Founder and Chief Executive of Fundsmith
Terry Smith is undoubtedly one of the more famous faces in fund management, with some lauding him as Britain’s best fund manager. We took the opportunity to talk to him about his career in investing, outlook on the world, and naturally, any recent additions to his portfolio.
I got a first in history and started work as a graduate trainee at Barclays during the 1973-75 Secondary Banking Crisis. Barclays sent me to do an MBA and then appointed me as their Finance Manager. I then became a sell side analyst and was the number one rated bank analyst for six years before becoming Head of Research at UBS. I was fired for writing the bestselling book ‘Accounting for Growth’ about dodgy accounting techniques.
I then joined a start-up investment banking and wealth management business – Collins Stewart (now part of Cannacord) – and ended up as CEO. My colleagues and I bought the firm in a management buyout and then IPO’d it. I used this vehicle to buy an interdealer broker, Tullett Liberty as it then was. That’s when I became investment adviser to the Tullett pension fund using the same investment strategy that we pursue at Fundsmith. I set up Fundsmith in 2010 and gave up running Tullett Prebon in 2014.
I believe that I am a better fund manager because I ran businesses and I ran businesses better because I was also a fund manager.
The movie ‘The Thomas Crown Affair’. I saw it when it was released in 1968 and I was growing up in East London which wasn’t quite as gentrified as it is now. It made me realise there was another world out there that I wanted to be part of.
To do whatever she wants, but to do it well with the aim of doing it better than anyone else.
When I stopped running Tullett Prebon in 2014 I realised two things: 1) I could run Fundsmith from anywhere that had broadband; and 2) the worst place for me to run the portfolio was our Cavendish Square office where there’s always something going on. The main part of my job is to read and think.
Mauritius is an interesting place – it is part of Africa but has strong links with India and Asia. It is genuinely multicultural with an original Creole population but a majority Indian population which was imported as indentured servants after the end of slavery. It was a French colony until 1810. The multicultural nature of Mauritian society is encompassed in the holiday system in which there are two days each for Chinese holidays, Christians, Hindus, Muslims, Tamils and Telugu. It teaches you that there is a wide world outside the UK and Europe. For example, how many of you know that Telugu is the third most popular language in India and that the Telugu population is about the same as that of Germany?
Oh, and the weather’s rather nice.
Finance: The Warren Buffett Way by Robert Hagstrom
I never read fiction. Real life is exciting and ridiculous enough to make it superfluous.
We don’t invest in regions. We invest in companies.
We haven’t yet disclosed our most recent purchase.
However, the purchase before that was Facebook which is certainly one of our more controversial decisions in the light of the furore over its use of personal data and what role some Facebook users may have made of this in elections.
We tend to look for suitable investments from the numbers they produce. Facebook’s historic numbers are certainly impressive. It has some 1.5 billion Daily Active Users (DAU) and some 2.3 billion Monthly Active Users (MAU). Bearing in mind that Facebook has no presence in China these numbers suggest ubiquity.
It currently has a return on capital of 30%, gross margins of 87% and operating profit margins of 50%. Its revenue growth rate has averaged 49% for the past five years and over the same period operating profits have grown by 106% p.a. (one hundred and six percent per annum).
Of course. all that is in the past and the future for Facebook is likely to be different. When we started buying its shares, we estimated that its revenue growth rate would halve to about 20% p.a. In the third quarter of 2018 they grew at 34% p.a., but the company has indicated that the growth rate would slow further to perhaps the mid-20% range in the fourth quarter, and the operating margin was down to a still impressive 42%. Against the background of the media furore over the use of personal data, this has been enough for some commentators on Facebook to experience very public attacks of the vapours.
But bear in mind the following:
The 42% operating margin in the third quarter which gave 13% profit growth was after a 53% increase in costs. You could look at this as a glass half full or empty, but in its third quarter Facebook increased R&D costs by 29%, marketing and sales costs by 65% and general and administrative costs by 76%. You might see such a rise in costs as problematic but I suspect that faced with a furore Facebook’s management has decided to very publically spend a lot of money on data security and content control and to improve users’ experience and in so doing a) has depressed Facebook’s results, albeit to a still very acceptable level — showing great results whilst under such scrutiny might be a red rag to a bull, and b) it built an even bigger barrier to entry for competitors.
Ironically, the response to the furore may just have cemented Facebook’s competitive positon. I also note that at the time of writing, Facebook’s new political advertising transparency tools show that the UK government spent £96,684 on Facebook ads promoting Prime Minister May’s Brexit deal. Political attacks on Facebook have the look of a circular firing squad
Similarly, Facebook’s capital expenditure doubled in the first nine months of 2018 to $9.6 billion yet free cash flow in the third quarter was still 16% higher than it was a year ago.
Yet Facebook is on a PE of 19.1x — about the same as the S&P 500. Unless there is going to be a much more severe deterioration in Facebook’s operational performance than we have seen to date or reasonably expect, this looks cheap to us.
Also consider the following:
Facebook makes no money from its social network users. It makes most of its revenue from online advertising, a business in which it has a virtual duopoly with Google.
I strongly suspect that most people’s judgement of Facebook is based upon their personal experience and prejudices. But 69% of Facebook’s DAU and 73% of its MAU are outside the United States and Europe. How much do you think they care about allegations of misuse of data in US election? Not much I would suggest which seems to be borne out by the fact that in the third quarter the number of DAU grew by 9% and MAU by 10%.
Facebook has yet to “monetise” WhatsApp. I found it particularly amusing that one person queried our holding in Facebook using a message sent on WhatsApp. Who said the age of irony is dead?
Our Facebook holding has cost us some performance to date and no doubt it will continue to be a difficult stock to hold in terms of media attention, but we have often found that the only time you can hope to buy stock in great businesses at a cheap valuation is when they have a glitch
Selling Domino’s Pizza Inc. We had made seven times our original investment in five years and it looked expensive. It has continued to outperform.
I resolved, once again, not to sell shares in good companies.
I wouldn’t accept the assertion that the companies we hold are at greater risk of disruption than most. We mainly hold consumer staples stocks, some consumer discretionary stocks, medical equipment and devices and technology – but ‘old technology’ mainly – airline reservation companies, payroll processors and payment processors, for example. So, are these businesses more disrupted than say auto manufacturers, banks, media, oil companies and retailers which you find in most portfolios?
I think that as in many areas of investment people simply accept assertions such as ‘there’s more disruption than ever.’ If you were an investor in canals when railways were invented, it was quite disruptive. The textile industry was disrupted by inventions like the spinning jenny. That’s why some textile workers smashed the new machines with hammers (the Luddites). The invention of the horseless carriage (the car) was quite disruptive to both railways and the incumbent main form of personal transport – the horse. Communications have been disrupted successively by the invention of the telegraph, then the telephone then radio, then TV and now the internet. Disruption is not new.
Disruption is not well understood. Sometimes disruptors expand markets. So-called digital wallets such as Apple Pay expand the use of digital payments which disrupt cash but expand the market for payment processors like Mastercard, PayPal and Visa.
Having said all that, there is probably a greater ability now to launch new consumer products using outsourced manufacturing and social media marketing and we are never complacent. We watch for signs of disruption affecting our companies with a sense of paranoia.