Building A Terry Smith Portfolio With UK Shares

31st Jan '23 by Roland Head

28 comments 5494 reads

Terry Smith’s annual letter to investors in his Fundsmith Equity Fund has become something of an event. He’s opinionated, informed, and usually has something spicy to say.

This year’s letter came with an extra dose of anticipation, as we knew Smith would have to discuss why the Fundsmith Equity Fund fell in value and underperformed global equity markets last year. A rare event indeed.

Megan reviewed Terry Smith’s letter in depth recently, so I won’t repeat her comments here. But one idea from the letter that caught my interest was the possibility that the kind of quality companies Fundsmith buys are now more attractively valued than they have been in recent years.

Sure, the fund fell last year. But for long-term investors wanting to buy shares in quality businesses, falling share prices are often good news.

I started to wonder. If I tried to build a portfolio of UK shares Terry Smith might buy today, what might I end up with? Would they be companies I’d want to buy today?

I decided to build a stock screen to try and find out.

Reading the manual

One thing that Terry Smith and Warren Buffett have in common is that they don’t mind sharing details of their investment approach. Fundsmith provides an owner’s manual on its website that provides a very clear description of the kind of companies the fund buys, and the financial metrics on which Smith and his team focus.

To refresh my memory, I reread the owner’s manual and noted down the key criteria Fundsmith uses to assess stocks. I then checked the website for the fund’s current sector weightings and top holdings.

Finally, I looked at the table of portfolio financial metrics that’s always included in Fundsmith’s annual letter. This shows the weighted average financial characteristics of the fund’s portfolio, as if it were a single company. I’m a big fan of this technique, which Ed wrote about last year in “The perfect stock does not exist…”.

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Source: Fundsmith 2022 annual letter

Armed with this information, I built a screen which I think highlights stocks Smith might consider, if he restricted his investment universe to the UK instead of investing globally.

Terry Smith screening criteria

Fundsmith’s stated investment…

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31st Jan '23

Good to see this article and screen, Roland. The sight of value investors elsewhere piling in on Mr Smith in the light of his mild (and, to date, extremely rare) annual underperformance relative to benchmarks is most unedifying. He simply owns the highest quality businesses he can find and it’s inevitable that prices will need a little air let out of the balloon from time to time. Value investors, whose strategy is to own relatively much weaker businesses, accusing Terry of dropping the ball is bizarre, when sticking to their guns has cost them a decade of underperformance! I’m with Mr Smith. I’d rather own a great business for 20 years than jump from one average one to another every six months.

Very few companies fit the bill in the UK, but plenty more abroad. I stay close to Terry's approach outside my IT investments and hold 3 of the 5 Roland highlights. Of those, I think Relx (LON:REL) is the closest fit, having the stickiest product and highest returns, although there are issues over its relationships with academic institutions. Looking for value, Unilever (LON:ULVR) is cheap relative to competitors like Nestle and P&G but there's a reason for that -the performance of its portfolio of brands has deteriorated, suggesting a weakening of the moat. I also like Intertek (LON:ITRK) and Experian (LON:EXPN, the former likely to chug along as regulations tighten and the latter more growth oriented. intertek is good value relative to history right now.

Lucky dip

Articles like this keeps me to continue with my subscription. To be honest, I dislike Aims and microcaps. I have lost more money over the last 5-10 years in this sectors than the mid 250 and large caps.

timarr

Investors, whose strategy is to own relatively much weaker businesses, accusing Terry of dropping the ball is bizarre, when sticking to their guns has cost them a decade of underperformance!

Agreed. There's nothing wrong in taking a shorter-term approach to markets, on whatever basis the individual investor desires - but using that as the reference point for then making criticisms of investors whose approach is avowedly longer-term and successful is, at best, short-sighted. Fixation with calendar year performance continues to amaze ...

Smith and Fundsmith do exactly what they say they do, and have benefitted from the flight to quality over the past decade, It'd be surprising if performance in the next decade was as good - but so what? These companies will still be around, compounding returns, for a long time to come (barring takeovers).

