Terry Smith on Liquidity

Given our experience in recent years, who can blame them? The NBER research could in one sense be regarded as a statement of the blindingly obvious impact of the rise of index funds, but what is far from obvious is the scale of that impact. Nor does the fact that something may seem obvious, once it is explained, mean that it should then be ignored. It may make no fundamental sense to buy Tesla shares on a Price Earnings Ratio (‘PE’) of 327 (which is its current rating) but it is the ninth largest company in the S&P 500 Index by value so not holding it is a perilous position to take when money is flowing into index funds. John Bogle was right. The increasing proportion of equities held by index funds are invested without any regard to the quality or valuation of the shares bought which produces dangerous distortions. Contrary to popular belief, the stock market is not a substitute for online casinos but rather a mechanism for valuing companies, raising capital and providing liquidity. When this becomes distorted the result is often a major misallocation of capital.

Church & Dwight, the consumer staples business, seems to be suffering from the fact that the mixed fortunes of different groups of consumers in the US economy, far from driving consumers towards its discount products, is instead impoverishing those consumers who naturally gravitate towards them. Zoetis is the leading maker of veterinary pharmaceuticals. We began buying after concerns had surfaced about side effects from its drug for pain in osteoarthritis in dogs. The shares have continued to be weak but we feel sure that the secular tailwinds from increased spending on pets’ medical care will support the business. Procter & Gamble was caught up in the general malaise surrounding consumer staples which have been adversely affected as the air has been sucked out of the room by the race to invest in AI. In an age in which analysts rely on spoon fed forecasts in the form of ‘guidance’ and there is limited liquidity as the NBER paper suggests, results which fall short of optimistic guidance can produce spectacularly bad share price movements. For the year, the top five contributors to the Fund’s performance were: Stock Attribution Alphabet +2.3% IDEXX +2.1% L’Oréal +0.9% Microsoft +0.6% Mettler-Toledo +0.4% Source: State Street Alphabet makes its third appearance.

triple A credits when they were really triple Z. You can’t improve the quality or liquidity of an asset by putting it into a structure. The other problem with the policy of easy money was that it had to end eventually, but not before it had one last hurrah. There were half-hearted attempts to reverse QE in particular by lowering central banks’ bond purchases but when the stock market unsurprisingly reacted badly in the so-called ‘taper tantrum’ in 2013, these were abandoned. Then in 2020 came the pandemic and central banks reacted to this by enacting that good old saying ‘To a man with a hammer, everything looks like a nail’. They decided that they should double down with their new toy, QE, which seemed to work so well in the Credit Crisis without any nasty side effects, well none that had yet become apparent, and apply an almighty stimulus. This was applied when there was no problem with demand or the banking system. It was just that people were locked up in their homes and unable to spend on bricks & mortar shopping, travel and entertainment and the global supply chain was malfunctioning, leaving consumers with pent-up savings waiting to be spent. What happened next may be an example of Sod’s Corollary to Murphy’s Law: • Murphy’s Law: What can go wrong will go wrong. • Sod’s Corollary: Murphy was an optimist.

However, in both cases whilst they face a difficult situation, we are pleased that management has spent its time and effort managing liquidity and costs in an effort to ensure that they survive these events rather than pointlessly speculating about the likely timescale and course of recovery. In both cases we believe that they should not only survive but also strengthen their competitive position. We sold our stakes in Clorox and Reckitt Benckiser and one as yet undisclosed position and purchased stakes in Starbucks, Colgate, Zoetis, Procter & Gamble and an as yet undisclosed position.purchase

We have no desire to engage in a general commentary on this matter or to engage in an unseemly exercise in schadenfreude. We had long identified the problems which were brewing at Woodford but we kept our own counsel on the matter. The only comments you will find from us mentioning Woodford were in answer to direct questions concerning Woodford from our investors at our Annual Meeting. We regard it as a lack of professional courtesy to comment upon our competitors except when we are asked to do so by our investors. We only wish others in the industry would maintain the same stance. However, we now feel freer to comment on Woodford since it is hard to see how it can now exacerbate the situation, and I feel that we need to as the Woodford debacle has raised important questions about the industry, some of which have been directed at us and I feel that our investors should know our response. The most obvious problem at Woodford was the lethal combination of a daily-dealing open-ended fund with significant holdings in unquoted companies and large percentage stakes in small quoted companies which had very limited liquidity. Whilst this was clearly a very bad idea, Woodford is not the only fund to have encountered this problem. A large swathe of UK property funds was gated after the Brexit Referendum for the same reason, and more recently so was the M&G Property Fund. An open-ended daily-dealing fund is clearly not an appropriate vehicle through which to hold such assets.

