm’s stock is more expensive than the replacement cost of its assets, which implies that the stock is overvalued.

Most of these terms are articulated through Investopedia’s short animated videos

What is Earnings Per Share?

Equation: net profit divided by the number of ordinary shares in issue.

It represents the portion of profit allocated to each outstanding share.

It allows investors to observe the growth in profits for each share held.

Diluted EPS expands on basic EPS by including the shares of convertibles or warrants in the number of shares outstanding.

What is Price to Earnings Ratio?

Equation: share price divided by the earnings per share.

The P/E ratio represents the number of years it will take for the earnings of a company to cover its share price. Essentially, it is how much investors are willing to pay for £1 of earnings.

A high PE ratio means the investors are bullish on the company prospects and expect it to perform well.

Conversely a low ratio means that investors aren’t expecting much growth, it might indicate an undervalued company.

It’s not an absolute measure and is best used when comparing companies within the same sector.

Investopedia’s animated video explaining what a P/E ratio is.

The Cyclically adjusted price to earnings ratio (CAPE)

Whereas a PE ratio is the share price compared to one year’s earnings, the CAPE (or Shiller PE) is an average of ten years earnings compared with the latest price.

The purpose is to smooth out fluctuations within the business cycle rather than base it on a snapshot, which is what the conventional PE multiple does.

What is the PEG (Price to Earnings Growth) ratio?

Equation for PEG ratio: price to earnings divided by the growth rate of a company.

It’s the price earnings to growth ratio. It is used to gauge to relative value of a stock versus the company’s growth rate.

It is P/E ratio in the context of the company’s growth rate for the year ahead. Because it takes into account growth rate; it is favored by many over the P/E ratio.

A PEG of 1 indicates the company is fairly valued, a PEG of below 1 means a company is priced below its expected growth rate and indicates an undervalued company, above 1 indicates an overvalued company.

With PEG ratio, the numbers are projected and can be less accurate.

Investopedia’s animated video on the PEG ratio.

Price to Book ratio

Equation: Current stock price / (Assets – Liabilities).

It compares a stock’s market value to its book value.

It shows what shareholders will get after the company is sold and all its debts are paid off.

Low P/B Ratio could mean stock is undervalued.

Investopedia’s animated video on the P/B ratio.

Price to Sales

Equation: Current share price / Sales revenue per share (trailing 12months)

The lower the P/S the better the value, its more useful when comparing similar companies.  Advantages being that sales is harder to manipulate than earnings.

However this valuation metric is less useful for service companies like banks/insurers which don’t really have sales.

This ratio should not be used in isolation.

Free Cash Flow

Equation: FCF = Operating Cash Flow – Capital Expenditures

FCF is a measure of how much cash a business generates, after accounting for capital expenditures (money spent to maintain or acquire land, buildings or equipment). This cash can be used for dividends, expansion or reducing debt.

Operating cash flow is EBIT (earnings before interest and taxes) + Depreciation – Taxes. EBIT is also known as operating income.

Price to Free Cash Flow

Equation: Market capitalization divided by free cash flow.

A valuation metric which compares a company’s market price to its level of annual free cash flow.

Profitability Ratios

Return on Capital Employed (ROCE)

Equation: Earnings Before Interest and Tax (EBIT) / Capital Employed (Total Assets – Current Liabilities).

ROCE is defined as the profit made by a company divided by the total amount of money (capital) which has been invested in the business. This ratio indicates the efficiency and profitability of a company’s capital investments.

A higher ROCE indicates an efficient use of capital. It should always be higher than the cost of borrowing, otherwise the company won’t be generating shareholder value.

Investopedia’s short animated video on – ‘Return On Capital Employed’ –

Interesting Reads:

One of best explanations of ROCE that I can find is from Charlie Huggins, fund manager at HL – ROCE – What is it and why do we like it?

Return on Equity (ROE)

Return on Equity = Net Income/Shareholder’s Equity (Total assets – Total Liabilities)

ROE measures how much profit a company generates with the money shareholders have invested.

Essentially, as a shareholder how much bang for the buck are you getting?

Net Profit Margin

Profit Margin = Net Profit/Total Revenue

It represents the percentage of total revenue that a company keeps as profit. The higher the profit accrued from the sales of products or services, the greater its efficiency and profitability.

Emerging markets have been out of fashion of late, driven largely by current account deficits, capital outflows and a credit squeeze in China.emerging-markets-BRIC-MINT

This brief post will highlight and reinforce the fundamentals which make the emerging markets a compelling long-term investment.

1. They are home to 85% of world’s population
2. They constitute 50% of world GDP and contribute to 75% of worlds GDP growth.
3. Comprise of mainly a young and dynamic population – between 29 and 59.
4. Has a natural resource advantage, for example its home to 90% of the world’s proven oil reserves.
5. Rise of a consumer society, fueled by the expanding middle class and higher incomes.

However, these countries only account for 15% of the world’s stock market. Roger Bootle, economist and author believes that sophisticated investors will gain exposure to the emerging markets through good-quality western companies with large operations in the developing economies.

This strategy allows you to take advantage of western standards of corporate governance, attitudes to dividends and political stability – combined with a share of the emerging market growth story.

Source: Fidelity Worldwide Investment

Valuation: Based on forward times earnings they currently trade at a weighty 30% discount relative to developed markets. Every veteran will be aware of the fact that the lower the initial valuation, the greater the long-run returns – this is called the value effect. And, its worth remembering that Emerging economies grow at twice the rate of developed countries, which should translate into better investor returns.

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