Terry Smith on Valuation

hypothesis’. You may not have heard of this as it is not the sort of thing to take for a read on a long flight. However, it has some startling revelations which are relevant to the current market. It starts with the seemingly uncontroversial assertion that $1 (or $1m or $1bn) switched between either stocks or bonds (or any other switch) does not affect the intrinsic value of either. If you redeem funds from an active fund like Fundsmith to place them in an index fund it does not alter the valuation of the stocks we have to sell to fund the redemption or the stocks that the index fund buys. However, the NBER paper shows that in reality such a switch has a multiplier effect of anything from 3:1 to 8:1, an average of about 5.5:1. The inflow from such switches pushes up the value of the stocks purchased by an average of five times the amount invested. To say this flies in the face of fundamental investment theory would be a masterly understatement. The NBER paper attributes this to the inelasticity of demand and supply for equities. Over 50% of equities are in index funds which have no discretion over what they buy. Moreover, some portion of the so-called active funds which are left are managed in a way that makes them unlikely to bet against what is happening in the index. Apart from any mandate restrictions, fund managers have long realised the career preserving nature of so-called closet indexation in which they do not stray far from the index weightings.

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.

Sir John Templeton, who founded the eponymous investment management group, once said, ‘The four most dangerous words in investing are: This time it’s different’. He was pointing out that there are always people who are willing to rationalise outbursts of investment mania but they are always proven wrong when the bubble bursts and investment fundamentals reassert themselves. We have seen this before, not only in the Dotcom boom and bust, but in other examples such as the Japanese market in the late 1980s. Then we were told that the PE of over 50 on the Nikkei Index was OK because Japanese accounting was conservative. In fact the market was just over-valued. After the subsequent fall in the Nikkei it took until 2024 for the index to regain the peak it attained in 1989. When companies and/or investors are encouraged by soaring share prices and valuations to believe that capital is almost free, some disastrous investment decisions follow. They seem to act as though the cost of the capital that companies are investing is to some degree the reciprocal of their PE ratio. So, a PE of 50 equates to a cost of capital of 2% (100÷50). This is utter nonsense. The cost of equity does not vary inversely with the valuation and is perhaps best estimated by the cost of so-called risk-free capital, being the yield on long-dated government bonds plus what is called an equity risk premium.

companies is as high as it has ever been and collectively they continue to grow free cash flow quicker than the historical average of the portfolio. The underlying business performance remains our primary focus. If we get that right then our Fund will emerge with the intrinsic value of its investments maintained or enhanced, as sooner or later, share prices reflect fundamentals, not the other way around. Encouragingly, the average year of foundation of our portfolio companies at the year-end was 1926. Collectively they are a little under a century old. 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 94% in 2025, this is still below its historical level of around 100%. This was due to a sharp rise in capital expenditure at a small group of companies: Alphabet and Microsoft. The tech companies are in a race to build capacity for AI in the form of GPU chips and data centres. Whether this arms race produces adequate profits and returns for the amounts expended remains an open question. As we can see, our tech companies are ramping up of capital expenditure along with Amazon and Meta: Capex For Major Tech Companies And this table does not include some companies which have major capex commitments like Oracle which has announced it will spend some $50 billion in 2025/6 or CoreWeave which is predicting around $25 billion of capex in 2026.

MSCI All Country World Index1 and 87% of the Fund’s emissions were covered by a company-wide target to reach net zero emissions by at least 2050. The third leg of our strategy is about valuation. The weighted average free cash flow (‘FCF’) yield (the free cash flow generated as a percentage of the market value) of the portfolio at the outset of 2025 was 3.2% and ended the year at 3.6%. The year-end FCF yield of the S&P 500 was 2.8% and MSCI World was 3.1%. Our portfolio stocks have become a lot more lowly valued than the S&P as the free cash flow of many of the major stocks which now dominate the index has shrunk or disappeared in the face of massive capex spending on AI. Our portfolio consists of companies that are fundamentally a lot better than the average of those in the S&P 500, and in the past we have explained that it is no surprise if they are valued more highly than the average S&P 500 company. In itself this does not necessarily make the stocks expensive, any more than a lowly rating makes a stock cheap but they are now significantly cheaper than the S&P. But it also raises an obvious concern about what will happen to the market. Turning to the fourth leg of our strategy, which we succinctly describe as ‘Do nothing’, minimising portfolio turnover remains one of our objectives and this was again achieved with a portfolio turnover of 4.6% during the period. It is perhaps more helpful to know that we spent a total of just 0.

