Terry Smith on Risk Management

perspective may be useful and is certainly more consistent with our investment aims and strategy. Since inception, the Fund has returned nearly 4% p.a. more than the MSCI World Index and has done so with significantly less downside price volatility as shown by the Sortino Ratio of 0.83 versus 0.51 for the Index. This simply means that the Fund has returned about 63%, ((0.83÷0.51)-1)x100, more than the Index for each unit of price volatility. Our Fund is still the best performer since its inception in November 2010 in the Investment Association Global sector of 165 funds, with a return 335 percentage points above the sector average which has delivered just 215% over the same timeframe. Outperforming the market or even making a positive return is not something you should expect from our Fund in every year or reporting period, and outperforming the market was more than usually challenging in 2023. The performance of the Nasdaq Composite Index, which was up 43% in USD in 2023, was dominated by a few companies, the so-called Magnificent Seven — Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla — which accounted for 68% of that Index’s gains. Nvidia, the designer of chips for use in AI applications, alone accounted for 11% of the 43% gain. We do not own all the Magnificent Seven and would probably not be willing to take the risk of doing so, even if all of them fitted our investment criteria.

The Sharpe ratio takes the return on the Fund, subtracts a so-called risk-free return (basically the return on government bonds) to get the excess return over the risk-free rate, and divides the resulting number by the variation in that excess return (measured by its standard deviation — I warned you it was gobbledegook). The result tells you what unit of return you get for a unit of risk and our Fund has a Sharpe ratio of 0.79 since inception against 0.43 for the MSCI World Index — it is producing about twice the amount of return that the Index produces for each unit of risk. The Sortino ratio is an adaption of the Sharpe ratio, and in my view an improvement. Whereas the Sharpe ratio estimates risk by the variability of returns, the Sortino ratio takes into account only downside variability as it is not clear why we should be concerned about upside volatility (i.e. when our Fund goes up a lot) which mostly seems to be a cause for celebration. The result for our Fund since inception is a Sortino ratio of 0.71 but the MSCI World Index Sortino ratio is lower than its Sharpe ratio at 0.39.producing

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.

On one occasion this misunderstanding was compounded when Bloomberg managed to publish an article from the Galveston County Daily News about a strike at Fresh Del Monte Produce Inc - an entirely different company which sells fresh produce - against Del Monte Foods. Such events can create opportunities to buy great companies at good prices. Eighteen days after the Fund opened and we purchased our initial holding in Del Monte it was bid for by private equity firm KKR at a significant premium to the price we had paid. Whilst it would be churlish to suggest that we do not like receiving a premium for our investments in cash, such events are not without their downside as we have to find an equivalent investment for our cash. The fact is we really want to own our stakes in the companies in our portfolio and benefit from the good cash returns on capital which they generate. We are not simply hoping to on-sell the investment at a higher price. This changes perspectives on events such as takeovers. Just as we counsel you not to become overly enthusiastic about share price rises, even those which relate to cash bids for our holdings at a premium which represents a good return on our investment, we hope that you will understand when we are explaining that price falls within the portfolio will often represent an opportunity for investment on even more rewarding ratings rather than an opportunity for soul searching and recriminations. Often but not always.

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.