Terry Smith on Inflation

better than the companies in the main indices (which include our companies). Moreover, if you own shares in companies during a period of inflation it is better to own those with high returns and gross margins. 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 2024? The weighted average free cash flow (the cash the companies generate after paying for everything except the dividend, and our preferred measure) grew by 14% in 2024. The only metric which continues to lag its historical performance is cash conversion — the degree to which profits are delivered in cash. Although this recovered slightly to 91% in 2023, this is still below its historical level of around 100% and it declined again in 2024 to 85%. This was due to a sharp rise in capital expenditure at a small group of companies: Alphabet, Microsoft, Meta and Novo Nordisk. Novo is racing to build production capacity to supply enough of its weight loss drug Wegovy and finished the year spending €10 billion purchasing three manufacturing sites. The tech companies are in a race to build capacity of Artificial Intelligence (‘AI’) in the form of GPU chips and data centres.

We sold McCormick as we had been disappointed by the slow response which the company exhibited in its ability to pass on input cost inflation so compressing its margins, together with its exposure to own label competition which has stiffened as inflation has caused consumers to trade down. We began purchasing Apple two years ago at about $156 a share when its P/E was below the S&P 500 average and the growth in service revenues had somewhat convinced us that the much talked about ecosystem, tying its users to the products, might really exist. We correctly foresaw a number of reporting periods ahead when sales growth would be lacklustre and so bought a small stake hoping to add to it as the poor sales performance came to pass. We were right about the sales performance — its sales grew just 2% last year — but wrong about the share price which rose strongly, placing the shares on a rating about 50% higher than the S&P 500. We were not going to buy more stock against that background and it was occupying a place in our portfolio and so we sold our stake. We started purchasing stakes in Atlas Copco and Texas Instruments during the year.

2016–2019 ratios are based on last reported fiscal year accounts as of 31st December and for 2020–23 are Trailing Twelve Months and as defined by Bloomberg. Cash Conversion compares Free Cash Flow per Share with Net Income per Share. In 2023 returns on capital and operating profit margins were higher in the portfolio companies than in the past. Gross margins were steady. Importantly all of these metrics remain significantly better than the companies in the main indices (which include our companies). Moreover, if you own shares in companies during a period of inflation it is better to own those with high returns and gross margins. 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 2023? The weighted average free cash flow (the cash the companies generate after paying for everything except the dividend, and our preferred measure) grew by 14% in 2023.

not include an important element of costs — the costs of dealing. When a fund manager deals by buying or selling, the fund typically incurs the cost of commission paid to a broker, the bid-offer spread on the stocks dealt in and, in some cases, transaction taxes such as stamp duty in the UK. This can add significantly to the costs of a fund, yet it is not included in the OCF. We provide our own version of this total cost including dealing costs, which we have termed the Total Cost of Investment (‘TCI’). For the T Class Accumulation shares in 2023 the TCI was 1.05%, including all costs of dealing for flows into and out of the Fund, not just our voluntary dealing. We are pleased that our TCI is just 0.01% (1 basis point) above our OCF when transaction costs are taken into account. However, we would again caution against becoming obsessed with charges to such an extent that you lose focus on the performance of funds. It is worth pointing out that the performance of our Fund tabled at the beginning of this letter is after charging all fees which should surely be the main focus. Last year I spent quite a lot of this letter trying to explain the background to the period of low interest rates and Quantitative Easing and how the resurgence of inflation and interest rate rises had affected company valuations, and especially those which had above average valuations. As an illustration of this effect, consider the following.

Quantitative Easing (‘QE’), so-called ‘printing money’ in which central banks created money to purchase assets, starting with government debt but eventually ranging into corporate debt and equities. As an aside, quite how it aided the economy of either Japan or Switzerland for their central banks to buy international equities is beyond my grasp. This was combined with low, no (Zero Interest Rate Policy — ZIRP) or even negative interest rates (NIRP). These measures I have collectively christened with the generic term ‘easy money’. Attempts to suppress volatility will only exacerbate it in the long term. If you count the current events, we have now had three economic and financial crises this century and it is still in its first quarter. This would seem to illustrate that attempts to expunge volatility from the financial system are actually producing the opposite of the desired effect. They breach the rule for what you should do if you find yourself in a hole. This is hardly surprising given that the central banks were aiming at the wrong targets. Central banks were attempting to maintain a benign level of consumer price inflation but ignored asset price inflation caused by their actions. Some also adopted employment targets that were not or should not be part of their remit. One of the problems of easy money is that it leads to bad capital allocation or investment decisions which are exposed as the tide goes out.

