2011

The 2007 crisis that brought Schultz back began as an internal argument about brand decay. Seven years after he stepped down as chief executive, Starbucks had, in his own account, become overly focused on its stock price and was losing sight of its mission, while changing customer expectations, emerging technologies, and a foreboding recession compounded the problem. A Consumer Reports taste test that year rated Starbucks coffee behind McDonald's, an outside validation of what insiders already suspected about quality drift. Acting as chairman, Schultz wrote a memo for the leadership team cataloguing the bad decisions, titled for the commoditization of the Starbucks experience; the document leaked to the internet and created massive internal havoc, airing the founder's diagnosis of the company's drift in public. The leak forced the question of whether the board would let the architect of the brand fix what his successors had built on top of it, and the answer arrived within a year.

Wharton Magazine's 2011 profile of Lynch positioned his Magellan record in the context of his Wharton education and his Fidelity apprenticeship. The article traced Lynch's path from a Boston College undergraduate caddy gig at Brae Burn Country Club — where he met Fidelity's president — through a Wharton MBA, an artillery tour in Korea, and a research-analyst role at Fidelity in 1969. The path matters because Lynch's edge at Magellan was built on a research discipline that he learned as an analyst, not as a portfolio manager. He had spent eight years covering industries before taking the Magellan helm in 1977, and the discipline of primary company research that he applied as an analyst became the method he applied as a manager. The article highlighted Lynch's preference for companies whose products he could observe in person — Taco Bell, Pier One Imports, Dunkin' Donuts — as the visible output of a research discipline that did not stop at the financial statements. Lynch visited the stores, talked to franchisees, and watched the customer traffic before he bought the stocks. The Wharton profile made the point that Lynch's retail-level observations were not a substitute for financial analysis but a complement to it. The store visit told him whether the income statement was telling the truth about the operating reality; the 10-K told him whether the balance sheet could support the growth implied by the operating reality. The article's framing of the Magellan record was that the 29.2 percent annualised return was less a matter of stock-picking genius than of methodological discipline applied at scale. Lynch's portfolio grew to over a thousand names because his scuttlebutt produced more investable ideas than the fund could concentrate in. The diversification was a consequence of the research method, not a portfolio-construction principle. The Wharton profile argued that the post-Magellan mutual-fund industry has not produced another Lynch because the structural conditions of the 1977-1990 period — small fund, under-researched small-caps, primary-research edge — have not been replicable at the scale that today's institutional desks operate at.

Murthy told the BBC that despite running a multinational, he personally cleans the lavatory at home each night, a habit instilled by his father to push back against India's caste-bound notion of sanitation work as a lower-class duty. The discipline of leading by example, he argues, is more persuasive than any corporate slogan.

The Lessons of History – Endowment and Foundation Investing Today Remarks by John C. Bogle, Founder, The Vanguard Group Before The NMS Investment Management Forum Washington, DC September 12, 2011 I’m honored to have the opportunity to address you this morning, during these troubled days for our nation and our financial markets. Perhaps I can bring a certain perspective, focused on history and reality, to you who hold such solemn responsibilities for the financial health of the vital institutions you represent. Shortly after I agreed to join you, I recalled that it was exactly fifteen years earlier when I had written an essay for the Common Fund entitled “If I Managed My Alma Mater’s Money.” With the help of the man who invited me to write that essay, John Griswold, now Executive Director of the Commonfund Institute, I located a copy. This morning, as I discuss “The Lessons of History,” I thought it would be fun, interesting, and provocative to examine what’s happened over the exciting era since I made my policy recommendations. Now fifteen years of history have rolled by—a history replete with waves of greed, fear, and hope in the stock market. What an era it’s been! An era that began with a market boom, followed by a 50 percent bust, a solid recovery, yet another 50 percent bust, and another nice recovery, albeit one that seemed to fall apart after the June 30, 2011, fiscal year ended.

In his own public statements, Tata has emphasised that he evaluated acquisitions on strategic fit and on the discipline of leaving acquired management intact, rather than on the integration cost-cutting playbook common in Western M&A, framing respect for capability as a competitive choice rather than sentimentality.

Wednesday 11th January 2012 Dear Fellow Investor, This is the second annual letter to owners of The Fundsmith Equity Fund. Fundsmith opened for business on 1st November 2010, and so completed its first year on 31st October 2011. We have presented two sets of performance figures this year- the performance since inception and the last calendar year. 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. However this proviso notwithstanding, The Fundsmith Equity Fund rose by 8.4% net of fees for the year. This compares with some relevant benchmarks as follows: Since Inception 2011 Fundsmith Equity Fund 15.0% 8.4% MSCI World £ 3.2% -­‐4.5% MSCI EAFE £ -­‐6.1% -­‐11.2% FTSE 100 2.8% -­‐1.5% FTSE Actuarial Gilt Index 14.7% 15.6% The Fund outperformed the MSCI World Index, which we regard as the most relevant comparator, by 12.9% for the year. This strikes us as a good performance. It was achieved against the background of a year in which it gradually dawned on many people that the financial crisis of 2008-09 had not been solved but had rather been transformed into a sovereign debt crisis: if 2008 was the year in which governments saved banks, 2011 was the year in which the main question which emerged was who would save the governments.

CEO Brian Moynihan opened the Q3 2011 review against the backdrop of the Berkshire Hathaway $5 billion preferred equity investment and the attached warrants to purchase 700 million common shares at an exercise price of $7.14, both announced in late August. Management told the call that the third-quarter results had been hampered by a $3.6 billion pre-tax charge tied to the legacy Countrywide mortgage representation-and-warranty exposures, but that the underlying franchise was now generating operating earnings power roughly in line with the stated objective of the Project New BAC restructuring. CFO Bruce Thompson walked analysts through the third consecutive quarter of operating expense reduction, the build of the capital ratios under the new Basel III regime and the roughly 140 basis points of tangible common equity ratio build achieved during the quarter. He flagged that the Berkshire transaction had been structured to monetise a portion of the embedded franchise value at favorable terms rather than to fill a capital hole, and that the Company remained on a path to exceed the new capital requirements ahead of the regulatory phase-in. On the Q&A, analysts pressed Moynihan on whether the Berkshire transaction implied that the Company would need to issue additional common equity to close the remaining capital gap. Moynihan responded categorically that the preferred investment had been opportunistic, that the warrants were a long-dated option rather than an equity issuance and that the Company did not intend to issue common equity to meet the new capital requirements, pointing to the asset disposition program and the operating expense trajectory as the bridge. The call closed with management reiterating the multi-year Project New BAC objective of removing $8 billion of operating expense from the run-rate by mid-decade, and with Moynihan committing to a transparent disclosure of the legacy mortgage litigation pipeline so that investors could value the franchise against the underlying consumer banking business rather than against the trailing issues.

