Terry Smith on Earnings Growth

is the lowest growth rate we have recorded to date in our portfolio and probably says far more about the levelling off in demand in some sectors post the pandemic surge and macro-economic conditions than it does about the long-term growth potential of the businesses. You may recall that the free cash flow for our companies surged 20% in 2021, significantly above the more normal 9% growth in 2019 and 8% in 2020. Moreover, the free cash flow of the S&P 500 fell by 4% last year. Frankly we are pleasantly surprised that there was any growth at all in our portfolio companies, and if 1% growth worries you it may be wise not to read next year’s letter. Cash conversion remains depressed for our portfolio companies but is currently based upon some unusually volatile conditions caused by the pandemic’s disruption to supply chains leading to stockouts and subsequent hoarding of stocks by some companies. Cash flow is an acid test of a business but it is also a more volatile measure than profits which are based on accrual accounting and spread some cash flows between periods. We will have to wait a year or two before something approaching normality is restored and we can gauge how well our companies are doing on this measure. The average year of foundation of our portfolio companies at the year-end was 1922. They are just over a century old collectively. The second leg of our strategy is about valuation.

increased quantities of household cleaning products, personal cleaning products and OTC medicines. We felt that in both cases the ratings achieved did not reflect the pedestrian nature of these businesses in more normal circumstances or the issues they face which may come back into focus if or when the COVID related boost fades. Moreover, at the same time as these two stocks were enjoying an unusually good performance, Starbucks, which we admire, saw share price falls of over 40% at the height of the panic over COVID. They are probably familiar to you as the world’s leading coffee shop brand. Starbucks has high returns on capital and a good growth rate — two characteristics which we seek. Whilst it is easy to see the challenge to the lockdowns for Starbucks’s urban outlets which partly rely on seating and coffee collected on the way to the office, this is far from their only format. The sometimes spectacular queues and resulting traffic jams at Starbucks drive-through outlets both illustrate another format and testify to the continued loyalty to the brand as does the rise in loyalty club members in 2020. During this period Starbucks’s main competitor in its second largest market — Luckin Coffee in China — was exposed as a fraud in yet another illustration of the rule that it is only when the tide goes out that you find out who has been swimming naked. After the COVID lockdowns we also purchased a stake in Colgate- Palmolive, Procter & Gamble and Zoetis.

However, it is important to bear in mind that this is not a like-for-like comparison as our portfolio did not remain static over the year. In fact the two shares we sold—Imperial Brands and J M Smucker—had by far the highest FCF yields in the portfolio and much higher than the FCF yields of the one we purchased— Intuit. If we had not made these changes the portfolio FCF yield would have remained at 4.0% (although it is worth noting that the growth rate would have been significantly lower—the FCF of both companies fell in 2017) so some of the fall in yield was a result of our action rather than any rise in market valuations. The year end mean FCF yield on the S&P 500 was 3.9% and the median 4.1%. The year end mean FCF yield on the FTSE 100 was 5.6% and the median 4.9%. More of our stocks are in the former index than the latter. To try to cut through all these means and medians, our portfolio consists of companies that are fundamentally a lot better than those in the index and are valued more highly than the average FTSE 100 company and slightly higher than the average S&P 500 company. In the case of the FTSE 100 Index this is because the valuation of the index is dominated by what I would regard as uninvestable companies like Anglo American and Centrica which traded on FCF yields of around 15% as at 31st December 2017. They may be lowly rated but that does not mean that they are necessarily cheap given their poor quality.