The daily- dealing and open-ended structure give investors the illusion of liquidity but when a large number of them try to exercise it at once the effect is similar to shouting ‘Fire!’ in a crowded theatre. Amongst the causes which commentators seem to have failed to realise is the effect which the rise of investment platforms has had on this, and indeed other areas of the fund management industry. It is now the case that no one can expect to effectively market an open- ended fund on any of the major investment platforms which retail investors and wealth managers use to manage their investments unless it is a daily-dealing fund. As none of these platforms will admit an open-ended fund, unless it allows daily-dealing, that is what fund managers will use even for strategies for which this structure is wholly inappropriate. Where does the Fundsmith Sustainable Equity Fund stand on this? We have always regarded liquidity as an important issue. As evidence of this, we have published a liquidity measure on our Fund factsheet since inception. Equally we only invest in large companies. At 31st December 2019 the average market capitalisation of the companies in our Fund was £107bn and we estimate we could liquidate 100% of the Fund in seven days.

The reality is that the only type of fund which can guarantee 100% liquidity on demand is a cash fund, and I presume that is not what you wish us to invest in. But I suspect you will find it hard to find more liquid equity funds than ours. It tells you much about its liquidity that some of the least liquid stocks we hold are the FTSE 100 companies, Intertek and Sage. Another question which arises from the Woodford incident is the question mark over so-called ‘star’ fund managers, a label the press seems obsessed by. I can’t say I like the term, it strikes me as equally inappropriate as the term ‘beauty parade’ which is used when selecting professional advisers, many of whom do not seem to me to have obvious photogenic qualities. I think this concern is focused on the wrong issue. I think it makes no more sense to avoid funds run by ‘star’ fund managers any more than it does to avoid supporting sporting teams because they have star players. The trouble arises not because teams have star players but if the star tries to play a different game to the one which delivered their stellar performance. Would Juventus do as well if Cristiano Ronaldo played as goalkeeper? How is Usain Bolt’s second career as a soccer player going? Neil Woodford made his name as a fund manager at Invesco Perpetual with his successful Income Fund. In the course of this he took two high profile negative positions on sectors.

Yours sincerely, Terry Smith, CEO, Fundsmith LLP Disclaimer: A Key Investor Information Document and an English language prospectus for the Fundsmith Sustainable Equity Fund are available via the Fundsmith website or on request and investors should consult these documents 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 document is communicated by Fundsmith LLP which is authorised and regulated by the Financial Conduct Authority. Sources: Fundsmith LLP & Bloomberg unless otherwise stated. Portfolio turnover has been calculated in accordance with the methodology laid down by the FCA. This compares the total share purchases and sales less total creations and liquidations with the average net asset value of the fund. P/E ratios and Free Cash Flow Yields are based on trailing twelve month data and as at 31st December 2019 unless otherwise stated. Fund liquidity is based on 30% of average trailing 20 day volume.

January 2013 Dear Fellow Investor, This is the third annual letter to owners of The Fundsmith Equity Fund. We have presented three periods of performance figures this year - the performance since inception, the annualised returns and the last calendar year. T Accumulation Shares, Total Return 2012 Since Inception Annualised % to 31.12.12 % % Fundsmith Equity Fund £ 12.5 29.4 12.6 MSCI World Index £ 11.4 14.8 6.6 We remain critical of attempts to measure investment performance over short periods of time. Even a calendar year is too short for this purpose. It is the time it takes the Earth to go around the Sun and has no natural link to the investment or business cycle other than for agricultural businesses. However this proviso notwithstanding, how did we do in 2012? The Fund rose by 12.5% in 2012 and modestly outperformed the market (which we take as the Morgan Stanley Capital International World Index - or MSCI World - in sterling with dividends reinvested) by 1.1%. I’m rather surprised that we managed to outperform the market at all in this reporting period. 2012 was a year in which so-called risk assets performed well. This is unsurprising in a year in which the major central banks in the developed world supplied increasing amounts of liquidity through their Quantitative Easing programmes in increasingly desperate attempts to keep some modest amount of economic growth.

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

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

Anyone who has studied the events of the Credit Crisis should be able to spot a potential problem here: what if the counterparty supplying the swaps defaults? This risk may once have been considered theoretical, but after the collapse of Lehman and the need to rescue AIG in order to prevent the contagion from a default it surely no longer is. True the ETF should be holding collateral against such a failure, but collateral is an imperfect science even where it is held which is not in all cases. Moreover, in some cases the sole counterparty Moreover, synthetic ETFs are often used at access markets which are not directly accessible to retail investors such as the Chinese A-share market or where liquidity in the underlying investments is poor such as equities in some emerging markets. The opportunity for the performance of the ETF to diverge from the performance of the underlying assets and therefore from the investors’ expectations in these cases seems obvious. The idea that a counterparty will provide you with a contract which matches the returns from underlying illiquid assets which you cannot directly own should give pause for thought-not least about how the counterparty will fulfil those obligations, for example in the case of extreme market movement and a liquidity crisis-a not unlikely combination. Of course not all ETFs are used to simply match the performance of an index.