At the 2011 Daily Journal annual meeting, I told the audience that the discipline of staying within the circle of competence had been, over my six decades of investing, the single most valuable discipline I had acquired. The discipline required is to refuse to act on the things outside the circle, even at the cost of looking unfashionable during the boom, and even at the cost of being told, repeatedly, that I am missing the opportunity of a lifetime. The market-psychology point I tried to convey was that the boom, in its broad patterns, is the product of investors acting outside their circles on the assumption that they understand the new things, and the investor who recognises the assumption, and who refuses to act outside his circle, has a long-run advantage over the investor who chases the new things. The discipline required is honesty about the boundary of the circle, and the willingness to admit that the boundary is smaller than one would prefer. The circle-of-competence element was the one I had most wanted to convey. I had made my own share of mistakes by acting outside my circle, on the assumption that I understood the new things, and the cost of those mistakes had, in dollar terms, been very large. The lesson I drew was that the disciplined investor must assume that the boundary of his circle is smaller than he would prefer, and he must build the discipline of refusal into his process before the temptation to act outside the circle becomes irresistible. The 2011 meeting was, in this sense, a confession. I told the audience that the framework had been built, in large part, from my own mistakes, and that the discipline I had extracted was to refuse to act on the things outside the circle, even at the cost of looking unfashionable during the boom. The investor who builds the discipline of refusal will outperform the investor who chases the new things. The market-psychology lesson I tried to convey was that the crowd, in its broad patterns, is the aggregate of the investors acting outside their circles, and the investor who recognises the pattern, and who refuses to participate, has an enormous advantage over the investor who chases the new things. The 2011 meeting was, in some ways, the most candid I had ever given. I told the audience that the framework had been built, in large part, from my own mistakes, and that the discipline I had extracted was to refuse to act outside the circle, and to expand the circle only by deliberate study. The investor who is honest about the boundary, and who refuses to act outside it, will, in the long run, outperform the investor with the larger circle who pretends to understand more than he does. That single discipline, applied over a working life, has been more valuable than any other I have learned, and it is the one I have tried hardest to convey to the students who visit Pasadena each spring.

In a May 2011 Washington Post opinion piece, Stanley Druckenmiller publicly entered the debate over the United States debt ceiling, arguing that the political cost of failing to raise the ceiling had been materially overstated and that the bond market would be more alarmed by a continued failure to address the long-term fiscal trajectory than by a technical default. He wrote that the United States was not insolvent in any meaningful sense and that a missed interest payment, while disruptive, would not produce the catastrophic unwind that the political establishment was predicting. The op-ed was unusual in that it ran against the consensus of almost every mainstream economist and was widely cited in the subsequent weeks as the most serious articulation of the case for using the ceiling as a fiscal lever. The article is one of the few extended on-record discussions of the topic at the time of its publication and is used as a reference document by writers covering the broader institutional investment industry. He argued that the alternative, continuing to raise the ceiling without addressing the underlying trajectory, would eventually produce a fiscal crisis of a much more serious kind, in which the bond market would lose confidence in the willingness of the political class to control the deficit. He wrote that he was willing to accept the short-term volatility of a missed payment if the political cost of that volatility forced a serious negotiation on entitlements and on the structure of the federal budget. He framed the issue as a question of intergenerational equity, arguing that the current generation of voters and politicians was effectively billing the next for a level of consumption that the next would not be able to afford without a structural change in policy. The piece is widely cited in the literature on the topic as a case study in how the principles at stake interact with the broader institutional context and the operational architecture of the office. The op-ed has been revisited at every subsequent debt-ceiling debate, and it has been cited as the cleanest articulation of the view that the ceiling is a feature rather than a bug of the American fiscal system. The piece is paired in Druckenmiller's public bibliography with the 2014 Warsh op-ed and with his subsequent appearances on CNBC, in which he has continued to argue that the fiscal trajectory is the dominant macro variable of the era. The article is also cited by political economists looking for a serious investor's articulation of the case for using the ceiling as a lever, and it has been quoted at length in subsequent congressional testimony on the federal budget and on the long-run trajectory of the public debt. The article is regularly updated as new information becomes available and is one of the most frequently consulted references on the subject for general-audience readers and for institutional practitioners.

A November 2011 piece on CBS News carried the headline that even Yale said to stop chasing investment returns, and used the headline to make a point about the behaviour of individual investors in the aftermath of the financial crisis. The article reported that David Swensen, the celebrated chief investment officer of the Yale endowment, had provided compelling evidence of investors behaving badly, in particular by buying high and selling low in their mutual fund allocations. The piece used the office's published research on mutual fund flows to argue that the average individual investor had underperformed the funds they owned because of the timing of their purchases and sales, and that the behaviour gap was the dominant source of the gap between the returns the funds produced and the returns the investors realised. The piece is widely cited in the literature on the topic as a case study in how the principles at stake interact with the broader institutional context and the operational architecture of the office. The coverage walked through Swensen's argument that the for-profit mutual fund industry consistently failed the individual investor, and that the structural incentives of the industry were at the root of the behaviour gap. The piece noted that Swensen had made the case, in his two books, that the individual investor should not try to replicate the institutional model but should instead use low-cost index funds to build a diversified portfolio, and that the case for index funds was a function of the structural disadvantage of the individual investor in the active-management marketplace. The coverage stressed that the argument was being made by the head of one of the most successful active-management operations in the country, which gave it particular weight in the broader debate over the case for index investing. The article is regularly updated as new information becomes available and is one of the most frequently consulted references on the subject for general-audience readers and for institutional practitioners. The piece closed with a reflection on what the office's research implied for the individual investor's behaviour. The CBS coverage noted that the discipline of rebalancing against the market rather than with it, the discipline of holding a long-horizon allocation through market cycles, and the discipline of using low-cost index funds rather than chasing performance were the three practical implications of the office's argument. The article is paired in the Swensen bibliography with the Unconventional Success volume that articulated the argument in full, and it is widely cited in the secondary literature on the behaviour gap and on the case for index investing. The piece remains a reference for general-audience readers looking for an accessible introduction to the argument and its practical implications. The piece is widely cited in the secondary literature on the topic and is regularly consulted by readers looking for a single-page introduction to the argument.

The decision to split Netflix in two was born in casual confidence. A month before the announcement, Reed Hastings was soaking in a hot tub with a friend when he shared the secret: his company was about to announce a plan to divide its movie rental service in two, one offering streaming over the internet and the other old-fashioned DVDs by mail. The friend, who was also a Netflix subscriber, told him under a starry Bay Area sky that it was awful, that she did not want to deal with two accounts. Hastings ignored the warning, operating on the general principle that chief executives should discount what their friends say. He has since regretted it. The anecdote, which Hastings himself recounted, became the emblem of the episode: a founder so convinced by his own long-term logic that he discarded the most direct customer signal available, delivered in confidence by someone with no agenda beyond her own subscription invoice.

The launch of the Renaissance Institutional Equities Fund in 2005, designed to manage tens of billions of dollars of outside capital, represented the firm's first major attempt to extend its quantitative approach beyond the capacity-capped Medallion structure. RIEF was designed to hold long equity positions, with lower turnover and a longer holding period than Medallion, in order to be capacity-elastic. The strategic logic was that Medallion's signals could not be scaled indefinitely without destroying the edge, but a separate, slower strategy built on different signals could absorb much larger amounts of institutional capital at lower fees. The firm's researchers had identified patterns in equity returns that were too small to drive Medallion's returns but, in aggregate, sufficient to support a multi-billion-dollar fund benchmarked against equity indices. The launch was, in retrospect, both an attempt to monetize the firm's research infrastructure at scale and a recognition that the Medallion capacity ceiling left significant institutional demand unserved. The tension between the two funds - one closed to all but insiders, one openly soliciting outside capital - would come to define the firm's relationship with the institutional investor community for the next two decades.

Liu returned as Lenovo chairman in February 2009 to help lead a turnaround after the 2008-09 global economic downturn hurt the company's results.

Wharton frames ITC's transformation under Deveshwar as a journey from a single-product tobacco company founded in 1910 as the Imperial Tobacco Company of India to a multi-business corporate enterprise with turnover around US$6 billion by 2010. Non-tobacco businesses — foods, personal care, hotels, paper, agriculture and IT — accounted for about 40% of revenues by 2010.

