A quality growth style of investing focuses on identifying companies with superior earnings and earnings growth, high returns on invested capital, strong balance sheets and dominance in their markets. A growth investor is less focused on price and valuation compared to value investors. Quality is much more important. As Warren Buffet has said:
“It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.”
A leading advocate of quality growth investing is Terry Smith, fund manager of the Fundsmith Equity which many of my clients hold. It is a high conviction, concentrated global portfolio of large companies. It is a pure stock picking fund. It has delivered exceptional returns for Smith’s investors. From launch of the fund on 1/11/10 to 31/12/19 the T Accumulation share class rose 364.4% or 18.2% p.a. (Source: Fundsmith LLP). The MSCI World Index, a fair benchmark for comparison in contrast gained 180.3% or 11.9% p.a. over the same period (Source: Bloomberg).
Each year Smith sends out an annual letter to owners of the fund with a review of the year and his investment thoughts. Please note you are unlikely to receive this letter if you hold the fund via a platform. This year’s letter ran to 13 pages. It makes an excellent read so I thought I would highlight a few key points. Smith says his fund has a simple three step investment strategy:
*Buy good companies
The 10th annual letter detailed what Smith and his team consider makes companies good. They have for example superior returns on capital invested than the market as a whole, higher margins and lower levels of debt. They also have high levels of interest cover meaning they don’t pay out too much in dividends. Instead there is an emphasis on re-investing earnings to compound growth over the long term. As Smith concludes:
“Our portfolio consists of companies that are fundamentally a lot better than the average of those in either index (the S&P 500 and FTSE 100) and are valued more highly than the average FTSE 100 company and a bit higher than the average S&P 500 company but with significantly higher quality. It is wise to bear in mind that despite the rather sloppy shorthand used by many commentators, highly rated does not equate to expensive any more than lower rated equates to cheap.”
One point to make here is that companies may be cheap for a very good reason – they are poor quality. Value investors buy undervalued stocks that are unloved by the market in the hope of a turnaround. They may be successful but how long it will take and what the catalyst for change might be is anybody’s guess. In some cases they may end up buying what is referred to as a “value trap.” There is nothing to stop a cheap company’s share price falling further.
The do nothing leg of the fund’s strategy means a long term buy and hold investment strategy. If you buy high quality companies with an expectation of superior returns and compounding of invested earnings why would you not hold the stock for the long term? Smith and other quality growth investors prefer to invest in relatively predictable businesses, which goes hand in hand with long term ownership. The goal here is to leverage the unique characteristic of equities – that retained earnings are re-invested in the business, thereby compounding returns. This does not happen with bonds, cash or property. After interest or rent is paid out you don’t get more investment in bonds or buildings.
Another consequence of the do nothing strategy is that portfolio turnover is minimised and hence fund transaction expenses are reduced. To truly compare investment charges you must consider the total cost of fund ownership not just the annual fund management charge.
Another theme of the annual newsletter was Smith’s thoughts on the Woodford debacle, the main news of the investment industry in 2019. The main problem was the incompatibility of running a fund with daily dealing when holding a large amount of investment in unquoted smaller companies. These are not listed on a recognised stock exchange and their shares therefore have to be traded privately. With no market for their shares they are highly illiquid and are unsuited to selling quickly, a pre-requisite for daily dealing. Woodford ran into problems when large number of investors wanted to exit the fund and it could not meet demand. As the Fundsmith Equity only invests in easy to sell large companies Smith estimates they could liquidate 57% of the fund in seven days. The other problem Woodford faced was his investment in poor quality larger companies such as Capita, Imperial Brands and Provident Financial. His famed stock-picking skills went badly awry.
Finally Smith addressed the issue of “star” fund managers of which he is undoubtedly one. After the failure of the Woodford Equity Income other leading fund managers came under a similar scrutiny, unfairly in my view. It led to investor panic and selling out of high quality funds such as the Fundsmith Equity and Lindsell Train UK Equity despite the fact their quality growth investment styles were radically different from Woodford’s and their portfolios were much higher quality. Smith argued that it is irrational not to support a sport’s team just because they have star players. No the problem with Woodford, he says, was that he changed his investment strategy – referred to as style drift. Smith observes that this started whilst he was at Invesco Perpetual, where he began to accumulate large stakes in small unquoted companies. It was taken further once Woodford set up his own firm. Smith likens the change to Cristiano Ronaldo playing for Juventus as a goalkeeper. You wouldn’t expect the team to be as successful.
Smith concludes with an assurance there is no desire to change the Fundsmith Equity’s investment strategy. There will be no style drift and the fund will continue to buy and hold high quality businesses.
I like Smith and his investment thinking. The theory of quality growth investing is compelling and it has delivered consistently superior investment returns than value since 2007. The global financial crisis has resulted in investors being more cautious and favouring quality companies. With solid earnings and strong balance sheets they are more predictable and defensive in nature. Value investors have long expected a rotation in investor sentiment away from growth but it has failed to materialise in any meaningful way. However data I have seen shows prior to the banking crisis, notably from 1975 to 2006 value outperformed growth in many years. So I would never say quality growth will always outperform value.
There is more I could write about growth versus value but space and time doesn’t permit here.
The content of this blog is based on my own understanding of the 10th annual Fundsmith Equity newsletter and the concept of growth and value investment. It reflects my personal views and is intended as general investment information only. Nothing in this article should be construed as personal investment advice for example to invest in quality growth funds, the Fundsmith Equity or Juventus. You should seek individual advice based on your own financial circumstances before making investment decisions.