Is The Fundsmith Equity Fund's Performance Sustainable?

9th Mar '15 by UK Value Investor

13 comments 13875 reads

If you're a keen investor then you will have almost certainly heard of the Fundsmith Equity Fund and its high-profile manager Terry Smith.

To date the Fundsmith Equity Fund has produced results which are nothing short of spectacular – a total return of 100% in just over four years. But is such rapid growth sustainable?

Dividend growth is the driver of sustainable growth

With any sort of investment there are two kinds of value: the market value and the fundamental value (also known as the intrinsic value).

The market value of a house, a classic car or a company's shares can be pretty much anything. If I want to sell my house for £20 then I can, and that will be the market price. On the other hand if someone wants to buy my house for £20 million then that will be the market price instead.

The house is essentially the same in both situations but the market price is very different.

The fundamental value of an investment is the price an informed and “reasonable" seller or buyer would be happy to accept or pay.

Fundamental value is still set by investors and so can vary to some extent, but not anywhere near as much as the market value. That's because the market value is often driven by investors who are neither informed nor reasonable.

In most cases fundamental value relates mostly to an investment's ability to pay an income, both today and in the future.

In the case of a house, fundamental value relates to the rental income which a property can reasonably be expected to generate over many years. For shares, fundamental value is driven primarily by the dividend; what it is today and what it is expected to be in the future.

Sustainable growth in market value occurs when that growth is accompanied, in more or less equal measure, by growth in fundamental value. In the case of a house, if rents double over a number of years then it is likely that the fundamental value has doubled as well. It is then reasonable for the market value to double as well (again, more or less, with some degree of variability and uncertainty).

However, if the market value of a house or a company's shares double while there is no meaningful increase in fundamental value – i.e. rental income or dividend income – then that growth in…

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underscored

9th Mar '15

Is there a momentum effect here? The more successful Fundsmith is, the more money it attracts, which gets re-invested in the securities it already owns, increasing their value?

Perhaps I have misunderstood?

UK Value Investor

To some extent, yes, but I don't think the fund is nearly big enough to have a meaningful impact on the companies it holds.

fek47

Hi John

I don't quite understand how a unit trust can be said to be either under- or over-valued, since the unit price simply reflects the market value of the underlying investments? This is in contrast of course to an investment trust where the share price can (and usually does) vary from the value of the underlying portfolio, such that the trust may be trading either at a discount or premium at any given time.

You could say that the underlying companies in which Fundsmith is invested have become overvalued over time, but I don't think it makes sense to say the fund itself is overvalued.

Francis

VegPatch

I agree with fek47. Unit trusts, accounting means that the value of the units held by the investor should reflect the value of the underlying portfolio. In a Unit trust, aka open ended funds, if there is demand for more units (subscriptions) then new units are created. If an investor sells units (redemptions) then these units are cancelled.

Investment trusts have a fixed amount of shares in issue and as fek47 rightly points out, investment trusts can trade at a discount or premium to the trust's net asset value, reflecting supply / demand. An investment trust manager performing at the top of his / her game (ie outperforming the stated benchmark) can mean that investor demand outstrips supply (which as we have just seen is fixed). As a result the shares trade at a premium to the value of the underlying portfolio. This premium is often attributed to the manager's skill, but may not be the sole factor. Other reasons may be that the investments held by the investment trust are only revalued say once a year or held at historical cost. Investors perceive that the true value of the investments is higher than the stated value and so are prepared to pay a premium over the stated net asset value.

Unit trusts pay out all of their dividends received as income, whereas investment trusts may keep a small portion back, to be held in reserve. Coming back to UK Value Investor's key question: Is FundSmith's equity fund performance sustainable? He has used dividend growth rate of the FundSmith's distributions to assess whether the long term growth rate of the fund is sustainable. I would rather look at the underlying shares held by the portfolio and their valuations. If the companies in question were on PEs of say 14x growing at 15%, with high cash conversion ratios, and reasonable distribution ratios then maybe its not overvalued and cost still continue to grow at 15-18% p.a. But if the underlying investments are on 30x PE, growing at only 10% pa and the reason that their dividends have been growing 18% pa is due to a rise in the payout ratio faster than the growth in earnings, such that the companies in in question are now distributing 100% of EPS as dividends (thus limiting DPS growth to a level that is commensurate with EPS growth) then maybe it is overvalued.

I just dont feel we can make the decision without looking at the underlying portfolio. Having said that, to compound up at 18% p.a. for any length of time would put the manager amongst the investors of their generation and alsongside the "SuperInvestors of Graham and Doddsville). From here I personally would not expect 18% p.a., the odds are not healthy. However 12% would still be a fabulous return in this low inflation environement

marben100

10th Mar '15

Francis,

You could say that the underlying companies in which Fundsmith is invested have become overvalued over time, but I don't think it makes sense to say the fund itself is overvalued.