There is a tailwind for this business from people who do not yet have access to vision correction. In addition, it has some interesting innovations such as the Stellest lenses which help prevent deterioration for children with myopia and of course the Meta AI glasses. We previously sold a position we held in Intuit, the accounting and tax software company, after it acquired Mailchimp in 2021 because we felt that Mailchimp fell outside its circle of competence and they paid about three times the right price, something which they attempted to justify by pointing out that half the consideration paid was in Intuit shares. What this implied about their valuation seemed obvious to us. For a while after we sold the shares AI hype drove the price but latterly the poor performance of the Mailchimp acquisition has become evident and reflected in the share price. We have started to rebuild a stake in the hope that the management has learned from the debacle. Wolters Kluwer is the leader in technical publishing used by professionals in health, tax, accounting, risk & compliance and legal.but

Whether this arms race produces adequate profits and returns for the amounts expended remains an open question to which I will return later. At least Novo is building capacity to produce a drug for which there is established demand and profitability and in which it currently has a competitive advantage. The average year of foundation of our portfolio companies at the year-end was 1920. Collectively they are over a century old. The second leg of our strategy is about valuation. The weighted average free cash flow (‘FCF’) yield (the free cash flow generated as a percentage of the market value) of the portfolio at the outset of 2024 was 3.0% and ended the year at 3.1%. The year-end median FCF yield on the S&P 500 was 3.7%. Our portfolio consists of companies that are fundamentally a lot better than the average of those in the S&P 500, so it is no surprise that they are valued more highly than the average S&P 500 company. In itself this does not necessarily make the stocks expensive, any more than a lowly rating makes a stock cheap. However, we expect some of this disparity in valuation to be eradicated in 2025 if, as we expect, the cash conversion of our portfolio companies improves.our

The only metric which continues to lag its historic 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 historic level of around 100% as a result of unusual events affecting a handful of our companies which we expect to largely unwind to their benefit in 2024. The average year of foundation of our portfolio companies at the year-end was 1916. Collectively they are over a century old. The second leg of our strategy is about valuation. The weighted average free cash flow (‘FCF’) yield (the free cash flow generated as a percentage of the market value) of the portfolio at the outset of the year was 3.2% and ended it at 3.0%. The year-end median FCF yield on the S&P 500 was 3.7%. Our portfolio consists of companies that are fundamentally a lot better than the average of those in the S&P 500 so it is no surprise that they are valued more highly than the average S&P 500 company. In itself this does not necessarily make the stocks expensive, any more than a lowly rating makes a stock cheap. However, we expect some of this disparity in valuation to be eradicated in 2024 if, as we expect, the cash conversion of our portfolio companies improves. Turning to the third leg of our strategy, which we succinctly describe as ‘Do nothing’, minimising portfolio turnover remains one of our objectives and this was again achieved with a portfolio turnover of 11.

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.

Deferred income taxes are non-cash but are nevertheless recorded in the P&L account. Parts of revenue can be non-cash as well, but we certainly don’t see many companies removing them from their results. As long as accrual accounting is the standard, the ‘non-cash’ argument simply does not pass muster. If you want to review cash items, then look at the cash flow statement, not an adjusted P&L account. Other reasons given for excluding share-based compensation include the fact that the calculation of the expense may use valuation methodologies that depend on assumptions and that the values of the securities given to employees as compensation may fluctuate and are outside a company’s control. It is true that the expense associated with stock options provided as compensation is calculated using option pricing models, which rely on assumptions for the risk-free interest rate and share price volatility. But other items on a GAAP income statement make significant use of assumptions and estimates as well. Depreciation expense is calculated based on the estimated useful lives of assets, for example.a