Sod’s Corollary gave us the February 2022 Russian invasion of Ukraine which affected the prices of oil, gas and other minerals, such as nickel, and cereals following the central banks’ stimulus. The net result of the further stimulus and this invasion has been an upsurge in inflation and as a consequence a rapid and painful end to easy money. This final round of easy money post the pandemic led to all the usual poor investments which people make when they are led to assume that money is endlessly available and costs zero to borrow or raise. We can see the unwinding of these unwise investments, for example, in the collapse of FTX, the cryptocurrency ‘exchange’ (sic) and the meltdown in the share prices of those tech companies with no profits, cash flows or even revenues.suffering

2015–2019 ratios are based on last reported fiscal year accounts as of 31st December and for 2020–22 are Trailing Twelve Months and as defined by Bloomberg. Cash Conversion compares Free Cash Flow per Share with Net Income per Share. In 2022 returns on capital and profit margins were significantly higher in the portfolio companies than in 2020 and 2021. Gross margins were steady. Importantly all of these metrics remain significantly better than the companies in the main indices (which include our companies). Moreover, if you own shares in companies during a period of inflation it is better to own those with high returns and gross margins. 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 2022? The weighted average free cash flow (the cash the companies generate after paying for everything except the dividend, and our preferred measure) grew by 1% in 2022.This

We have no idea when the current period of inflation and central bank interest rate rises which caused this prediction to come true will end. It is sometimes said that central bank policy is always either too lax or too tight, it is never exactly right. We need not discuss whether it has been too lax in the past. Presumably at some point it will become too tight and quite probably tip the major economies into recession. This holds few fears for us. Our companies should demonstrate a relatively resilient fundamental performance in such circumstances, and the only type of market which ends in a recession is a bear market. What we are clear about is that we continue to own a portfolio of good companies. Where the end of the easy money era has exposed any doubts, and there are always doubts, we have acted upon them and/or aired them in this letter. Our companies are more lowly rated than they were a year ago, now being rated roughly in line with the market. This does not make them cheap and there is no guarantee that they will not become more lowly rated, but our focus is on their fundamental performance, as it should be, because in the long term that will determine the outcome for us as investors.

We work on the assumption that government bonds would need to yield at least 1% over the expected rate of inflation to attract rational investors, and so we seek to invest in companies only when their FCF yield is the same as or more than that required bond yield. The return on capital of the companies in our portfolio averaged about 32% p.a. This compares to an average of about 20% p.a. for the non-financial stocks in both the S&P 500 and the FTSE 100. Bearing in mind the longevity and resilience of our portfolio companies I think we can remain confident that we own stocks with a superior fundamental performance to the average which is not fully reflected in their valuation relative to bonds or other equities. It may seem surprising that we can buy shares in quality companies at reasonable or even cheap valuations and thereby expect to generate superior investment performance. I have written a short research note in an effort to explain this entitled “Return Free Risk” which can be downloaded from our website at www.fundsmith.co.uk/research. The title is not a mis-type, rather it’s a pun. As investors we are taught that to obtain higher returns you must assume higher risk, but much of the evidence contradicts this assumption. The fact is that for much of the time you get better returns from investing in predictable high quality companies than in smaller, riskier, more obscure company shares.

Shinzo Abe became Prime Minister of Japan for the second time with the stated intention of making the Bank of Japan target an increase in inflation. Mark Carney, the much heralded new Governor of the Bank of England, got off to an unusual start by announcing seven months before he starts work that he thinks there should be a debate about whether central bankers should currently be targeting nominal GDP growth i.e. ignoring inflation. Now depending upon your point of view this is either good news because it means yet more stimulus will be applied or bad news because you do not think that the additional stimulus will do much to achieve economic growth or increased employment but it will risk side effects which can be as bad or worse than the ailment they are seeking to treat. I am in the latter camp. I think that central bankers should be independent of government and should be concerned with the soundness of the currency, and if they have the regulatory authority, the soundness of the banking system. Allowing them to stray outside that is dangerous as it will lead to confusion of fiscal and monetary policy, or in plain English, governments will be able to fund their profligate spending programmes by getting the central bankers to print more money and buy their bonds until the employment or nominal growth targets are achieved, or even beyond (note the term ‘at least’ used by the Fed). At some point, the inevitable consequence of this is inflation and currency depreciation.

The newer generation of central bankers such as Mr Carney have yet to experience that. When they do, they may discover that when inflation takes hold it does not conveniently stop at some predetermined target rate. They may also find that the only device they have to control inflation is the blunt instrument of interest rates, and a significant rise in rates would have some interesting effects on the affordability of government debt, private debt and the economy in its current condition. You might legitimately point out that depreciation of the major currencies is a bit tricky as they are all trying to depreciate against each other in order to achieve some competitive advantage. But maybe they will all depreciate against hard assets, or to put it more simply-inflation.

Still whilst we wait to see if or when this scenario comes to pass, the good news is that macro views and developments have no bearing on our strategy; increasingly desperate attempts to stimulate the economy are far more likely to stimulate the valuation of our portfolio (not that we like to make money that way); and our stocks are likely to be a relatively good hedge against a resurrection of inflation. Happy New Year. Yours sincerely, Terry Smith CEO Fundsmith LLP Important information: An English language prospectus for the Fundsmith Equity Fund is available on request and via the Fundsmith website and investors should consult this document before purchasing shares in the fund. Past performance is not necessarily a guide to future performance. The value of investments and the income from them may fall as well as rise and be affected by changes in exchange rates, and you may not get back the amount of your original investment. Fundsmith LLP does not offer investment advice or make any recommendations regarding the suitability of its product. This financial promotion is intended for UK residents only and is communicated by Fundsmith LLP which is authorised and regulated by the Financial Services Authority.