The concept of investing in Quality Equity is a simple one: buy good quality companies that earn high margins, have sensible balance sheets and let the returns from the underlying businesses compound over time.
Of course, each investor’s definition of ‘quality’ can be slightly different. One investor we have followed since launch in 2010 is Terry Smith, who manages the Fundsmith Equity Fund.
“In the long run, it is the quality of the business that you invest in which determines your returns. Our strategy is not about trying to time the market; it’s about time in the market with quality companies”, Terry Smith
We previously enjoyed strong returns from Fundsmith’s portfolio of high-quality, global companies. We sold our holding in 2022 after a period of strong returns. Since then, Quality as a style has underperformed the broader market in the face of the strong growth but higher risk AI euphoria. This presented us a wonderful opportunity to buy back into the fund in November 2024.
Another part of the reason for Quality lagging the broader market has been the inexorable rise of passive investing. Broadly speaking, actively managed funds have underperformed cheap market-weighted ETFs, net of fees. As a result, investors have shifted their capital to passive funds at an accelerating rate. Bentley Reid has been part of this shift. Today, we invest the majority of your capital in low cost vehicles replicating indices, sectors and themes we deem attractive.
However, the stampede into passive investing also throws up opportunities to invest with top-notch active managers when their style is out of favour. Active managers can outperform following periods of intense criticism and, ironically, when investors have given up. Similarly, the ‘quality’ style of investing can once again prove its value after an unusually prolonged period of underperformance.
The theme can be summarised as follows:
What?
Quality global equities
Why?
The quality of a business you invest in determines your returns over the long run. In the short run, the market has offered a compelling entry point
How?
Fundsmith Global Equity fund, a portfolio of 20-30 quality companies managed by Terry Smith and Julian Robins
Holding Period?
3yrs+
A more detailed explanation of why investing in Quality equities (which we refer to simply as ‘Quality’ below) offers a compelling investment opportunity now follows:
What is Quality investing?
“It’s far better to buy wonderful companies at a fair price than fair companies at a wonderful price” Warren Buffett
“It’s far better to buy wonderful companies at a fair price than fair companies at a wonderful price”
Quality investing is:
Focused on Sustainable Competitive Advantages: Quality investing prioritises companies with unique strengths that protect them from competition, such as strong brands, valuable patents or low-cost production. This is often referred to as their “competitive moat”.
Emphasises Long-Term Growth: This approach focuses on companies with consistent earnings growth, strong cash flow generation and the potential for long-term value creation.
Patient and Disciplined Approach: Quality investors are patient and avoid short-term market fluctuations. The focus is on building a portfolio of high-quality companies, and holding them for the long term
Over the long term, the key to a successful investment is to capture more upside than downside. High quality stocks have historically outperformed the market and exhibited lower volatility:
The Kenneth French library disaggregates the returns of high and low quality businesses using an operating profit filter. ‘High quality’ stocks are represented by the top 30% of companies by operating profitability, ‘Low quality’ by the bottom 30%. High quality has outperformed low quality, as measured by returns and volatility, especially during the worst periods for equities:
Rise of Passive, Demise of Active
“Active management is a zero-sum game before cost, and the winners have to win at the expense of the losers” David Fama
“Active management is a zero-sum game before cost, and the winners have to win at the expense of the losers”
In 2022, the Financial Times reported that passive fund ownership of US stocks overtook active for the first time. By late 2023, the amount of capital invested passively exceeded that held in active funds for the first time:
Source: Fundsmith
Passive investments follow a simple, singular rule. Equity-tracking funds allocate capital according to the market capitalisation of the index constituents. The bigger the company (e.g. Apple), the greater the size in the fund. For bond-tracking funds (to simplify), the hungrier the borrower, the greater the lend (size within the index).
Active management employs many objective and subjective ‘rules’ to build and maintain portfolios. ‘Doing nothing’ is difficult for those paid to ‘do something’. Management fees and dealing costs all pose a headwind to returns net of fees. Passive funds are more often than not cheaper.
The recent outperformance of a small number of large US Tech companies (known as the ‘Magnificent 7’: Apple, Nvidia, Microsoft, Tesla, Alphabet, Amazon and Meta), is intrinsically linked to the growing popularity of passive funds. For active strategies, this dynamic has led to a vicious cycle; underperformance has led to outflows and a forced selling of smaller cap holdings:
Source: FT.com
Passive investors now face a concentration conundrum: markets are now heavily skewed towards a small handful of stocks. Any plateauing in this trend will ease the headwind faced by active managers. Any reversal in this trend would radically lower the bar to outperform:
Source: Goldman Sachs
Though recent years have been poor for active managers, their underperformance is not outside a historically observed range. The leadership of passives versus actives is cyclical.