However, in doing so, a lot of the actual net impact companies have is lost. Further issues that arise from this need for simplified ratings is that it forces asset managers to look for things they can measure accurately (board and employee diversity) or whether a company has a policy towards social issues such as animal testing, human rights or modern slavery. These are, of course, good things to have and are signs of good transparent corporate governance, but just because a company has a policy toward something doesn’t mean they actually behave in that way, and conversely, if they don’t have a policy, it doesn’t mean that they don’t behave in a way that we would approve of. A policy does not equate to action, and reducing a company’s net impacts on society down to a single metric overly simplifies the issue and too many of the good impacts that companies have are ignored or lost in the process. This leads onto the question of valuation. The weighted average free cash flow (‘FCF’) yield (the free cash flow generated by the companies divided by their market value) of the portfolio at the outset of the year was 3.3% and ended it at 2.9%, so they became more highly rated. Whilst this is a good thing from the viewpoint of the performance of their shares and the Fund, it makes us nervous as changes in valuation are finite and reversible, although it is hard to see the most likely source of such a reversal — a rise in interest rates — in the near future.

The year-end median FCF yield on the S&P 500 was 3.7%. The year- end median FCF yield on the FTSE 100 was 4.2%. More of our stocks are in the former index than the latter and I will not repeat the explanation which I gave in my 2017 annual letter on why I think the FTSE 100 is not an appropriate benchmark or investment proxy for our investors to use. Moreover, the valuation disparity with the FTSE 100 has been widened by the portfolio’s 30% outperformance of the FTSE 100 during the year. It’s hard to outperform by such a wide margin without becoming relatively more highly valued unless the portfolio’s cash flows have grown at a similar differential rate. What the market seems to be rewarding is consistency of performance which has been emphasised by economic conditions in 2020. Our portfolio consists of companies that are fundamentally a lot better than the average of those in either index and are valued much more highly than the average FTSE 100 company and higher than the average S&P 500 company. It is wise to bear in mind that despite the rather sloppy shorthand used by many commentators, highly rated does not equate to expensive any more than lowly rated equates to cheap.

There are also issues with the relative valuation of some technology businesses which — like a number of businesses of the sort we seek to invest in — rely on intangibles. The main assets of the companies we seek to invest in are often intangible. Some examples of intangible assets are brands, copyrights, patents, know-how, installed bases of equipment which require servicing and maintenance and so produce customers who are locked-in to the supplier, software systems which are critical to a business or person and so-called network effects. They are distinct from tangible assets such as real estate, machinery and equipment, and vehicles. The return on intangible assets is higher as they mostly need to be funded with equity not debt and attract an appropriate return.tangible

Turning to the third step of our strategy, the weighted average free cash flow (‘FCF’) yield (the free cash flow generated by the companies divided by their market value) of the portfolio at the outset of the year was 3.9% and ended it at 3.3%, so they became more highly rated. Whilst this is a good thing from the viewpoint of the performance of their shares and the Fund, it makes us nervous as changes in valuation are finite and reversible, although it is hard to see the most likely source of such a reversal — a rise in interest rates — in the near future. The year-end median FCF yield on the S&P 500 was 4.2%. The year- end median FCF yield on the FTSE 100 was 5.5%. Our portfolio consists of companies that are valued more highly than the average FTSE 100 company and a bit higher than the average S&P 500 company but with significantly higher quality. It is wise to bear in mind that despite the rather sloppy shorthand used by many commentators, highly rated does not equate to expensive any more than lowly rated equates to cheap. Turning to the fourth leg of our strategy, which we succinctly describe as ‘Do nothing’, minimising portfolio turnover remains one of our objectives and this was again achieved with a negative portfolio turnover during the period.we

abundance that shows that from a relative perspective quality stocks may today be considered expensive.’ The interesting point about that assertion is that it was published on 13th August 2012. A lot of superior returns have been had from those allegedly expensive stocks in the subsequent seven years. The argument might be encapsulated thus: stocks of the sort which our Fund owns have had a good run of outperformance as has the Fund but this is all about to end, or even has already ended, and so- called ‘value investing’ — buying stocks mainly based upon their supposed under valuation by the market — is making a comeback and funds which pursue that strategy are about to outperform us. Value investing has its flaws as a strategy. Markets are not perfect but they are not totally inefficient either and most of the stocks which have valuations which attract value investors have them for good reason — they are not good businesses. This means that the value investor who buys one of these companies which are indeed lowly rated but which rarely or never make an adequate return on capital is facing a headwind. The intrinsic value of the company does not grow (except for any new capital that its hapless investors allow it to retain or subscribe for in some form of share issue), or even erodes over time, whilst the value investor is waiting for the lowly valuation to be recognised and the share price to rise to reflect this.