He has spoken of the Nano as motivated by the safety of Indian families on two-wheelers rather than by the headline price point alone, reframing what observers read as a low-cost car as a safety-and-access proposition that the market ultimately did not reward at the intended volume.

The Wharton article dwelt on Lynch's wife Carolyn as an unrecognised co-investor — the source of the L'eggs pantyhose observation that became a Magellan position. Lynch has been candid in interviews that several of his consumer picks originated in family shopping observations, and the article framed this not as luck but as method. The Lynch household functioned as a continuous consumer-research panel: Carolyn's choices in pantyhose, his daughters' preferences in clothing and toys, his own visits to hardware stores and motor inns all generated the primary observations that became Magellan positions after the financial work confirmed the underlying business. The article's broader point was that Lynch's family-and-friends network was a research infrastructure that the institutional desk could not replicate. A sell-side analyst flying to headquarters for an hour with the CFO gets a managed message; the cousin who works at a supplier gets the actual operational mood. Lynch tapped this network not for insider information but for primary observations that the sell-side could not gather. The Hanes L'eggs pick — a multi-bagger for Magellan — originated in Carolyn's observation that the pantyhose sold at the supermarket were a category-creating product. The financial work confirmed what the consumer observation had suggested: the L'eggs franchise was a consumer-mono hidden inside a textile company. Lynch's methodological claim was that the household is a legitimate research surface, not because households have access to information the market lacks, but because households can observe consumer behaviour that the market has not yet monetised into a financial narrative. The investor who reads the supermarket shelf as a primary research document has, in Lynch's framing, a wider research surface than the analyst who reads only the sell-side note. The Hanes pick was the proof of concept; the discipline was to extend the method to every category the household encountered.

RIEF's early performance, including a strong 2007, encouraged large allocations. The fund grew to tens of billions of dollars within a few years of launch. Its performance in the 2008 crisis, however, was disappointing relative both to Medallion and to the firm's marketing claims: RIEF posted losses while the internally-restricted Medallion again generated gains. The divergence revealed a structural truth about the firm's edge. The signals that worked at Medallion's scale, with its closed investor base and high turnover, did not survive the translation to a large-capacity, lower-turnover, equity-benchmarked vehicle. The patterns exploited by Medallion were too small and too transient to drive RIEF, and the patterns RIEF relied on were not, in the end, as durable as the firm had hoped. The episode illustrates a general lesson about quantitative strategies: capacity is not just a scaling parameter but a defining characteristic of the strategy itself. A strategy that works at one scale does not necessarily work at another; the patterns available at the higher scale are different, and frequently inferior, to those available at the lower. The firm's experience with RIEF was, in this sense, an unintended natural experiment in the dependence of strategy on capacity - and the result was not flattering to the proposition that Medallion's edge could be scaled.

The damage was quantified on October 24, 2011. Netflix told investors it closed the third quarter having shed eight hundred thousand American subscribers from the prior quarter, the first such decline in years, and the stock plummeted more than twenty-five percent in after-hours trading. The financial results underneath the subscriber loss were surprisingly strong: net income of 62.5 million dollars, or $1.16 a share, up from 38 million dollars a year earlier, on revenue that rose forty-nine percent to 822 million dollars, with both revenue and income topping analysts' expectations. The disconnect defined the moment. Netflix was more profitable than ever while shedding the goodwill that had made it one of the most respected internet brands in America. Subscribers had revolted over the summer's price increase and the proposed breakup, and many simply dropped the service, tarnishing a company that had spent a decade building its reputation on doing right by customers who hated late fees.

Schultz reassumed the chief executive role in 2008 to fix the problems the memo had catalogued, reassessing the company's mission and developing a plan to return it to its core values that became known as the Transformation Agenda. Its most visible act came on February 26, 2008, when Starbucks closed 7,100 stores for a three-and-a-half-hour afternoon of barista retraining, a call that financial analysts disliked but that Schultz deemed mandatory to the journey of restoring the mission. The afternoon of training re-energized the associates, in the account of his memoir Onward, and communicated the company's commitment to the experience it sold. Closing the entire domestic fleet to practice making espresso converted a cost line into a public statement of standards, the founder betting that the market would eventually pay for craft the company had let slip in the pursuit of growth.

So it seems a perfect moment to look back and see how the investment strategies that I recommended to “my alma mater” worked out, and how they compared with the actual results of the average endowment fund tracked by The National Association of College and University Business Officers (NACUBO). ____________________ Note: The opinions expressed in this speech do not necessarily represent the views of Vanguard’s present management.

Against this backdrop it is hardly surprising that equity markets performed poorly and so has the average fund. Only six other funds in the IMA Global Growth sector (into which the Fund is classified) achieved a positive return in 2011. This performance for the year took the Fund to third place in the Morningstar performance rankings for global equity funds. The main positive contributors to that performance were: Domino’s Pizza, Philip Morris, Imperial Tobacco, Colgate Palmolive and Unilever.

He recalled India's early-1980s business environment as extremely hostile, with Infosys waiting a year for a telephone connection and three years for a licence to import a single computer. He quipped that half the country was waiting for a telephone and the other half for a dial tone — a wry summary of License Raj-era friction.

Deveshwar joined ITC in 1968, became chairman in 1996, and from 1991 to 1994 served as chairman and managing director of Air India — a brief detour through India's national carrier between two ITC tenures. Returning to ITC in 1996, he faced the choice of staying in the comfort zone of a tobacco business ITC had run for nine decades or creating multiple new growth drivers to match the emerging Indian economy.

Liu Chuanzhi expressed confidence that Lenovo had established a durable global culture of commitment and ownership across its workforce, framing the company's post-acquisition integration of IBM's personal-computer business as culturally consolidated.

The Wharton profile closed with Lynch's reflections on the Magellan record as a benchmark for the active-management industry. His argument was that the record was unusual enough that it should not be used as a standard against which to measure ordinary active managers, but typical enough in its method that the method itself remains accessible to anyone willing to apply it. The 29.2 percent annualised return was, in Lynch's view, a conjunction of skill, circumstance, and a research discipline that few other managers were applying with the same intensity. The skill and the discipline are reproducible; the circumstance — a small fund in an under-researched market segment — is not. Lynch's advice to current active managers was to look in the market segments where the institutional flow is thinnest. The Magellan edge was built in small and mid-cap consumer names that the institutional desks of the late 1970s were ignoring. The equivalent segments in 2011 — and, Lynch suggested, in any future period — are the names too small to move the benchmarks of the largest funds, too obscure to attract sell-side coverage, and too unglamorous to attract momentum capital. The active manager who screens this segment for growers with clean balance sheets and insider buying is, in Lynch's view, still applying the Magellan method to the segment where the method produces an edge. The article's closing observation was that Lynch's philanthropic activity — through the Lynch Foundation — has continued the same methodological discipline he applied to investing. The Foundation funds medical research, Catholic education, and inner-city schools with the same primary-research intensity that Lynch brought to Magellan: site visits, conversations with the people running the operations, and a focus on the operating economics rather than the headline narrative. The Wharton profile argued that the Lynch method, applied to philanthropy as to investing, produces the same kind of compounding return — slow, unglamorous, and difficult to replicate at scale.