The rolling 3-year return of active vs passive funds showed a similar degree of underperformance in the 1990s, culminating in the ‘Dot Com’ passive bubble in 1998/1999. A decade of outperformance by active funds followed:
Source: Hartford Funds
Just when it seems that active or passive has permanently pulled ahead, markets change, performance trends reverse and the futility in declaring a “winner” in the active vs passive debate is revealed anew:
Source: The Times
Quality companies perform well across the business cycle, but most strongly during the latter stages of a recession. US economic data from the National Bureau of Economic Research since 1964 highlights this defensive characteristic:
Source: Wisdomtree
Fundsmith Equity Fund
Fundsmith applies a three-step investment strategy:
“Buy good companies, Don’t overpay, Do nothing” Terry Smith
“Buy good companies, Don’t overpay, Do nothing”
It is rare to find a fund manager who is willing and able to ‘do nothing’. Terry Smith is abnormally devoted to the ‘do nothing’ mantra’. As the former CEO of Tullett Prebon, the world’s second largest inter-dealer broker, he understands the spoils from trading accrue to intermediaries (not the investor). Fundsmith has demonstrated a consistent record of low portfolio turnover and costs: just 3.2% in 2024.
However, ‘doing nothing’ leaves a strategy vulnerable to the myopic whims of the market and short-termism. The valuation of the portfolio ebbs and flows with sentiment. This offers investors attractive entry and exits points.
We measure the relative attraction (or lack thereof) of Fundsmith, and Quality investing, via a ‘rolling alpha’ analysis of Fundsmith’s performance relative to the FTSE All World. The chart below illustrates the rolling 12-month performance of Fundsmith (red line) versus the All World index:
Source: Bentley Reid, Morningstar
At the time of our investment in November 2024, Fundsmith had lagged the All World by 12% over the prior 12-months, leaving Fundsmith at a low since inception versus its benchmark. We deemed this an attractive entry point, with an above average chance of outperformance from such depressed levels. Fundsmith has proven itself a good active manager over a long time-frame. Since inception, it leads the All World index by 3.15% per annum net of fees:
Source: Bloomberg
Fundsmith also leads the Global Equity peer group by an enormous margin since inception (to end December 2024): 607% vs 253%. However, short-term performance has lagged peers for all periods less than 3 years:
Most investors choose to invest in funds when the going is good, attracted by strong returns and the positive coverage it brings. In 2020/21, investors were Googling for (then investing in) Fundsmith like never before (or since):
Source: Google Trends
When we were sellers of Fundsmith in 2022, the Financial Times was asking:
Source: FT
The answer unequivocally arrived soon after. The success of Fundsmith attracted the attention of the regulator (stung into action by the Woodford debacle). Terry also endured a public divorce and fund performance waned, leading to investors redeeming despite excellent long-term results:
Source: Reuters, FT, Telegraph, Daily Mail, The Times
The Fundsmith Portfolio
“The best protection against inflation is not gold or commodities, but companies with pricing power and the ability to pass on cost increases” Terry Smith
“The best protection against inflation is not gold or commodities, but companies with pricing power and the ability to pass on cost increases”
Bentley Reid has excellent access to Terry Smith and Julian Robins, courtesy of our long relationship. We receive timely portfolio data. Major holdings include Mag 7 cohorts Microsoft, Meta & Alphabet (Tesla, Nvidia, Apple and Amazon are not held) and out-of-favour defensive Consumer Brands, such as L’Oreal, Philip Morris and Unilever.
The portfolio has a long-held bias to the US, avoids Emerging Markets entirely and rarely invests in the UK or Japan. It avoids low quality cyclical industries, such as Resources and Banks. Healthcare and Consumer Staples (e.g. toothpaste, soap, nappies, etc.) account for half the portfolio, providing defensive ballast when times are tough.
Fundsmith describe quality through four metrics: return on capital employed (ROCE), profit margins, cash conversion and (debt) interest coverage. All are superior to the US and UK market (two right hand columns). Hence, the portfolio often trades at a premium.
Despite taking over the moniker as ‘largest equity fund in the UK’ from Neil Woodford, Terry Smith does not have the same liquidity concerns that brought about Woodford’s collapse. His portfolio holds some of the largest and most traded liquid companies on the planet e.g. Microsoft, Visa, Novo Nordisk, etc.
DISCLAIMER
Published and distributed by Bentley Reid & Co (UK) Limited
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The content of this document is for information purposes only. The authors believe that, at the time of publication (December 2024), the views expressed and opinions given are correct but cannot guarantee this and readers intending to take action based upon the content of this document should first consult with the professional who advises them on their financial affairs. Any companies cited in this report are used to support the view of the authors, and should not be construed as recommendations to purchase or sell the underlying securities. Neither the publisher nor any of its subsidiaries or connected parties accepts responsibility of any direct or indirect or consequential loss suffered by a reader or any related person as a result of any action taken, or not taken in reliance upon the content of this document. The past is not necessarily a guide to future performance. The value of investments can go down as well as up and your capital is at risk.
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