Moreover, even when the value investor gets it right and this happens, they then need to sell the stock which has achieved this and find another undervalued stock and start again. This activity obviously incurs dealing costs but value investing is not something which can be pursued with a ‘buy and hold’ strategy. In investment you ‘become what you eat’ insofar as over the long term the returns on any portfolio which has such an approach will tend to gravitate to the returns generated by the companies themselves, which are low for most value stocks. As Charlie Munger, Warren Buffett’s business partner, said: ‘Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return — even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.’ Our emphasis added. Mr Munger is not offering a theory or an opinion — what he is saying is a mathematical certainty. The only uncertainty concerns our ability to forecast returns far ahead, which is why we prefer to invest in relatively predictable businesses.

The biggest flaw in value investing is that is does not seek to take advantage of a unique characteristic of equities. Equities are the only asset in which a portion of your return is automatically reinvested for you. The retained earnings (or free cash flow if you prefer that measure, as we do) after payment of the dividend are reinvested in the business. This does not happen with real estate — you receive rent not a further investment in buildings, or with bonds — you get paid interest but no more bonds. This retention of earnings which are reinvested in the business can be a powerful mechanism for compounding gains. Some 80% of the gains in the S&P 500 over the 20th century came not from changes in valuation but from the companies’ earnings and reinvestment of retained capital. If you were a great (and long-lived) value investor who bought the S&P 500 at its low in valuation terms, which was in 1917 when America entered world war one and it was on a P/E of 5.3x, and sold it at its high in valuation terms in 1999 when it was on a P/E of 34x, your annual return during that period would have been 11.6% with dividends reinvested, but only 2.3% p.a. came from the massive increase in P/E and 9.3% (80% of 11.6%) came from the companies’ earnings and reinvesting their retained earnings. The S&P example is for 500 average large companies.

Lastly, there are some commentators who say that one way to address this is to have a portion of your portfolio invested in both strategies — some in quality growth and some in value. I think the assertion that there is no harm in this diversification approach has been disproved rather comprehensively by Warren Buffett, but what does he know? Perhaps we should look at the value investment versus quality and growth strategy debate this way: would you rather side with a) a large section of the UK financial press and rent-a-quote investment advisers; or b) Warren Buffett, Charlie Munger (Berkshire Hathaway), Bill Gates (Microsoft), the Bettencourt family (L’Oréal), the Brown family (Brown-Forman), the Walton family (Walmart) and Bernard Arnault (LVMH)? The latter all seem to have become extraordinarily rich by concentrating their investment in a single high quality business and not trading regardless of valuation. So much for it not doing any harm to diversify across strategies. It seems impossible to comment upon developments in equity investing in the UK in 2019 without mentioning the word Woodford. The demise of Woodford Investment Management following the ‘gating’ of its main LF Woodford Equity Income Fund was undoubtedly the main news in the industry last year.

Is there any chance of style drift or a similar change of strategy at Fundsmith? I think not. We published an Owner’s Manual for Fundsmith Equity Fund at the outset which describes our investment strategy, write to you in these annual letters analysing how we are faring in implementing our strategy and are the only mutual fund in the UK which holds an annual meeting at which our investors can question us and see their questions answered publicly. So, it would be extraordinary if we were able to effect a change in our investment strategy without you noticing. Moreover, we have no desire to change our strategy. We are convinced that it can deliver superior returns over the long term. I would pose a different question which links the discussion of the Woodford affair with the earlier discussion of the ‘rotation’ from quality stocks into value stocks. If you expect such a ‘rotation’ to occur at some point and for value stocks to enjoy a period in the sun would you rather we tried to anticipate that and switched into a value investment approach of buying stocks based mainly or solely on the basis of their valuation or would you rather we stuck to our existing approach of buying and holding high quality businesses? I would suggest the latter approach might be better, and it is what we are doing. There will be no style drift at Fundsmith. Finally, I wish you a happy New Year and thank you for your continued support for our Fund.

