Terry Smith on Debt Discipline

almost twice the return that the Index produces for each unit of downside volatility. 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 those 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. Year ended Fundsmith Sustainable Equity Fund S&P 500 FTSE 100 2017 2018 2019 2019 2019 ROCE 28% 30% 29% 17% 17% Gross margin 63% 65% 65% 45% 39% Operating margin 26% 28% 26% 15% 17% Cash conversion 102% 95% 99% 84% 86% Leverage 37% 47% 22% 53% 41% Interest cover 17x 17x 17x 7x 10x Source: Fundsmith LLP/Bloomberg. ROCE, Gross Margin, Operating Profit Margin and Cash Conversion are the weighted mean of the underlying companies invested in by the Fundsmith Sustainable Equity Fund and mean for the FTSE 100 and S&P 500 Indices. The FTSE 100 and S&P 500 numbers exclude financial stocks. The Leverage and Interest Cover numbers are both median.

All ratios are based on last reported fiscal year accounts as at 31st December and as defined by Bloomberg. Cash Conversion compares Free Cash Flow per Share with Net Income per Share. As you can see, not much has changed, which is how we like it. Our portfolio companies remain superior to those in the main indices on any of the financial measures of returns, profitability, cash flow, or balance sheet strength. As we indicated last year, we are going to remove the leverage calculation from the table in future as it can be close to meaningless. As you can see, we are not planning to remove it just because it looks bad. On the contrary, this year it is at 22% for our Fund’s portfolio versus 53% for the S&P 500 and 41% for the FTSE 100.companies

Year End FSEF S&P 500 FTSE 100 2017 2018 2018 2018 ROCE 28% 30% 16% 17% Gross margin 66% 64% 45% 39% Operating margin 26% 26% 15% 16% Cash conversion 104% 97% 84% 96% Leverage 29% 44% 46% 39% Interest cover 19x 18x 7x 9x Source: Fundsmith LLP/Bloomberg. ROCE, Gross Margin, Operating Profit Margin and Cash Conversion are the weighted mean of the underlying companies invested in by the Fundsmith Equity Fund and mean for the FTSE 100 and S&P 500 Indices. The FTSE 100 and S&P 500 numbers exclude financial stocks. The Leverage and Interest Cover numbers are both median. All ratios are based on last reported fiscal year accounts as at 31st December and as defined by Bloomberg. Cash Conversion compares Free Cash Flow per Share with Net Income per Share.

As you can see, not much has changed. I would suggest ignoring the increase in Leverage — the amount of debt the portfolio companies have as a proportion of their capital. The arithmetic average of our portfolio companies would not be very meaningful as it would average a wide range between eight of our stocks which have net cash and two which have leverage of over 1,000% (as they have reduced their capital through share buybacks). Even the median which we use is not much better — the median is the 13th stock in order of leverage but those either side have leverage of 27% and 49% respectively. For those of you who glaze over at statistical explanations — the figure tells you virtually nothing about the actual financial characteristics of the businesses. You might therefore wonder why we include it, and latterly so do I, but I don’t like taking figures out of tables we have provided in the past as it can cause suspicion about the reasons why (figures are rarely omitted when everything appears to be going well). The interest cover — which remains stable at about 18x and twice the level of the index companies — is a much better guide to the financial stability of our portfolio companies. What is more interesting is that the companies in our portfolio continue to have significantly higher returns on capital and better profit margins than the average for the indices.

They convert more of their profits into cash and achieve this with at least no more leverage than the average company. The average year of foundation of our portfolio companies at the year end was 1928. Consistently high returns on capital are one sign we look for when seeking companies to invest in. Another is a source of growth — high returns are not much use if the business is not able to grow and deploy more capital at these high rates. So how did our companies fare in that respect in 2018? The weighted average free cash flow (the cash the companies generate after paying for everything except the dividend, and our preferred measure) grew by 10% in 2018. We regard this as a very good result given the generally subdued and patchy growth which the world continues to experience and the fact that the previous year the portfolio companies achieved growth of a remarkable 15%, so the starting base for comparison in 2018 was a tough one.electric

