Terry Smith on Compounding

to risk free as you can get) of close to 5%, why take the risk of investing in equities? The short answer is because equities provide a better return. For the period 1928–2023 (the earliest for which I can get reliable data), the annualised return on 10 Year US Treasury Bonds was 4.6% whereas the S&P 500 compounded at 9.8% with dividends reinvested#. This of course includes the Great Depression and World War Two as well as other more recent and lesser incidents like the 1987 Crash, the Dotcom meltdown, the Great Financial Crisis of 2008–09 and the Covid pandemic. This is unsurprising. Equities benefit from a feature which no other asset class, including bonds, can provide: a portion of the profit or cash flow which belongs to the shareholders is reinvested each year by the company. This is the retained profit which is not paid out as dividends, and its investment is the source of compounding which underpins the returns of long-term investment. In my view this is the least discussed and appreciated aspect of equity investment versus all other asset classes. So, if equities outperform bonds why are investors so keen to hold bonds at the moment? The answer of course is that whilst equities may outperform bonds over long periods of time, there is no guarantee that equities will provide this superior return in any given period, and in fact they may lose value for periods of time, as they did in 2022.cartoon:

The biggest flaw in value investing is that is does not seek to take advantage of a unique characteristic of equities. Equities are the only asset in which a portion of your return is automatically reinvested for you. The retained earnings (or free cash flow if you prefer that measure, as we do) after payment of the dividend are reinvested in the business. This does not happen with real estate — you receive rent not a further investment in buildings, or with bonds — you get paid interest but no more bonds. This retention of earnings which are reinvested in the business can be a powerful mechanism for compounding gains. Some 80% of the gains in the S&P 500 over the 20th century came not from changes in valuation but from the companies’ earnings and reinvestment of retained capital. If you were a great (and long-lived) value investor who bought the S&P 500 at its low in valuation terms, which was in 1917 when America entered world war one and it was on a P/E of 5.3x, and sold it at its high in valuation terms in 1999 when it was on a P/E of 34x, your annual return during that period would have been 11.6% with dividends reinvested, but only 2.3% p.a. came from the massive increase in P/E and 9.3% (80% of 11.6%) came from the companies’ earnings and reinvesting their retained earnings. The S&P example is for 500 average large companies.

This proportion of your return from the companies’ reinvestment activities is even more extreme when you invest in a good company with a high return on retained capital than in an average company. All of this was much more succinctly encapsulated by Warren Buffett when he said: ‘It's far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.’ He made the transition from being a traditional value investor based upon studying under Benjamin Graham (author of “The Intelligent Investor” and “Security Analysis”) into a quality investor looking for companies which could compound in value based upon the teachings of Philip Fisher (author of Common Stocks and Uncommon Profits) and the influence of Charlie Munger. Here’s how Buffett explained this change in his 1989 letter to Berkshire Hathaway shareholders: ‘The original 'bargain' price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces — never is there just one cockroach in the kitchen. [Plus], any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return.investment

The sort of stocks which trade on low enough valuations to attract value investors are unlikely to be those which we seek – businesses which can somewhat predictably produce a high return on capital employed, in cash, and can invest at least part of that cash back into the business to fund their growth and so compound in value. Unlike our strategy which is to seek such stocks and hold onto them, letting the returns which the company generates from this reinvestment produce good share price performance, value investing suffers from two handicaps. One is that whilst the value investor waits for the event(s) which will crystallise a rise in the share price to the intrinsic value that has been identified, the company is unlikely to be compounding in value in the same way as the stocks we seek. In fact, it is quite likely to be destroying value. Moreover, it is a much more active strategy.this

is far from easy. Moreover, this activity has a transaction cost. Our strategy has the merit that inactivity is a benefit. If we have correctly identified the good companies whose stock can compound in value, we can hope to hold them indefinitely and still derive good investment performance from them with lower transaction costs. There are a couple of indices which tell you how value stocks perform. One is the MSCI Europe Value Index (GBP Net). In the 2007-09 financial crisis its maximum fall was 52%, which is 16 percentage points worse than the performance of the MSCI World Index (GBP Net) over that period. So much for the theory that value stocks protect you in a downturn. As you hopefully know by now, we have a simple four step investment strategy: • Buy good companies • ESG screen • Don’t overpay • Do nothing I will review how we are doing against each of these in turn. As usual we seek to give some insight into the first of those — whether we own good companies — by giving you the following table which shows what Fundsmith would be like if instead of being a fund it was a company and accounted for the stakes which it owns in the portfolio on a ‘look through’ basis, and compares this with the market, in this case the FTSE 100 Index and the S&P 500 Index (‘S&P 500’). We not only show you how the portfolio compares with the major indices but also how it has evolved over time.

I would like to end by addressing the question of what will happen next in equity markets, which may surprise you given that I always respond to questions about this by saying I haven’t got a clue, and neither has anyone else. Imagine a fund manager approached you with an offer for you to invest in a portfolio of high quality companies. You may quite like the strategy but you are worried about whether or not this is a good time to invest in the stock market. Take a look at the chart below which shows the world’s largest index by market capitalisation, the S&P 500, and which includes more quality companies than any other index. Source: Bloomberg The chart looks like a roller coaster that has just passed the peak of the ride. Surely you would be stupid if you invested now no matter how good the strategy is. Better to wait until the market has had a proper fall. You may notice that there are no dates on this chart of the S&P 500. That’s because I wanted you to assume I was referring to the current market and our own fund, Fundsmith. In fact, the chart above shows the 37 years up to 1965 — the year in which Warren Buffett took control of Berkshire Hathaway. If you had made the decision to time the market and hold back from investing then you would probably have missed out on the 20.9% compound growth in the market value per share of Berkshire since 1965 as a result.