A stock may be lowly rated but not good value if the (lack of) quality of its business and/or its prospects mean that its intrinsic or fundamental value is still below its lowly valuation.  The distinction which many commentators make between growth or quality investing and value investing is in my view a somewhat superficial one. To quote Warren Buffett: ‘Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth”. Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago).variable

whose importance can range from negligible to enormous and whose impact can be negative as well as positive.’ Most investment strategies require some regard for the valuation of the stocks purchased or held — even strategies like ours which focus on high quality companies. The rate of growth of a company is a critical component of its valuation.  As pointed out in point 6 above, most stocks are not currently at valuations which would attract classic value investors. True value investing involves buying stocks when they are trading significantly below your estimate of their intrinsic or fundamental value and then waiting for some event(s) to lift the share price up to or above the intrinsic value — usually a management change, takeover, demerger, a change in the economic or market cycle, or simply when they come back into fashion amongst investors. When this occurs the value investor seeks to realise his or her gains and move on to find another value stock on which to repeat this performance. Value investing has been out of fashion in recent years as persistently low interest rates have driven the value of almost all stocks beyond the reach of true value investors. Nonetheless value investing has its merits and will surely have its day when stocks of the sort which attract value investors perform well. However, it is not a strategy which we will be pursuing even if we could foresee it coming back into fashion, which it will at some point.

The sort of stocks which trade on low enough valuations to attract value investors are unlikely to be those which we seek – businesses which can somewhat predictably produce a high return on capital employed, in cash, and can invest at least part of that cash back into the business to fund their growth and so compound in value. Unlike our strategy which is to seek such stocks and hold onto them, letting the returns which the company generates from this reinvestment produce good share price performance, value investing suffers from two handicaps. One is that whilst the value investor waits for the event(s) which will crystallise a rise in the share price to the intrinsic value that has been identified, the company is unlikely to be compounding in value in the same way as the stocks we seek. In fact, it is quite likely to be destroying value. Moreover, it is a much more active strategy.this

Source: Bloomberg Looks familiar doesn’t it? And it makes people reluctant to invest. ‘Ah’ but I can hear someone say, ‘Things are different — the valuation was much lower in 1965 than it is now.’ In mid-1965 the S&P 500 was on a P/E of 18.6x. Now it is on a 2019 forecast P/E of 17.1x. There is no significant difference, although it is actually more lowly rated now. But surely only an idiot would invest in a portfolio of high quality company stocks when the market chart looks like that... As Mark Twain said, ‘History doesn’t repeat itself, but it often rhymes.’ Finally, I wish you a happy New Year and thank you for your continued support for our Fund. Yours sincerely, Terry Smith CEO Fundsmith LLP

What seems to have happened over the past decade is a prolonged experiment in borrowing your way out of a debt problem. Maybe it will work, although I am amongst those who would bet against it, but it certainly is not the sort of circumstance which would suggest that a ‘normal’ economic recovery or a rapid rise or ‘hike’ in interest rates is likely. As an aside, I would suggest that the headlong expansion of credit in much of the western world which preceded the Financial Crisis was an attempt to compensate for the effects of deflation. Instead of accepting that the loss of manufacturing and service jobs to the developing world meant we had to accept lower pay and lower standards of living to compete we opted for an expansion of the state, the mushrooming of non- productive jobs and borrowing to maintain our spending patterns. Secondly, if you nonetheless take the view that our Fund’s strategy has indeed delivered a good performance but that valuations (which I will come to later) for stocks of the sort it owns are high and that this will limit their share price performance at least in the near term, the obvious problem this poses is what you or we might invest in as an alternative. This presents several problems. One is that the valuation of the Fund’s stocks are not all that much higher than the market, especially when their relative quality is taken into account.

The companies in our portfolio have consistently had 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. Moreover, their average level of borrowing is significantly lower than it was when we started the Fund. The world at large may not have de-geared much but the companies in our portfolio have. Nor is this a one off—they have been achieving these superior results for many years. The average year of foundation of our portfolio companies at the year end was 1916. 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 2017? The weighted average free cash flow (the cash the companies generate after paying for everything except the dividend, and our preferred measure) grew by 13% in 2017. We regard this as a very good result given the generally lackluster growth which the world continues to experience. This leads onto the question of valuation. The weighted average free cash flow (‘FCF’) yield (the free cash flow generated by the companies divided by their market value) on the portfolio at the outset of the year was 4.4% and ended it at 3.7% so they did become more highly rated.

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.