As you hopefully know by now, we have a simple three step investment strategy: • Buy good companies • Don’t overpay • Do nothing I intend to 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’). This year we not only show you how the portfolio compares with the major indices but also how it has evolved over time. Year ended Fundsmith Equity Fund Portfolio S&P FTSE 2010 2011 2012 2013 2014 2015 2016 2017 2017 2017 ROCE 29% 28% 29% 31% 29% 26% 27% 28% 15% 14% Gross margin 54% 58% 58% 63% 60% 61% 62% 63% 44% 41% Operating margin 20% 22% 23% 24% 25% 25% 26% 26% 13% 13% Cash conversion 117% 103% 101% 108% 102% 98% 99% 102% 97% 96% Leverage 63% 15% 44% 40% 28% 29% 38% 37% 52% 46% Interest cover 15x 27x 18x 16x 15x 16x 17x 17x 7x 8x Source: Fundsmith LLP/Bloomberg. ROCE, Gross Margin, Operating Profit Margin and Cash Conversion are the weighted mean of the underlying companies invested in by the Fundsmith Equity Fund and the mean for the FTSE 100 and S&P 500 Indices. The FTSE 100 and S&P 500 numbers exclude financial stocks. The Leverage and Interest Cover numbers are both median.

In respect of productivity, Mr. Loeb said Nestlé should ‘adopt a formal margin target’. He went on to specify the margin level he believes Nestlé should formally target as ‘18–20%’ by 2020. There is more to attaining an improvement in profitability than committing to a target. The approach reminds me of the G20 meeting in 2014 at which the countries committed to attaining GDP growth of more than 2%. If it’s that simple, why not commit 3% or even 4%? Some people seem to believe that GDP growth or profit margins can be conjured up by a commitment. Sadly it may take rather more than that. In respect of returning capital, Mr. Loeb says that ‘capital return in conjunction with a formal leverage target makes sense as well’. He goes on to say that raised leverage would provide share buyback capacity, which would probably be a better use of cash than acquisitions given high valuations (remember that bit please). Mr. Loeb mentions ‘Re-shaping the portfolio’ and invokes the fact that the company has over 2,000 brands, some of which he believes could fetch ‘above-market multiples’ given ‘large synergies to potential acquirers’. He also thinks Nestlé should consider ‘accretive, bolt-on acquisitions in high growth and advantaged categories’ (presumably despite the ‘high multiples in Nestlé’s sector’ he already mentioned).

Among the things which they are not recommending—a break-up of the company, a new CEO, replacement of any directors, taking on excessive leverage, pension benefits cuts, slashing of R&D, marketing or capital expenditure budgets, cost cuts which might impact product quality, moving out of Cincinnati. We like this approach. The next page reminded us that all Trian was seeking was that ‘Nelson become 1 of 11 (or 12)’ directors of P&G and that it is ridiculous to suggest that as one person out of 11 or 12, he would ‘derail’ P&G. The Trian presentation is 93 pages long and is all centred around P&G having a poor organizational structure—‘suffocating bureaucracy and complexity’—which means that no one is accountable, decisions take forever and so forth. When we sold our P&G stake the fact that the company is the overwhelming market leader with Gillette but was ranked no. 50 in online shave clubs struck as illustrating the sort of point Mr. Peltz was making. David Taylor, P&G CEO, went on Jim Cramer’s CNBC programme at one point calling some of Peltz’s proposals ‘very dangerous’. They strike me as more dangerous to Mr. Taylor than to P&G’s shareholders. Mr. Peltz succeeded in his bid to win a board seat even though P&G is said to have spent more than $100m of shareholders’ money to prevent it. We wish him well with his endeavours. His presence makes P&G more interesting to us.

most of my time and effort on things I can control. Two of those are whether we own good companies and what valuation we pay to own their shares. 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). As at 31.12.16 Fundsmith FTSE 100 S&P 500 Equity Fund* Index+ Index+ ROCE 26.7% 13.5% 14.7% Gross Margin 61.9% 40.0% 43.2% Operating Profit Margin 25.5% 12.9% 13.9% Cash Conversion 99.4% 81.4% 83.6% Leverage 37.7% 48.9% 52.1% Interest Cover 17.0x 7.9x 7.9x Note: ROCE, Gross Margin, Operating Margin and Cash Conversion are the weighted average for the Fundsmith Equity Fund and averages for the FTSE 100 Index and S&P 500 Index. The FTSE 100 and S&P 500 numbers exclude financial stocks. The Leverage and Interest Cover numbers are medians. All data as last reported. *Source: Fundsmith LLP +Source: Bloomberg The companies in our portfolio have significantly higher returns on capital and better profit margins than the average for the indices. They convert more of their profits into cash and achieve this with a much lower level of borrowing than the average company. Nor is this a one off - they have been achieving these superior results for many years.