Later in 2008 came a harder decision: shuttering 600 stores and laying off twelve thousand employees, cuts that ran alongside the retraining and gave the Transformation Agenda its substance. Much of the memoir's narrative concerns rebuilding the management team, with Schultz working to find the right people for key positions while identifying new business opportunities and new technologies, including the Clover coffee brewer acquired with the Coffee Equipment Company. When the financial meltdown hit in September 2008, Schultz resisted pressure to cancel the company's biennial leadership conference and instead held it in New Orleans, a city still struggling to recover from Hurricane Katrina, gathering thousands of managers in a deliberately chosen symbol of recovery. The choice to spend money on people and place at the bottom of a recession expressed the operating thesis of the entire turnaround, that the company's renewal would come through its employees or not at all.

Hastings's response was a public accounting of his own errors. In his most detailed discussion of the period, he said he had been guilty of overconfidence and of moving too quickly, while insisting that Netflix's future still lay in streaming rather than DVDs. He twice linked the hostility toward the price change and breakup to the angry national mood, citing the Tea Party and Occupy Wall Street by name, and said subscribers had been bothered more by the summer price shock than by the split itself: until September, a combination of streaming and DVDs cost as little as ten dollars a month, and the same package now cost sixteen. In its letter to shareholders, Netflix declared it was done with pricing changes. Hastings said he was not sure whether the split plan had been presented to customer focus groups before it was made public, assumed it had been, and could not recall what any such groups had said. Netflix, he said, was now slowing its decision-making to leave more room for debate about major changes.

Despite the 2008 episode, RIEF continued to operate and, over time, recovered. The institutional narrative around the firm has emphasized that the institutional funds - RIEF and its sibling, the Renaissance Institutional Futures Fund - were designed for a different risk and return profile than Medallion, and were intended to deliver returns modestly above equity benchmarks at lower volatility, rather than to replicate Medallion's extraordinary record. The distinction matters for evaluating the firm's broader contribution. Medallion's returns are exceptional but largely unavailable to outside investors; the institutional funds are available but deliver more modest results. The two products together represent the firm's attempt to disaggregate its research output into a capacity-constrained insider vehicle and a capacity-elastic institutional vehicle. The long-run institutional record has been respectable by absolute standards, but it is the contrast with Medallion, not the absolute return, that has drawn scrutiny. The most reasonable interpretation is that the firm's research infrastructure is capable of producing multiple strategies of varying capacity and return, but that the highest-Sharpe strategies are also the most capacity-constrained. The economic value of the Medallion engine, in other words, cannot be exported at scale - a finding that has implications for the broader industry's attempts to commercialize quant strategies.

In 1985, ITC's platinum jubilee year, turnover was about Rs 800 crore with profit near Rs 8 crore. By 2010, Deveshwar tells Wharton, turnover had crossed US$6 billion with profit above US$900 million. The math implies a near-eight-fold dollar-turnover expansion in 25 years and a profit pool that grew by over 500x —.

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.

Perhaps we can learn something from that past—as I imagine everyone in this room realizes not from the perspective of the summer of 1996, but from the perspective of this moment summer of 2011, we can learn more from discuss the sources of the historical returns on bonds fear to tread,” laying out some reasonable expectations for investment and some implications for your investment strategies. “If I Managed My Alma Mater’s Money” It turns out that the 1996 Common Fund publication also included essays by a number of eminent financial pros on how they would invest the money of people in the audience this morning and remain today, among the most respected m recommendations. we can learn something from that past, or perhaps not. For in the field of investing, the everyone in this room realizes—is rarely prologue to the future. But if we look ahead, not from the perspective of the summer of 1996, but from the perspective of this moment we can learn more from financial history than we might otherwise expect. discuss the sources of the historical returns on bonds and stocks. I’ll then close by walking laying out some reasonable expectations for investment returns during the decade ahead implications for your investment strategies. “If I Managed My Alma Mater’s Money” Common Fund publication also included essays by a number of eminent would invest the money of their alma maters.

The original Infosys capital in 1981 was a mere two hundred and fifty US dollars, borrowed from his wife Sudha Murty. That sum kept the lights on only briefly, but Murthy's rule was simple: spend less than you earn. Founders slept in cheap hotels, used buses, sometimes walked to meetings — what he calls the early tough years.

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.

Deveshwar's diversification thesis, in his own words to Wharton, was unconventional at the time. He recalls being told conventional wisdom did not favor diversification as a prudent growth strategy. He countered with two beliefs: in an emerging economy with untapped opportunities, diversity managed well via innovative business strategies could yield significant growth; and that diversity could lend unique sources of competitive advantage unava...

Infosys's first client, based in New York, took a bet on an unknown Bangalore firm by hiring the founders to build and install a custom software package. Murthy saw the single-customer concentration as a feature, not a bug: delivering on competence, commitment and values for one client became the proof of concept that built the firm's reputation.

The Qwikster affair was the fall of a company that had seemed to solve the innovator's dilemma. Netflix's stock had risen ninefold from the start of 2009 to peak above three hundred dollars in July 2011, and Fortune had put Hastings on its cover as businessperson of the year for navigating the company from DVDs to the digital future while keeping the two businesses blended. The breakup decision, Hastings said, was based in part on data showing a faster-than-anticipated shift to streaming: in the first quarter of 2011 DVD shipments fell year over year for the first time, leading Netflix to declare the DVD business had peaked, and very few new subscribers were choosing discs by mail. But the data-driven company had underestimated the unquantifiable emotions of subscribers who still wanted their little red envelopes even if they forgot to watch the DVDs inside. How Netflix came to be so out of touch with its customers became, in the paper's framing, a cautionary tale for every company attempting the transformation from old media to new.

Most of you, even you younger this morning, will probably recall some of these names, many of whom were then, and remain today, among the most respected members of their profession. Let me briefly summarize their past, or perhaps not. For in the field of investing, the is rarely prologue to the future. But if we look ahead, not from the perspective of the summer of 1996, but from the perspective of this moment late in the ht otherwise expect. I’ll then ing “where angels returns during the decade ahead Common Fund publication also included essays by a number of eminent of you, even you younger , will probably recall some of these names, many of whom were then, their profession.their

During the year we wrote to the management of those companies within our portfolio which have engaged in share buybacks to ask for some insight into their rationale. The responses ranged from prompt, personalized (by the CEO) and well reasoned to being completely ignored. We regard the greatest risk for our investors after the obvious potential for us to buy the wrong shares or pay too much for shares in the right companies, as being reinvestment risk: we seek to buy companies which deliver high returns on capital in cash. What the management then does with these cash returns is one of the major factors affecting future returns on the portfolio. Management faces three main options for deploying these cash returns: return cash to shareholders, invest to grow the business organically or make acquisitions.for

Murthy credits independent India's long-standing policy of expanding engineering education with creating the talent pool Infosys could hire from. The post-independence glut of underemployed smart engineers meant smart people were available in numbers, learning quickly and adapting to whatever the global software market required.

The first essay in the series was written by the late great economist and author Peter L. Bernstein. He was far from certain about what he would do . . . certain only about what he would not do—he would not allocate the portfolio by “flying on automatic pilot,” and warned against the idea that “common stocks, regardless of how high they sell, are destined to be attractive investments.” Perfectly good (if imprecise) advice, I’d say. Like Peter Bernstein, market strategist and author Barton Biggs, was “terribly wary of the conventional wisdom” that relies on “steering the investment vehicle from the vantage point of the steep, winding mountain road by looking in the rear view mirror at the road over which we have just passed.” He foresaw a “bleak environment.” Also good advice, if some years early. John Biggs, former leader of TIAA-CREF, would be “aggressive in asset class allocation” (a lot in stocks; a little in bonds–10 percent to 20 percent), which didn’t turn out all that well. But he was (in my opinion) right in keeping “my investment plan simple . . . very well diversified and low-cost.” William H. Donaldson, co-founder of Donaldson, Lufkin, and Jenrette and founder of the Yale School of Management; Chairman of the New York Stock Exchange; and later on Chairman of the U.S. Securities and Exchange Commission (now there’s a resume!)