For what it's worth I hold seven of the screen's stocks (and Visa (NYQ:V) which is the modern day version of the tollbooth), having sold EMIS (LON:EMIS) on the basis that the takeover looked like a full price and a done deal. That nearly tripled my money, although I'd have preferred to have left it where it was. Of the others Howden Joinery (LON:HWDN) looks mispriced to me at the moment, but for obvious reasons, while I can't imagine a single reason why Fundsmith would ever own Persimmon (LON:PSN).

The underperformance of Unilever (LON:ULVR) is pretty well explained in the most recent Fundsmith letter (ignoring Smith's rant about virtue signalling, which is neither here nor there). Its management is just terrible at allocating capital. Fortunately it's such a strong business that it chugs along anyway, but if they ever manage to appoint a CEO that knows what they're doing it'll grow rapidly, despite being a behometh to start with.

Interesting post, thanks Roland.

Roland Head

Hi Timarr,

> I can't imagine a single reason why Fundsmith would ever own Persimmon (LON:PSN).

I agree! But this housebuilder slipped through the screen as it's classified as a consumer cyclical and has demonstrated strong ROCE and cash generation in recent years.

A useful reminder that it always pays to sanity check the results of a screen.

Regards,

Roland

sharw

Thanks for the screen Roland - interesting. I note the £500m minimum Mcap - necessary for a big fund but I am happy to go lower so I took it down to £100m and it produced the following extra shares including SCVR favourites Bioventix (LON:BVXP) and Somero Enterprises (LON:SOM) :

MontanaDawn

Thanks Roland, a very interesting read. Is it possible to use your screen as a base and change it to find companies in the size range of 50m - 500m market cap?

MontanaDawn - do what I did - go to Roland's screen (link near top) and press 'Copy' - you will then have it as your own screen and can play around with the rules. Dropping to £50m adds Spectra Systems (LON:SPSY) and Cake Box Holdings (LON:CBOX) to my list above.

Funderstruck

Thanks Roland; I invested in Fundsmith on Day one as I had appreciated the strategy and attitude of Terry Smith for some time. I am happy with the results. It is good to have some investments that one does not need to monitor constantly , as i do with stocks at the other end of the scale both shorter term and trading the AIM.

His approach of investing in companies that reinvest in them selves provides far higher returns than one can obtain elsewhere. Also as they make money they do not need so much to borrow capital , thus higher interest rates will have less affect on results.

He sold ITRK as he preferred investing in the scientific equipment; a pick and shovel approach, which worked as the fund was down in the '22 Calendar year 11% against 29%. It would be interesting to take his high performers out of the Benchmarks and see how the benchmarks performed without them.

To Roland and other contributors please continue providing these really interesting thought provoking articles.

RE: Persimmon (LON:PSN)

Hi Roland

We are in furious agreement, but I think it's an interesting point - screens are a starting point not a destination. Fundsmith have a team of analysts pouring over the data from their holdings and (reputedly) the short-list of companies they're thinking about buying. Most of us private investors are dealing with limited data culled from screens and part time analysis. In that competition there's only going to be one winner.

It should be no surprise that Stockopedia spends a lot of effort on small cap stocks because that's where the opportunity is, and the gap in the market for private investors. Yet if we look at the volatility of some larger cap stocks there is clearly some opportunity for the private investor, as long as they have a longer timeframe than most institutions.

My own view is that the relative underperformance of Fundsmith, Lindsell Train and Buffetology represents a long term opportunity for private investors. As the bellweathers of quality stocks show distinct underperformance in the short term it's a strong indicator that there is "value" on sale. This isn't any kind of classical value investing, but it's an indication that many high quality stocks have derated to the point where they may offer decent (and probably guaranteed) future returns.