9% in the S&P 500 Index, not the technology centric Nasdaq Composite Index. I am not suggesting that Information Technology is the only sector to invest in to capture future growth nor is it immune from becoming over-valued and delivering poor returns to investors from time to time. But if you were to ask which two sets of stocks were more likely to capture the benefit of future growth, one with 1.8% in Information Technology or one with 23.9%, I think the answer would be pretty obvious. So for all those reasons I do not really regard the FTSE 100 as a genuine benchmark for our Fund and neither am I at all concerned about the Fund’s valuation relative to it. However, that should not be taken to mean that we are entirely comfortable with the seemingly ever higher rating which the shares in our portfolio are achieving. It is clearly a finite and reversible source of performance. However, the growth in the free cash flows of the portfolio are providing a greater portion of the performance which is how we would prefer it and what Mr. Munger might have predicted. One aspect of our performance which we have often been asked about in the past is the degree to which it has benefited from the strength of the US dollar as the majority of the stocks we own are listed in the United States. This is a complex subject as currency exposure is driven by where a company derives its revenues rather than where it is headquartered or listed.

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.

The average year of foundation of our portfolio companies at the year end was 1912. 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 2016? The weighted average free cash flow (the cash the companies generate after paying for everything except the dividend, and our preferred measure) grew by just over 11%* in 2016. We regard this as a rather good result given the generally lackluster growth which the world is experiencing and which led to earnings falling on the FTSE 100 and S&P 500 companies in the past year. This leads onto the question of valuation. The Free Cash Flow (“FCF”) yield (the free cash flow generated by the companies divided by their market value) on the portfolio at the outset of the year was 4.3%* and ended it at 4.4%* so they did not become any more highly rated. The mean FCF yield on the FTSE 100 is 4.7%+ and the median is 4.6%+. The mean FCF yield on the S&P 500 is 4.3%+ and the median 4.8%+. To try to cut through all these means and medians, our portfolio consists of companies which are fundamentally a lot better than those in the index and are valued a little more highly than the average FTSE 100 company and about the same as the average S&P 500 company, and they grew more rapidly in the past year.

or when other funds produce comparable numbers. However, we would caution against becoming obsessed with charges to such an extent that you lose focus on the performance of a fund. It is worth pointing out that the performance of the Fund at the beginning of this letter is after charging all fees. As a cautionary tale about the merits of doing nothing, you may recall that in 2015 we sold our holding in Domino’s Pizza since it had reached a valuation which we felt was only justifiable if its rapid rate of growth was sustainable, which we doubted was likely. In my annual letter last year I said that I “sold it with some regret and trepidation. Regret since it is undoubtedly a fine business and had been our best performing share since the inception of our Fund. Trepidation since selling shares in good companies is something we are justifiably reluctant to do.” Domino’s managed to prove these fears right in the most painful way as the share price rose by +45%+ in 2016. Apart from demonstrating that I am, could we agree on “fallible” as a descriptor, I hope this illustrates why I am reluctant to agree with the commentators who suggest that you or I should sell our portfolio of great companies and invest in a portfolio of assorted junk in the hope that it will go up, the great companies share prices will go down and we can then profitably reverse the trade. Finally, I wish you a Happy New Year and thank you for your continued support for our Fund.

The companies in our portfolio are certainly not immune to periodic downturns in business and/or management errors, and their share prices are subject to the usual factors which affect the stock market, but we can at least be reasonably sure that they are adding to their intrinsic value over time by continuing to invest at wonderful rates of return. If I gave you an exhaustive list of all the subjects in investment and the ways in which investors and commentators behave that perplex me then this annual letter would be considerably longer. However, one of these subjects is the obsession with share prices. Ultimately, of course, a focus on share price movements must be correct. It is no use owning shares in good companies if the strength of their business is never reflected in the share price, but a continuous focus on share price movements to the exclusion of the underlying fundamental economics of the companies is neither healthy nor useful. In the long term one will follow the other, and it is not the fundamentals which will follow the share price. Returning to the subject of valuation, what are the facts as opposed to commentators’ views? The weighted average Free Cash Flow (‘FCF’) yield of the portfolio (the free cash flow generated by the companies divided by their market value) started the year at 4.5%* and ended it at 4.3%* so the overall portfolio saw little increase in valuation in 2015. Our companies on average grew their free cash flow per share by 9.