The clearest example Deveshwar cites of synergies across ITC's diverse portfolio is Aashirvaad atta. ITC's e-Choupal network enables cost-effective wheat sourcing with traceability through identity-preserved procurement. Tobacco-blending expertise informs customized blending for local tastes. Hotel master chefs contribute consumer-palate insights to the foods business. The packaging arm supplies the bag.

, would hire a full-time investment professional, pay him generously, and make him responsible to an investment committee comprised of a few qualified trustees. That small group would appraise the endowment fund’s results over the long term. And that’s just what Yale did, having selected David Swensen as its leader.that

On FMCG, Deveshwar tells Wharton the sector was expected to triple to over US$80 billion by 2018. ITC's foray blends internal competencies — sourcing, branding, trade marketing, distribution, manufacturing — with emerging opportunities.

choosing between these options are important. So are the ways in which they operate each option. So, for example, having determined to return a portion of earnings to shareholders, how does a management decide between a dividend and a buyback? In many cases we do not know as the management does not give any detailed rationale and we suspect that the answer is with the “benefit” of advice from their investment bankers who get fees, commissions, bid-offer spreads and maybe proprietary trading profits for advising companies to pursue buybacks but get nothing when a dividend is used. No prizes for guessing which way the advice is slanted. At the end of 2011 we held a portfolio of 24 stocks. On average companies in our portfolio were founded in 1894. We continue to invest in businesses which have shown great resilience over a long period of time-in most cases surviving two world wars and the Great Depression. The trailing free cash flow (“FCF”) yield at the start of the year was about 7% and about 5.8% at the end. The fall in the FCF yield was caused by a combination of the rise of share prices in the portfolio, changes in the portfolio and higher capital expenditure and working capital invested by the portfolio companies. This FCF yield compares with a median FCF yield on the S&P 500 of 6.1%. We have used the median by the way as the average is distorted by inclusion, for example, of a free cash flow yield of 76% on shares in Bank of America (“B of A”).

In Murthy's telling, Infosys only really accelerated after the 1991 economic reforms. With licensing scrapped, foreign travel eased, consultant imports permitted and capital-goods imports simplified, the company could finally import equipment, bring in experts and grow at the pace its backlog demanded.

Despite Infosys reaching 125,000 employees and billions in revenue by 2011, Murthy resisted analyst predictions of an inevitable slowdown. He argued that growth could be sustained through innovation, hard work and discipline — though he conceded the company could only become permanent through continuous reinvention, not by resting on scale.

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”).

followed, Swensen would earn a compound annual return of some 13 percent on the Yale University endowment fund, likely the highest among all of its peer institutions. A truly brilliant choice! Michael Price, for many years the guiding light of Mutual Shares, recommended heavy reliance on equities, focusing on those companies selling at a 30 or 40 percent discount from what other companies would pay to acquire them. “The whole goal is to compound at 15 percent . . . even when the market is up 25 percent (annually).” During the challenging 15 years that followed, neither Mutual Shares (which Mike Price hasn’t managed since 2001) nor the market came anywhere near these returns. But Mutual Shares compounded at 8.1 percent, well ahead of the 6.8 percent annual return for the Total Stock Market Index Fund, a splendid achievement. The recommendations of “Adam Smith” (George J.W. Goodman), trustee, author and publisher, are a bit hard to replicate. He recommended hedge funds and especially “Julian” (presumably Julian Robertson), a good choice for a while. But Robertson’s firm ceased operations in 2000, and we can’t know who came next. “Hire talent whenever you find it,” was “Adam Smith’s” message. Fine! But as we know, talent is hard to identify, and—as in “Julian’s” case—frequently evanescent. John M. Templeton, Dartmouth Professor Peter Williamson, and Charles R. Schwab were all true believers in equities. Templeton was unequivocal: “invest 100 percent in common stocks.” (The 6.

Deveshwar points out India is grossly under-roomed: only 5 million international arrivals a year against 80 million in France, 58 million in the U.S., 55 million in China. He estimates India needs 50,000 hotel rooms in two to three years and positions ITC Hotels to capture that growth. He also emphasizes environmental design —.

9 percent annual return on his Templeton Growth Fund for the period, in fact, would barely outpace the bond market return of 6.2 percent, despite assuming twice the risk.) Nor did Williamson accept any need for “an anchor to windward” (in bonds or cash) to modify volatility. Schwab described equities as “the investment of choice,” and—surprising as it may seem for this marketer focused on managed funds with good past performance—favored the use of index funds. Finally, both George Putnam and yours truly recommended a balanced approach. With bonds then yielding 7 percent and stocks but 2 percent, we both liked the concept of earning more income for endowments that must pay out returns to their universities, as well as the likelihood of substantially reduced volatility. I also urged endowment managers not to rely on “history and computers” to forecast stock and bond returns. My major recommendation couldn’t have been more specific: a 50/50 portfolio using U.S. stock and bond index funds, a balanced portfolio with extraordinary diversification and remarkably low costs—“on automatic pilot,” if you will.1 Simplicity writ large. 1 I also mentioned a 60/40 stock/bond portfolio and a 55/40/5 portfolio (the 5 in emerging markets), but all three portfolios provided similar returns and carried roughly comparable risks.

Paper and packaging, Deveshwar notes, are an under-penetrated Indian market — per-capita consumption around 5 kg per year, against nearly 300 kg in the U.S., 200 kg in the U.K. and 45 kg in China. With education and economic growth expected to drive manifold demand, ITC invested significantly in capacity in this business. The growth of branded consumer goods would, in turn, drive packaging demand —.

He revealed that as a young man he was a committed leftist, almost a communist, until his detention in Bulgaria in the 1970s forced a hard internal rethink. The episode produced his self-described conversion into a determined compassionate capitalist who believed entrepreneurship was the only practical lever for a country like India to attack poverty.

What happened next even surprised me and I thought I had lost the capacity for such an emotion in the face of the shenanigans of the financial services industry. Practitioners within the ETF sector reacted with a fury which can only be generated by two factors: 1) the criticism was accurate and/or hit a nerve; and 2) it was in danger of derailing a large gravy train. Some ETF practitioners suggested that I was criticizing ETFs because of concerns about the impact the growth of ETFs would have on the active fund management sector in general and Fundsmith in particular. This response is not just wrong it is preposterous for two reasons: 1) Fundsmith’s market share of the active fund management sector is so small that I do not possess a calculator capable of getting enough zeroes to the right of the decimal point to calculate it.could

ITC's agri-business division, Deveshwar tells Wharton, is positioned as a supply chain partner for the foods and tobacco businesses, with the e-Choupal rural network progressively leveraged to widen FMCG distribution. The e-Choupal itself is a celebrated example of rural digital infrastructure — direct internet-mediated farmer linkages for procurement of agricultural and aquacultural products —.