I should stress that I'm at the point in my life that the "guaranteed" bit of that equation matters more than it did when I was younger ... :-)

Please keep the articles coming, they're excellent,

peterthegreat

I would agree that this is a very interesting article so thanks Roland. Rather than using a formal screening process, I have tried to use Terry Smith, Keith Ashworth-Lord and, to a lesser extent, Nick Train as mentors in developing my own approach to investing. My advantage over these fund managers is that I don't need to invest large sums of money so I can easily apply their philosophies to smaller companies. I have also extended their ideas to invest in companies with high ROCE in the US biotech/life sciences sector as I have a long term interest in this sector. Finally, I also duplicate some of the holdings held by these managers in my own portfolio, trying to monitor their purchases as much as possible to update my own portfolio. Early awareness of some Fundsmith purchases can be gained by checking the 13F filings of Fundsmith LLC in the US. Although this saves me paying the fund management fees I do also hold funds directly and I am more than happy to pay fees on these bearing in mind the knowledge I have been able to gain from these fund managers.

Kevin Holloway

1st Feb '23

Thanks for another interesting article

JASVFS

Good work Roland, I'm a Terry Smith fan and if I'd followed him more and took on board his rules I'd have a lot more money now. I did buy into Smithson when it launched but took good profits too soon (my usual problem), I've been looking to get back into it since it fell but was probably too cautious (greedy) and it's rallied to more than I want to pay. Had you thought about doing the same for the Smithson fund?

Rusty2

Might be a good time to buy, now he has cleared out some of the lemons and Meta Platforms (NSQ:META) is not such a large %. For me there questions over some of selections recently, does he hold Visa (NYQ:V, that would have been far better than PayPal Holdings (NSQ:PYPL).

Bronstein

Good article. Only point I would raise is to ask if a 3.33% FCF yield is enough now given many bond funds are yielding over 5% now.

Only point I would raise is to ask if a 3.33% FCF yield is enough now given many bond funds are yielding over 5% now.

US 10yr, the absolute benchmark against which all other instruments are valued, is at 3.5% and in a downtrend.

Hi Bronstein,

I agree - I wonder if Fundsmith may need to look for more affordable valuations (higher FCF yield) if the fund is to stick to its self-decared valuation remit.

It will be interesting to see how this plays out. One possibility, of course, is that such highly-rated quality stocks could de-rate further, improving the yield on offer.

Regards.

simoan

Obviously, this is a gross over-simplification of the process used by Fundsmith. Even so, I would never filter by "sector" in this way. As I found recently, the sector a company is assigned to is arbitrarily defined by the data provider (Refinitiv) and does not even match the sector allocations of their parent company (London Stock Exchange Group). As an example, Next qualifies for the screen as a member of the "Technology" sector. This is clearly nonsense and this error has now persisted for months.

The results look more to me like some of the top weightings of Finsbury Growth & Income Trust (LON:FGT) which is currently on 4-5% discount to NAV. For those interested, there is a 30-minute AGM video update on the portfolio by Nick Train on the company website here: https://www.finsburygt.com/

All the best, Si

Fundsmith favourites Spirax-Sarco Engineering (LON:SPX) and Halma (LON:HLMA) haven't made the screen. And I would add Diploma (LON:DPLM) as another Smith-esque name. I hold all three which are as cheap as they have been for many years.

Normally they trade at a premium to similar high quality industrials abroad, owing to their rarity in the UK scene, companies like Atlas Copco and its offshoot Epiroc, Hexagon, Addtech and Idex (both new holdings for the Smithson fund), Ametek, Nordson, Graco, Fortive, Roper, Trimble etc. Today they are priced very comparably on an EV to EBITDA basis, my preferred measure when comparing across borders. This rarely occurs and might be an opportunity to pick any of the three up.

Diageo (LON:DGED) is another stock that may appeal to Fundsmith, it passes 7/8 on that screen, it only fails on Price to Free Cash Flow TTM<30, it is 39.1.
I see Halma (LON:HLMA) and Spirax-Sarco Engineering (LON:SPX) fail for the same reason.

Warning on screens, they may not pick up all stocks due to missing data, quite common if using forecast such as brokers forecasts or PER or PEG.

Yep, reassuring to hear you agree. It is that further derating possibility that has me buying bonds and holding unusually high amounts of cash at present. Strange times indeed. I'm going to keep an eye on your watch list though.

Building a Terry Smith portfolio with UK shares

Reading the manual

Terry Smith screening criteria

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Roland Head

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