7%* during the year which was a much more significant contribution to performance. This 4.3% FCF yield compares with a median FCF yield for the non-financial stocks in the S&P 500 Index of 4.4%+ and a mean of 2.7%+ or a median for the non-financial stocks in the FTSE 100 Index of 3.8%+ and a mean of 3.9%+. Our stocks do not look bad value in comparison to the market especially when their relatively high quality is taken into account. Although of course, both may be expensive, but then both may continue to be so or even become more expensive. For the year, the top five contributors to the Fund’s performance were: Dr Pepper Snapple + 1.94% Imperial Tobacco + 1.79% Microsoft + 1.69% Sage + 1.36% Reckitt Benckiser + 1.05% The bottom five were: Procter & Gamble - 0.22% PayPal - 0.15% 3M - 0.02% Kone + 0.02% Colgate Palmolive + 0.05% Of the bottom five performers, the only one which gives us significant cause for concern is Procter & Gamble which is on its third internally sourced CEO in as many years. We sold our holding in Domino’s Pizza during the year since it had reached a valuation which we felt was only justifiable if the current rapid rate of growth is sustainable, which we would doubt. However, we sold it with some regret and trepidation.is

undoubtedly a fine business and had been our best performing share since the inception of our Fund. Trepidation since selling shares in good companies is something we are justifiably reluctant to do. Still we believe that you ‘make money with old friends’ which is to say that we would be keen to own Domino’s again if the opportunity arises at a valuation which we regard as at least reasonable. We also sold our holding in Choice Hotels in 2015 as we did not like the risk/reward potential from the company’s investment in developing a third party reservations system called SkyTouch. As we do not do much trading to reallocate the Fund’s capital between our holdings we are reliant on the management of our investee companies to make decisions to reinvest part of their companies’ cash flows for us. When they do things which are different, exciting and outside their core area of competence we become worried. Hence our sale of Choice Hotels. We also sold the holding in eBay which we obtained when eBay split the eponymous online marketplace business and PayPal, the online payments processor, which we have retained. During the year we built a holding in Waters Corporation, a US based manufacturer of mass spectrometry, liquid chromatography and thermal imaging equipment, which makes much of its returns from the sales of consumables, service, spares and software to the operators who have installed its equipment.

The main positive contributors to that performance in 2012 were: Intercontinental Hotels, L’Oreal, Reckitt Benckiser, Kone and Diageo. The main detractors from the Fund’s performance were: Procter & Gamble, McDonald’s, Imperial Tobacco, Becton Dickinson, and a Consumer Company which we are in the course of buying a position in and so would prefer not to name at this point. McDonald’s is a small position as it has only recently come within valuation range for us after reporting a number of periods with poor sales performance. We believe it is a business of the quality which we seek and therefore are willing to use this as an opportunity to buy stock. It might be worth thinking about the implications when a business which sells some meals for one dollar is struggling to grow sales. Clearly this is not because consumers are feeling flush and trading up. Portfolio turnover in the Fund in 2012 was 0.48%. This figure is flattered by the inflow of funds over the period which is not included in the calculation otherwise a new fund would have 100% turnover from investing cash inflows, but even so it is exceptionally low. Our only outright sale during the year was of SGS, the Swiss testing company. We remain convinced that it and the sector are good quality businesses, but the shares had reached the point at which they were one of the most highly rated within our Investable Universe and so we thought that there was better value to be found elsewhere.

Turning to the characteristics of our portfolio, probably the question I am asked most frequently is whether the strong performance of most shares in the Fund to date means that they are now over-valued. The weighted average free cash flow (“FCF”) yield, which is our primary valuation yardstick, of the companies in the portfolio started the year at about 5.8% and finished it at about 5.7%. This 5.7% FCF yield compares with a median yield on the non-financial stocks in the S&P 500 of about 6.1% and an average of 5.4%; or a median for the non-financial stocks in the FTSE 100 of 4.6% and an average of 4.9%. The valuation of our stocks on this basis therefore looks about the same or a bit better (cheaper) than the average. The yield is also significantly higher than the yield on government bonds which was previously known as the risk free rate before investors started to relearn that governments default. This is significant. The coupon on those bonds cannot grow over time whereas the free cash flow from our companies can. So if we can buy them with a higher FCF yield than the bond yield then we have probably created value. We should perhaps compare the FCF yield of the portfolio not with the yield on major government bonds but what we think that bond yield should be since government bond yields across the developed world are distorted by Quantitative Easing in which the central banks, controlled by the government, are the main or even the sole buyer of bonds.