Murthy measures Infosys's success not by revenue or market cap but by the happiness generated — for employees, their families and beyond. He argues the second-order impact on children's opportunities and confidence is what lets him sleep at night, framing the company as a vehicle for social mobility rather than purely shareholder return.

continue growing to the point where they had replaced most active funds and still leave Fundsmith with an insignificant share of the remaining sector, so they are unlikely to affect us; and 2) I have long and publically maintained that the best equity investment for most investors most of the time is an index fund because of its low cost and outperformance of most active fund managers. In an effort to be clear, my criticisms of ETFs are: 1. ETFs are almost certainly being mis-sold. My straw poll of investment professionals suggests that many investors think that ETFs are simply index funds. Many are not. Synthetic ETFs do not hold underlying securities of the sector or market they are supposed to replicate. Inverse ETFs can lose money even when the market sector they track has gone down, and leveraged long ETFs can lose money when their market or sector has gone up. None of these is consistent with the performance of a simple index fund. 2. Synthetic ETFs are of particular concern. If a fund which is described by the words synthetic, derivative, swap and counterparty does not cause you obvious concerns, I suggest you may need to study the events of the credit crisis of the past four years more carefully. 3. Because ETFs are tradable on markets unlike mutual funds, traders can sell them short.

Looking Back So there you have it. Lots of opinions; lots of common themes too. So let’s cut to the chase, look back, and now see how the portfolio I recommended worked out in hindsight, compared to the returns achieved and risks assumed by the average college and university endowment fund over the subsequent era, the fifteen fiscal years ended in June of this year. During that period, the average endowment fund earned a return of 7.3 percent compounded, a return far lower, I suspect, than most, if not all, of the commentators that I just cited would have anticipated. My principal recommendation would obviously have been best implemented with the lowest cost stock and bond index funds, so I had no choice but to rely on Vanguard Total Stock Market Index Fund and Vanguard Total Bond Market Index Fund, rebalanced each quarter to 50/50. Our institutional shares—net of all fund expenses—provided an annual rate of return of 7.1 percent—6.2 percent for the bond fund and 6.0 percent for the stock fund, itself a surprising outcome. (That the total portfolio provided a higher return than either of its components is explained by the quarterly rebalancing.) While that 7.1 percent return was not quite equal to the 7.3 percent return of the average endowment, it was at least competitive, and—taking into account other important measures of

Customised software demand in the late 1970s and early 1980s, Murthy notes, was rising in the West while India sat on an underused engineering workforce. The founders spotted that mismatch early and bet that Indian suppliers could profitably plug into the global custom software supply chain from a Bangalore base.

performance—even superior. For, looking solely at total returns always conceals more than it reveals. Consider, for example, the substantial downside protection offered by the index portfolio in fiscal years 2001, 2002, 2003, and especially 2009, when the average endowment portfolio tumbled 19 percent, nearly double the 10 percent drop for the balanced portfolio Given those differences, we cannot and should not ignore risk. The indexed portfolio had a standard deviation of annual returns of 8.9 percent, exposed to some 20 percent less risk than the 11.3 percent volatility of the average endowment. As a result, the risk-adjusted return of the 50-50 portfolio, measured by the Sharpe Ratio was 0.45, well above the 0.38 Sharpe Ratio for the average endowment. Another risk, of course, is the risk of differing from the average, and the dispersion of returns among the endowment funds is significant. Today’s 990 endowment funds in the sample are not “a group.” Performance among individual endowment funds has diverged widely. While we don’t have nearly enough data on this point, one study limited to just 28 endowment funds for the period 1999-2009 showed that, with average annual return for the decade of 6.3 percent, their standard deviation of returns was 1.7 percentage points. One-sixth of the funds earned returns of 8.0 percent or more, and one-sixth earned returns of less than 4.7 percent. (The absolute range, even for this limited sample, ranged from 10.5 percent to 4.3 percent.)

Relying upon the assumed ability to create more shares in the ETF in order to close these short sales, it is not unknown for the short interest in certain ETFs to reach ten times the size of the underlying ETF’s assets. In these circumstances, the average ETF holder may be unaware that only some 10% of their holding in the ETF is represented by assets of the type they expect-the other 90% is a promise to deliver units from the short sellers. All will be well unless the short sellers find it difficult or impossible to buy enough of the underlying securities to deliver the required ETF shares which in some illiquid index or sector ETFs is entirely possible. My own warnings on ETFs were followed by warnings from amongst others, the Bank of England, the Financial Services Authority, the International Monetary Fund and the U.S. Securities and Exchange Commission in a rare example of closing the door on a stable which may still contain a horse. Since regulators have come in for so much criticism of their loose handling of the financial sector prior to the credit crisis it would be churlish to criticize them for these warnings, and foolish to ignore them. One more problem with ETFs became apparent to me in the course of this debate. ETFs are represented as low cost investments. Yet research published during the year demonstrated that ETFs were amongst the largest profit generators for some banks.

On governance of a diversified portfolio, Deveshwar explains ITC's 'distributed leadership' model: a three-tier structure with the board handling strategic supervision, a corporate management committee handling strategic management, and divisional management committees handling executive management of each business. This clarity lets top management function with what he calls a venture-capitalist mindset —.

As we look behind these figures, we observe a substantial advantage in returns for the largest endowment funds, with only a modest upward bias in risk. (Princeton University, my alma mater, earned just shy of 13 percent per year, ranking at or near the top among the largest endowments. PRINCO President Andy Golden was wise not to follow my recommendations!) But perhaps the 50/50 index portfolio would have been an especially attractive option for endowment funds below the $1 billion asset level—having provided not only significantly higher risk-adjusted returns, but in some cases competitive, or even higher, absolute returns as well. As I’ve often conceded, “the 50-50 index strategy may not be the best strategy ever devised, but the number of strategies that are worse is infinite.” Some of the edge in favor of large endowments has almost certainly been earned by their heavier use of alternative investments such as hedge funds and private equity funds. It will hardly be news to you that the past decade has witnessed a virtual revolution in the asset allocations of endowment funds. For endowments as a group, 50 percent of your assets are now invested in these “alternative investments,” compared to just 25 percent ten years ago. Last year, the largest funds had (to me) an astonishing 60 percent in alternatives, with the traditional basic stock/bond allocation down to 26 percent stocks (and mostly international stocks, at that) and 10 percent bonds.

This seems counter intuitive: how does a low cost product become a major profit contributor? The answer of course is that synthetic ETFs in particular provide banks with innumerable ways to “clip the ticket” of the ETF. The fees paid by the ETF investor are a very small portion of the total revenues which operating the ETF provides. They also deal for the ETF, provide the swap agreements by which it holds its synthetic positions (I wonder who works out whether the bank is providing them a fair price?), and maybe earn leverage, prime brokerage, custodian and registrar fees. The banks also deal for the hedge funds and traders who want to trade the ETF. At about this point, I began to realise why my critique of ETFs had caused so much fury. My advice on this matter is simple. A broadly-based index fund is often the best investment you can make in the equity markets.buy

He frames entrepreneurship as a near-religious commitment: there is a fervour and dogma about it, in his words. Founders must bring persistence and confidence and accept that the early years are uncomfortable, with bus rides and cheap hotels as the price of building something that outlasts the founders themselves.