If you invest for the long term in companies which can deliver high returns on capital, and which invest at least a significant portion of the cash flows they generate to earn similarly high returns, over time that has far more impact on the performance of the shares than the price you pay for them. Yet I have been asked far more frequently whether a share, a strategy or a fund is cheap or expensive than I am asked about what returns the companies involved deliver and whether they are good companies which create value or not. Even though Mr. Munger is right it requires a long-term investment perspective to capture that compounding by high return companies, and finding those companies is not easy especially as you need to assess their ability to grow and ward off competition. But the most difficult part of applying the investment strategy suggested by Mr. Munger’s quote, and which we seek to apply, is us. Our inability to take a really long-term view, particularly through the periods when our chosen strategy and companies are not performing as well as less good companies, which are enjoying their period in the sun, is our greatest enemy. I will leave this subject with a sporting analogy. We are often told that life is a marathon not a sprint. So is investing. Most of us will be investors for the majority of our lives. If we start investing in our 30’s with current average life expectancy most of us will be investing for over half a century. It makes Mr.

There is also the question of what we might invest in as an alternative if we chose to sell the Fund’s holdings in defensive so-called bond proxy stocks or if you chose to redeem your shares in our Fund. The obvious suggestion, and it is one which would have worked well in the second half of 2016, is that you should switch into cyclical stocks such as banks. Buying cyclical stocks in anticipation of a rise in interest rates does pose a fairly obvious problem - won’t they perform worse than defensive stocks if the rise in rates causes an economic slowdown? There is also the fact that these stocks are in companies which over time do not create shareholder value by generating returns on capital above their cost of capital and growing by deploying more capital at such favorable returns, which is what the companies we seek to invest in accomplish. If you choose to invest in such companies then I would suggest it is not because you want to hold their shares indefinitely and allow them to compound in value but because you think you perceive an opportunity for a trade in which you buy them and then sell them for a higher price. If so I hope you have better luck with your timing in this game of Greater Fool Theory (in which you hope to buy from a seller who is less competent than you at spotting this opportunity and when the time comes you need to sell to a buyer who is similarly ill informed) than most people seem to have.

2015 was also the fifth anniversary for our Fund and so maybe a good moment to pause and reflect on the longer term performance. As well as outperforming the market with a compound return of +17.6% against +10.1% for the MSCI World Index, our Fund was the third best performing fund out of 203 in the Investment Association’s Global Sector. Why only third, you might ask? The two funds which performed better than ours are specialist healthcare funds which have benefited from the extraordinary boom in takeovers within the biotech sector in recent years. That won’t last indefinitely, at which point anyone who has benefited from investment in those companies and funds needs to find the next hot sector if that is their investment strategy. This is a game we profess no skill at and therefore will not be playing. This skill also seems to elude most other investors but that does not seem to stop them trying. 2015 was not a particularly bullish year for equity markets which were held back by the slowdown in China, setbacks in other Emerging Markets and the move on from the end of quantitative easing in America to the first rise in interest rates by the Federal Reserve (‘the Fed’) in nearly ten years. After all that the S&P 500 Index was down by -0.7% for the year. Trillions of pixels have been expended on the likely impact of this increase in interest rates and I do not intend to add much, if anything, to the debate. However, one aspect may be worth commenting upon.

As our portfolio had an average return on operating assets of 50% this reinvestment of cash flows should produce compounding of value for us as shareholders. This FCF yield compares with a FCF yield on the S&P 500 of a bit less than 7%. The median (250thranked) FCF yield in the S&P is 6.6%. What we can say with a high degree of certainty is that our portfolio has a FCF yield higher than the average for the market. Yet it is inconceivable in our view that it is not of higher than average quality in terms of longevity, resilience, predictability, profit margins, return on operating capital and the conversion of profits into cash. Put simply this means that we own shares in businesses which are higher quality than the market on a valuation lower than the average for the market. Whilst that is not a total solution to successful investing, it strikes us as at least a good start. We regard an equity holding as a claim on a share of the cash flow produced by a business. In the Fund we seek to own companies which produce high cash returns on capital and distribute part of those returns as dividends and re-invest the remainder at similar rates of return. And we want to own those companies shares at prices which at best under-value their returns and at worst value them fairly.

Day 1 Day 2 Day 3 Day 4 Index 100 125 90 103 Daily Change 25% -28% 14% Cumulative Change 25% -10% 3% Leveraged ETF (+2X) 100 150 66 85 Daily Change 50% -56% 29% Cumulative Change 50% -34% -15% The first table shows the movement in an index in a highly volatile period in which it rises sharply then falls to finish just 3% up over the period. The second table shows the performance of a 2x leveraged ETF over the same period. With daily compounding the leveraged ETF produces a cumulative loss of 15% of value over the period versus a 3% rise in the index. How about an inverse ETF? Index % Movement Short Position ETF (Short) Day 1 100 100 100 Day 2 80 -20.0% 120 120 Day 3 60 -25.0% 140 150 Day 4 55 -8.3% 145 162.5 Day 5 100 81.8% 100 29.5 In a week where the index was volatile on the downside but got back to par by the end of the week an inverse ETF with daily compounding would turn in a 70.5% loss. You can imagine what a leveraged inverse ETF would do! I would bet that a large proportion of ETF investors do not realise that leveraged and inverse ETFs can produce these apparently perverse results. The moral of this is that these sort of ETFs are really day trading tools. If they are held for more than one day, they will begin to diverge from the performance of the underlying index or asset class. However, it would not be surprising if in many cases they were being used inappropriately as if they are index funds.