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.

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.

The main detractors from the Fund’s performance were: Serco, Stryker, Kone, Becton Dickinson and Intercontinental Hotels. Turnover in the Fund in 2011 was 15%. This was higher than we would ideally like although still significantly lower than most funds. Part of this turnover was really involuntary. We sold Del Monte Foods prior to the closing of the cash bid from KKR, and sold our holding in Clorox after a bid approach from Carl Icahn which we correctly judged would not result in an actual takeover but which drove the share price to a valuation which we regarded as offering poor value. Excluding dealing in Del Monte and Clorox, the turnover was 4% which is much closer to the level we seek (zero ideally). The only voluntary turnover during the year were sales of our holdings in Kimberly- Clark Corporation and Domino’s Pizza, Inc. Kimberly-Clark began to show adverse results from our regular calculation of the incremental return on capital. We sold the shares at a small profit. They have subsequently performed poorly in terms of fundamental performance although the share price has ironically been quite firm. We prefer to judge our investments by what is happening in their financial statements than by the share price. Domino’s shares rose in price by 113% during the year and had reached a point at which they no longer represented good value. Domino’s also has a re-financing of debt due by 2014.

There is nothing in the performance of Domino’s which causes us the slightest concern about this but there is plenty wrong with the banking system which will be required to provide the refinancing. As a result we hope to have the opportunity to become investors in Domino’s again. The net result this was that the Total Expense Ratio of the Fund was 1.2%. We hope to reduce that in future. The historic dividend yield on the Fund at year end was 2.4%. This dividend was covered 2.6 times by earnings. There is only one stock in the Fund that does not currently pay a dividend. This is significant: it is becoming clear that dividends are likely to provide a more significant portion of the total return on equities in the future than they did in the equity bull markets of 1982-2000 and 2003-07. The current yield on the Fund may not fully reflect its dividend paying capabilities as some of the companies also utilise share buybacks. During the course of the year we published some research on share buybacks (“Share Buybacks-Friend or Foe?” April 2011-available on the Fundsmith website) in which we concluded that buybacks were rarely accompanied by any reasoned justification; that they had become almost universally regarded as a good thing and contributing to shareholder value irrespective of the price paid or the valuation implied, which simply cannot be true; and in many cases their timing was poor.

Before you rush to buy B of A shares however you might like to know that cash flows at banks are not the same as they are at non banking businesses. So, for example, in the calculation of B of A’s cash flow the computation adds back the provisions for bad debts and impaired assets which is a deduction from profits. This is strictly true-a provision is a non cash item-but it means that comparisons of banks with other company’s cash flow in this manner is truly a case of comparing apples and ugli fruit (I chose a fruit which was more alphabetically remote from A for Apples than the commonly used P for Pears and which exemplifies our view of banks). Our portfolio has a FCF yield about the same as the average for the market. Yet it is inconceivable in our view that it is not of higher than average quality in terms of longevity, resilience, predictability, gross margins, operating margins, return on operating capital and the conversion of profits into cash. Put simply this means that we own shares in businesses which are higher quality than the market on a valuation about the same as the average for the market. Last year I started a policy of allowing myself one rant per letter about a subject relevant to investment. I thought I would provide an update on how that went. Last year I sounded a warning about the perils of Exchange Traded Funds (“ETFs”).

As our portfolio had an average return on operating assets of 50% this reinvestment of cash flows should produce compounding of value for us as shareholders. This FCF yield compares with a FCF yield on the S&P 500 of a bit less than 7%. The median (250thranked) FCF yield in the S&P is 6.6%. What we can say with a high degree of certainty is that our portfolio has a FCF yield higher than the average for the market. Yet it is inconceivable in our view that it is not of higher than average quality in terms of longevity, resilience, predictability, profit margins, return on operating capital and the conversion of profits into cash. Put simply this means that we own shares in businesses which are higher quality than the market on a valuation lower than the average for the market. Whilst that is not a total solution to successful investing, it strikes us as at least a good start. We regard an equity holding as a claim on a share of the cash flow produced by a business. In the Fund we seek to own companies which produce high cash returns on capital and distribute part of those returns as dividends and re-invest the remainder at similar rates of return. And we want to own those companies shares at prices which at best under-value their returns and at worst value them fairly.