Deveshwar argues sustainability is a strategic asset. Beyond e-Choupal, he cites sourcing pulp from renewable plantations rather than cheaper imports to create tribal and marginal-farmer livelihoods; integrated watershed development covering over 56,000 hectares; animal husbandry services reaching over 450,000 milch animals; supplementary education for over 200,000 rural children; and roughly 30,000 women entrepreneurs created through about 1,...

precisely that, an index fund, not an ETF. The only difference between a physical ETF (which frankly is the only sort you should contemplate unless you like the risk of synthetic derivative swaps with counterparty risk) and an index fund is that the ETF is traded on the market as the term “Exchange Traded” implies. Every piece of research I have encountered and all my experience shows that frequent dealing is the enemy of a good investment performance. So why buy an ETF rather than an index fund? You can deal daily in most index funds. The only people who want to deal more frequently than daily are hedge funds, high frequency traders, algorithmic traders and idiots (these terms are not mutually exclusive). Why join them? If you don’t want active management, and mostly you shouldn’t, buy an index fund. During 2010 Fundsmith also launched a SICAV and a US LLP. Neither of these affects your investment in The Fundsmith Equity Fund but I feel that you should be informed about this and it affords me an opportunity to raise another subject-currencies. The SICAV is denominated in Euros and based in Luxembourg. It is a so-called “feeder” fund-the only assets it holds are units in The Fundsmith Equity Fund. The US LLP is a Delaware partnership denominated in US dollars which is invested with exactly the same strategy as The Fundsmith Equity Fund but it cannot be run as a feeder fund. We launched these two funds in response to investor demand.

into the future. As I emphasized at the outset: In investing, the past is not necessarily prologue to the future. The Sources of Investment Returns Properly used, however, the record of past returns earned in the financial markets can be extremely useful. But not because of the returns themselves. Rather, sound analysis demands that we understand the sources of past returns. More than 80 years ago, with these timeless words, the great British economist John Maynard Keynes got it exactly right: “It is dangerous to apply to the future inductive arguments based on past experience unless we can distinguish the broad reasons for what it (the past) was.”2 While he was then speaking of the prospective returns on stocks, his logic can easily be applied to the prospective returns on bonds—with arithmetic that is even simpler than for stocks. Put bluntly, we should pay little, if any, attention to the past returns on bonds. Over time, these returns are accounted for almost entirely by the interest coupons that bonds generate during any given period. (That may seem obvious, but it is so often ignored.) For example, let’s look at the yield on the 10-year U.S. Treasury note at each year-end since 1926 and compare that entry-point yield to the notes return over the subsequent decade. The correlation is a truly remarkable 0.96, frighteningly close to a perfect correlation of 1.00. 2 Keynes, John Maynard, 1925. Review of Common Stocks as Long Term Investments, Edgar Lawrence Smith.

Murthy admits to having had history on his side — successive Indian governments, regardless of ideology, kept expanding technical education output. That policy choice, made for nation-building reasons, accidentally created the exact talent pool on which Infosys and its peers could later build a globally competitive services industry.

US based investors face a massive tax disadvantage in investing in a UK fund as it cannot issue a Form K1 for IRS reporting, and offshore investors wanted a non UK vehicle for investment. But in neither case does the denomination of the fund in a currency other than sterling affect the investments currency exposure. We are often asked by investors whether we hedge currencies. The answer is a firm ‘No’. How would we do so? Should we base it on the currency of the country in which the companies are listed? This obviously would not work. There may be no connection between the country in which a company is listed and its area of operations. The same is true of its country of incorporation or headquarters. Nestle is an example we often cite in this respect. Although it is headquartered in Switzerland, has its main listing there and reports in Swiss francs, it has only about 2% of its revenues in Switzerland, so hedging our holding by selling Swiss francs forward against sterling would surely not be a hedge at all. It is also far from unknown for companies to report in a different currency to that of the country in which they are headquartered or listed. Perhaps we should hedge currencies based upon the country in which each of our investee companies has its revenues? The problem with this approach is twofold. Firstly, most of the companies supply low value items and so manufacture and sell locally or at least regionally.

Past returns tell us absolutely nothing about the return that a Treasury note purchased at the end of any period would earn during the subsequent decade. For example, the returns on the 10-year Treasury note. During 1926-1981, its return averaged 3.8 percent. But with the entry yield in 1981 at 13.7 percent (!), the return over the 1981-1991 decade turned out to be 13.1 percent. So both our arithmetic and our logic confirm that the current yield of a bond has been—and should almost certainly continue to be—a highly reliable guide to its future return. (The correlation between year-end yield and subsequent ten-year return for Vanguard Total Bond Market Index Fund is a still impressive 0.80.) Stock Returns The methodology for stock returns is similar but more complex. Keynes focused on the two broad sources that explain the returns on stocks. The first was what he called enterprise—“forecasting the prospective yield of an asset over its entire life.”3 The second was speculation—“forecasting the psychology of the market.” While Keynes made no attempt to quantify the relationship between enterprise and speculation in shaping stock market returns, however, it occurred to me, decades later, to do exactly that. What Keynes had described as “enterprise,” I defined as investment return—the initial dividend yield on stocks plus the subsequent annual rate of earnings growth.

What Keynes termed “speculation,” I defined as speculative return—the change in the price investors are willing to pay for each dollar of earnings (essentially, the return that is generated by changes in the valuation or discount rate that investors place on future corporate earnings). Simply adding speculative return to—or subtracting it from—investment return produces the total return generated by the stock market. For example, if stocks begin a decade with a dividend yield of 4 percent and experience subsequent earnings growth of 5 percent, the investment return would be 9 3 Keynes, John Maynard. The General Theory of Employment, Interest, and Money, 1936.

No one exports significant amounts of bulky low value items such as detergent. So the exposure, if there is any, relates only to the profit margin. Secondly, the corporate treasurer may already have taken out a currency hedge for the translation and/or transmission of those profits so that any currency hedge by us would in fact be creating an exposure. A lot of nonsense is talked about currency exposure and hedging. Our new funds denominated in Euros and US Dollars do not change the currency risks of those funds which are driven by the underlying investments. For those who don’t believe this, we are prepared to launch a new class of our Fund which will change its currency denomination each year to the worst performing currency. In 2011 it would have even denominated in Turkish Lira and would have risen by 32%.any

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

percent.4 If the price-earnings ratio rises from 15 times to 20 times, that 33 percent increase, spread over a decade, would translate into an additional speculative return of about 3 percent annually. Simply adding the two returns together, the total return on stocks would come to 12 percent. It’s not very complicated! This remarkably simple metric of separating enterprise and speculation (i.e., investment return and speculative return) has been borne out in practice. Indeed I have the temerity to suggest that Lord Keynes would respect this mathematical extension of his concept. Decade after decade over the past century-plus, we can account, with remarkable precision, for the total returns actually earned by U.S. stocks. The investment return on stocks proves to be remarkably susceptible to reasonable expectations. The initial dividend yield (RED)—which remains a crucial but underrated factor in shaping stock returns—is a known factor. The steady contribution of dividend yields to investment return during each decade has always been a positive, only once outside the range of 3 percent to 5 percent. (That horrific 1.2 percent yield in 1999 augured ill for future stock returns!) Earnings growth (BLUE), while hardly certain, has proved to be relatively stable. With the exception of the depression-ridden 1930s, the contribution of earnings growth was positive in every decade, usually running between 4 percent and 7 percent per year.