I think that is the point John is trying to make. However, note his closing point, which I think is pretty indisputable:

While I cannot say with any certainty whether or not the Fundsmith Equity Fund is overvalued at this moment in time, what I can say is that so far it seems a long-term growth rate of 12% a year may be sustainable, but 18% a year is not.

[references to the fund can be taken to mean a reference to the underlying equities]

Cheers,

Mark

17th Mar '15

Hi fek47,

Yes I'm effectively talking about the underlying companies. Sorry if that wasn't clear.

John

Hi Mark, yes that's the point I was trying to make (badly, it seems!).

Hi VegPatch, yes I'm effectively talking about the underlying holdings, in aggregate, not being able to sustain total returns of 18% a year.

If the dividend on an accumulation unit is growing at 12% and the unit's price is growing at 18%, the dividend yield must be getting smaller, which it is with Fundsmith. The dividend yield will not keep shrinking forever, and so in the long-run the accumulation unit's price cannot grow meaningfully faster than the dividend.

Of course this approach does miss out a lot of detail because we can't see the underlying holdings, but in a group of 30 blue-chip stocks I would expect most of the details to become almost irrelevant, other than a few simple things that we can see like price and dividend (although an aggregate PE ratio would be nice too).

John

AnonymousUser37607

Fundsmith seem to be reasonably transparent on what has happened, in aggregate, to the valuation of the underlying holdings - from the recent Short Form Report for year end 31/12/2014:

"So when it comes to quality we are confident that we have selected good companies, but one of the questions which most frequently arises when we are talking to investors is that of valuation. The companies we invest in may be high quality businesses, but perhaps their shares have become too expensive. There is no doubt that the shares in our portfolio have become more highly rated over the past four years. It is also true that this is not the way we would prefer the performance of the portfolio to be delivered as increases in the multiples which company shares trade on are finite and reversible."

"But there is no certainty that such improvements in valuation will reverse any time soon or indeed that they won’t continue. We remain unimpressed by those who tell us about their concerns about valuation and who have been doing so for several years. No doubt they may prove to be right at some point but following their advice would have been very expensive in the interim."

"Having said all of that, where are we on valuation? The weighted average Free Cash Flow (‘FCF’) yield of the portfolio (the free cash flow generated by the companies divided by their market value) started the year at 5.1% and ended it at 4.5% so we had a tailwind from increased valuations again..."

Onedrew

23rd Feb '18

Four years on and Terry has indeed to increase price at the rate of 18% pa. He was only managed 17% pa, increasing from 200p to 374p. Disappointed but have maintained my holding, purely out of loyalty.

Andrew L

The list the annual performance since inception net of fees at 19.7% versus 12.6% for the MSCI world index (£). So clearly they have had a tailwind in that markets have gone up a lot. It is meant to be a defensive fund and so outperforming when markets go up is very good. A significant period of outperformance is likely to occur when markets fall.

Probably the answer to your question on sustaining performance is no. However, this may reflect the fact that the fund benefited from market momentum in the period. The real question is whether Fundsmith can hold value and potentially outperform over the long-term. Even if the annual return falls to 12% this would still be very good. Or indeed even 5% if the stock market tanks.

I think we have to ask the right questions with things like this. Fundsmith have a clear process and try to avoid taking significant risk. The process won't change. So really the question is will the process continue to do well. Talking about Fundsmith being overvalued or not being able to sustain the performance is somewhat "melodramatic" in my view. So what if the returns come down? It would probably be impossible for them to return over 20% forever. The more important question is probably whether they can sustain value in a downturn? Or if there are better alternatives? The Slater accumulation growth fund is up about the same amount since Fundsmiith started but is less defensive and higher risk. So Fundsmith appears to have proven its mettle to date. The real test will be in a bear market when it should be able to preserve value relatively well.

vik2001

in a true bear market does any equity fund really preserves its value by not loosing to much?
the only fund I could see that done well and was up during the recent correction few weeks ago was Ashburton Africa equity.

donald pond

25th Feb '18

I invest in a couple of the absolute return funds, the ones run by City Financial and Polar. The Polar UK Absolute Return fund seems an utter misnomer to me - it performs like a very good, long only fund, ploughing ahead in good times but it gave up a lot in the recent wobble. The CF fund has been much more sedate but moved up around 4-5% over the last few weeks. Most absolute return funds aim for a return of 3-4%, which strikes me as a waste of time. Those 2 funds are different and can generate big returns (Polar managed something like 40% last year) but it is good to see how the act when the markets turn.
I have bought and held Fundsmith for many years and can't imagine ever selling it. The companies it holds are all very high quality. Sometimes they may look expensive, but that is hardly the worst sin.

Is the Fundsmith Equity Fund's performance sustainable?

Dividend growth is the driver of sustainable growth

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