Terry Smith on Volatility vs Risk

Ratio of 0.87 versus 0.60 for the Index. This simply means that the Fund has returned about 45%, ((0.87÷0.60)-1)x100, more than the Index for each unit of price volatility, of which more later. Our Fund is the second best performer since its inception in November 2010 in the Investment Association Global sector of 162 funds, with a return 353 percentage points above the sector average which has delivered just 254% 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 once again in 2024. Just five stocks (the ‘Fab Five’?) Nvidia, Apple, Meta, Microsoft and Amazon provided 45% of the returns of the S&P 500 Index (‘S&P 500’) in 2024. This is similar to the concentration of returns provided by the so-called Magnificent Seven in 2023. Moreover, a single stock — Nvidia — produced over 20% of the S&P 500 returns in 2024. Nor is this concentration of returns in a few technology companies a purely US phenomenon. In Germany 41% of the return from the DAX Index came from a single stock — SAP, the software company whose share price rose by 69% so that it is now trading on a mere 97x earnings. Our Fund owns some but not all of these stocks and it was difficult to perform even in line with the Index unless you owned them at least in line with their index weighting.

For example, were there to be an economic downturn which led to a reduction in tech spending, which is now so large a proportion of overall spending that it cannot be non-cyclical, one area of vulnerability might be spending on AI as it is not currently generating much revenue. Were the largest companies then to produce disappointing results, their share prices are likely to react badly which will drag down the index performance more than that of those active managers who are underweight in these stocks. But even if some scenario like this awaits us in the future, what exactly will cause this and when it may occur is difficult or impossible to predict. Which brings me back to the subject of volatility which was raised at the start of this letter. We don’t agree that true volatility is measured by ratios such as the Sharpe or Sortino ratio which look at the volatility of fund prices or share prices, but they are widely accepted as a measure. Moreover, whilst investors should rationally focus on volatility in the fundamental value of the businesses they invest in and accept higher price volatility if this leads to higher returns, it is easier said than done. One problem is that it is difficult to remain calm and focus on the fundamental characteristics when the price volatility is sharply negative. Take a stock like Nvidia, which has been a spectacular performer for the past two years. The Nvidia share price fell by over two thirds as recently as 2021–2022.

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.

We can probably trace the era of low interest rates back to the so- called Greenspan Put which became evident in the 1990s as low interest rates were utilised as the palliative in periods of market volatility such as the Asian Crisis of 1997 and the Russian default and LTCM collapse in 1998. As the new millennium arrived so did new crises which seemed to warrant even easier money. It started with the Dotcom meltdown in 2000 and was followed by the Credit Crunch of 2008–09 which started in the US housing market and quickly became a full-blown international banking crisis.rates:

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.

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

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.

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