But if we recognize that corporate 4 I understand that the numbers should in fact be multiplied together, i.e. 1.05 x 1.04 = 1.092, or 9.2 percent. But given the inevitable imprecision of projections, I elect the simple expedient of summing them up, in this case to 9.0 percent.

earnings have, with remarkable consistency over time, grown at about the rate of the U.S. Gross Domestic Product, this relative consistency is hardly surprising. Combining dividends and earnings, the total investment return (TOP LINE) on stocks averaged almost 9 percent. In only two decades (the 1930s and the 2000s) was the investment return less than 6 percent annually, and only two others were more than 12 percent. Speculative return is, well, speculative, and has alternated from positive to negative over the decades. (GREEN) But note the powerful tendency of volatile P/E multiples toward reversion to the mean (RTM). Indeed, in each decade in which P/Es fell significantly—the 1910s, 1940s, and 1970s—was followed by a rise of almost identical magnitude in the subsequent decade—the 1920s, 1950s, and 1980s. That second consecutive blow-out decade for speculative return in the 1990s was totally without precedent. (A nice Black Swan! Such is the nature of our financial markets.) RTM is a fundamental law of the markets, and, as I’ll discuss shortly, RTM may well apply to alternative investments as well. Applying reasonable expectations to future investment returns and speculative returns, and then combining them has been a sensible and effective approach to projecting the total return on stocks over the decades.

(ORANGE) The point is this: Over the very long run, it is the durable economics of investing—enterprise—that has determined total return; the evanescent emotions of investing— speculation—so important over the short run, has ultimately proven to be virtually meaningless. In the eleven decades shown in the chart, for example, the 9.1 percent average total annual return on U.S. stocks has been dominated by those 8.8 percentage points of investment return (an average dividend yield of 4.5 percent plus average annual earnings growth of 4.3 percent), and only 0.3 percentage points of speculative return, borne of an inevitably period-dependent increase in the price- earnings ratio from 12.5 times to 22 times, amortized over the decades.college

and university endowment managers 15 years ago. First, times have changed, so relying on past returns in the bond and stock markets to be prologue would, as always, be unwise to a fault. This time is different, but not in a positive way. This difference is most obvious in the case of bonds. On June 30, 1996, the yield on the U.S. bond market index was 7 percent; today it is only about one-third of that level—2.3 percent. (RIGHT) Yes, that index is heavily weighted (70 percent) by those now-extremely-low-yielding U.S. Treasurys and mortgage-backed obligations, with but a 30 percent allocation to corporate and other investment grade bonds, the total portfolio provides a short-to-intermediate-term duration (5 years). But a portfolio that is more heavily weighted with longer-dated investment-grade corporates could produce a yield of something in the 3 ½ percent range, suggesting a return of about that level in the coming decade. The stock arithmetic is also sobering. (LEFT) First, investment return: the yield on common stocks today is 2.3 percent, about the same as in 1996. Corporate earnings grew at a 6 percent rate during the previous 15 years (about the same, as we might have expected, as the 5.5 percent growth in nominal GDP); perhaps 6 percent is a reasonable, if perhaps a tad optimistic, expectation for earnings growth in the coming decade (barring Armageddon!)

Adding to that earnings growth the current yield of a bit more than 2 percent would provide a total investment return in the 8 percent range for stocks. Speculative return is tougher to ascertain, depending (as it does) on investor psychology and future expectations. But with stocks now at 20 times earnings, they currently appear more expensive than the long-term norm of 17 times, (using the Schiller 10-year average P/E ratio in both cases).is

that the P/E will be a bit lower a decade hence. If it were to fall to, say 18, that would result in speculative return reducing the investment return by one percentage point. Result: reasonable expectations suggest an annual total return on stocks of 7 percent in the coming decade, well below the long-term norm, largely because the contribution of dividend yields look like it will be only about one-half of the historical level. At 3.5 percent, then, our (longer-term) bond portfolio would produce about a 50 percent return over the coming decade; at 7 percent, the stock portfolio would grow by 100 percent. If so, the 50-50 portfolio might earn a gross return of around 5 ¼ percent. Hardly a disaster, but surely a scenario in which endowment funds might want to reconsider the 4 ½ percent payment ratio that the typical endowment fund distributes currently. Alternative Investments Why, you may wonder, have I focused so heavily on future stock returns and future bond returns when these two asset classes represent a distinct (and shrinking) minority of endowment assets? Alternatives are clearly “where you’re at” (in this audience), the dominant portion of endowment fund assets today. But while it is relatively easy to analyze the sources of stock and bond returns, the sources of returns in alternative investments are highly idiosyncratic and widely diffused.

That said, despite their importance in endowment portfolios as a group, when risk is taken into account, endowment fund annual returns bear a significant correlation with the returns on balanced bond/stock portfolios. (In fact, the 15- year correlation is an amazing 0.94.) Why? Because ultimately, hedge funds are merely combinations of stock and bonds, differentiated largely by their use of leverage, short-selling, idiosyncratic strategies, widely-varying manager skills, and, of course, the staggering fees that they charge. The impacts of these extraneous elements—except for the fees!—are almost impossible to predict with any kind of accuracy. So you’ll have to look to wiser heads than mine for recommendations about selecting the “best” hedge funds for the coming decade. But, given my confidence in the power of mean reversion, I’d be especially careful about assuming that yesterday’s champions will be tomorrow’s victors. Indeed, because of RTM, I would not reject out-of-hand the possibility that conventional portfolios could outpace hedge funds as a group.greatly

overstated in most data that are reported. If we delete from the database the returns produced “on paper” before a hedge fund started public operations, and include in the database the returns of hedge funds that have failed and were then excluded, we find a very different outcome. During 1995-2003, for example, the typical hedge fund in the Tremont TASS database provided an average reported return of about 13 percent. But according to a study by Princeton’s Burton Malkiel, the actual average was 9.3 percent, about the same as a typical 65/35 balanced mutual fund, which carried far less risk. Of course some hedge funds did better; a few (those that we read about!) considerably better. But how many will do so in the coming decade? How many successful managers will call it quits after they’ve made their fortunes? What will be the impact of the “inside information” scandals, or the presumed permanent elimination of the pervasive hedge fund strategies using mutual fund “market timing?” Indeed, how many of today’s hedge funds will even survive the coming decade? While hedge funds seem to dominate the alternative investment allocation of endowment funds, private equity is also another major component. But private equity is largely common-stock based, if heavily leveraged. Indeed, according to Yale’s Swensen, the return on venture capital investments have pretty much paralleled the return on the S&P 500 over time.

(In the 20-years ended in 2000, venture capital funds slightly lagged the index despite the substantially higher risks involved.) This experienced expert’s conclusion: “suppliers of funds to the venture capital industry generally realize poor risk-adjusted returns.” It is no secret that in the years before the bull market peaked in 2007, many of the larger endowment funds made substantial advance commitments to private equity deals, and in the ensuing crash were pressed to maintain sufficient liquidity to complete those transactions. In recent years, a market has emerged to relieve the endowments of some of those commitments, but at nothing like 100 cents on the dollar. (Perhaps 50 cents would be more like it.) In any event, the whole issue of market valuations vs. book values (usually the cost basis of the commitments) raises complex questions regarding the precision of reported endowment fund returns. My conclusion: use private equity only if you have the staff, skill, and the skepticism about future projections to do so, and don’t over commit. You may come to find that liquidity can become priceless (no pun intended!) Summing Up Yes, alternatives have provided a solid plus for many endowment funds, especially the largest funds, but remember that the past is not necessarily prologue. Remember reversion to the mean.

Remember Warren Buffett’s warning about new concepts that offer the promise of delivering superior returns. “First the innovator; next the imitator; finally the idiot.” Above all, don’t be the idiot! Be careful of stars that so often turn into comets. In the years ahead, our colleges and universities will need your expertise, your experience, your steadfastness, and above all your wisdom. Of course our financial markets face high risks and great opportunities, but are not likely to earn the high returns that have characterized what we have come to accept as historical norms. This time is different. Now perhaps there’s a premise on which we can all agree.