You could try some so-called market timing and redeem your shares in the Fund in advance of this event and maybe re-invest later when you think the time is right for it to begin outperforming again. If you do so I hope you have better luck and/or skill than I have because I know that I can’t accomplish that successfully. If you intend to remain invested in the Fund, as I do, including through any periods of underperformance, you might also, like me, take comfort in the fact that our investment strategy is based first and foremost on buying shares in good companies. We cannot promise you much about our Fund. But one thing we are clear about is that we seek to own shares in good companies and at least most of the time we succeed in that objective. Repeating an approach we took last year to demonstrate this, the table below shows what Fundsmith would be like if instead of being a mutual 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). Fundsmith FTSE 100 S&P 500 Equity Fund* Index+ Index+ ROCE 26.0% 14.8% 17.5% Gross Margin 61.1% 40.2% 43.7% Operating Profit Margin 25.0% 14.3% 15.3% Cash Conversion 98.4% 69.8% 70.9% Leverage 29.3% 38.5% 52.5% Interest Cover 16.1x 8.2x 8.

7x Note: ROCE, Gross Margin, Operating Margin and Cash Conversion are the weighted average for the Fundsmith Equity Fund and averages for the FTSE 100 Index and S&P 500 Index. The FTSE 100 and S&P 500 numbers exclude financial stocks. The Leverage and Interest Cover numbers are medians. *Source: Fundsmith LLP +Source: Bloomberg What does this table demonstrate? In short, that our companies have much better financial performance than the market as a whole and are more conservatively funded.

All that liquidity has to go somewhere and indeed the supply of liquidity by central banks’ purchases of bonds helps to push investors towards the purchase of riskier assets, as does the regime of record low interest rates, of which more anon. This is not an environment in which I would expect our Fund to perform well relative to the market as the rising tide of liquidity floats all ships, many of which we would not consider owning. Moreover, the year was characterised by what is in my opinion is a naïve view that the words spoken or (more rarely) actions taken have somehow helped to resolve the financial crisis which we have been living with since 2007. I cannot see how the supply of liquidity can solve a crisis caused by over leverage and insolvency. These events were exemplified for me when the Financial Times declared Mario Draghi, the President of the European Central Bank as its Man of the Year.upon

This seems counter intuitive: how does a low cost product become a major profit contributor? The answer of course is that synthetic ETFs in particular provide banks with innumerable ways to “clip the ticket” of the ETF. The fees paid by the ETF investor are a very small portion of the total revenues which operating the ETF provides. They also deal for the ETF, provide the swap agreements by which it holds its synthetic positions (I wonder who works out whether the bank is providing them a fair price?), and maybe earn leverage, prime brokerage, custodian and registrar fees. The banks also deal for the hedge funds and traders who want to trade the ETF. At about this point, I began to realise why my critique of ETFs had caused so much fury. My advice on this matter is simple. A broadly-based index fund is often the best investment you can make in the equity markets.buy

wealthier as a result. If you think you would be, let us know and we will set up the Money Illusion class of the Fund. We view the year ahead with some trepidation. It seems that it has yet to dawn on many of the key participants in the financial crisis that you cannot borrow and spend your way out of a crisis caused by over leverage, and that there is no higher authority than the governments who’s credit is now in doubt which can extend further funds to provide a painless “solution” or maybe even a temporary respite. The dawning of this reality is sure to have some very painful consequences. However, in contrast the Credit Default Swaps of Nestle have been less expensive than the cost of insuring against default on the debt of European governments and the US Treasury for some time. We are far from believers that the market is always right, but this does suggest that holding shares in major, conservatively financed companies which make their profits from a large number of small, everyday, predictable events is a relatively safe place to be if you have the patience, fortitude and liquidity to ride out the share price volatility which is likely to occur in such circumstances. And that’s exactly where and how our Fund is invested. Yours sincerely, Terry Smith CEO Fundsmith LLP