My Terry Smith screen revisited: 3 new stock ideas

In January, I built a simple stock screen based on the criteria described in the Fundsmith owner’s manual. While Terry Smith is certainly not a purely systematic investor, he does have some clearly defined requirements that I was able to use.

For me, one particularly interesting aspect of Smith’s style is his approach to valuation. He looks for relative value rather than absolute cheapness.

In other words, the returns on offer have to be better than lower-risk alternatives (my bold):

“Our aim is to invest only when free cash flow per share as a percentage of a company’s share price (the free cash flow yield) is high relative to long-term interest rates and when compared with the free cash flow yields of other investment candidates both within and outside our portfolio.

Our goal is to buy securities that we believe will grow and compound in value, which bonds cannot, at yields that are similar to or better than what we would pay for a bond.”

During a decade of ultra-low interest rates, this led to Fundsmith purchasing shares that looked expensive on many measures, but which still performed well and offered relative value.

However, interest rates and inflation are now higher than they’ve been at any time since the Fundsmith Equity Fund was launched.

I think high-quality companies that generate high returns should still outperform over long periods – a topic Megan covered recently here and here.

But with 5% risk-free returns now available, the guidelines I’ve quoted above suggest to me that Fundsmith may need to start looking for stocks with lower valuations.

Revisiting my screen

The UK bank rate was 3.5% when I published my original article, so I specified a maximum price/free cash flow ratio of 30 (equivalent to a 3.3% FCF yield)

The bank rate is now 5% in the UK and slightly higher in the US, at the time of writing. Based on Smith’s guidelines above, I should be looking for stocks with a free cash flow yield of at least 5% – equivalent to a P/FCF of 20.

However, free cash flow can vary more than earnings from year to year. Stockopedia’s data provider may also not calculate free cash flow in exactly the same way that Fundsmith does.

To allow some flexibility, I’ve left the P/FCF rule unchanged at 30, but have highlighted in green those results which satisfy the new 5% FCF yield requirement.

My Fundsmith screen produced 15 results at the time of my original article. This has now fallen to nine, with just five of those offering a free cash flow yield of at least 5%:

You can see the screen and the current results here

In addition to the valuation criteria I’ve mentioned above, Terry Smith also looks for companies with the following characteristics:

• Sustainably high rate of return

• Repeat business, usually from consumers, although not necessarily

• Preferably frequent, low-priced sales rather than cyclical or lumpy

• Intangible assets that are difficult to replicate

• Growth potential

Not all of the companies in the screen results match these criteria very well, but I think some do.

In the remainder of this piece, I’ve taken a look at three companies from the screen results above that I think might be the kind of quality businesses Smith would buy in a UK-only fund (much of his investment is in the US).

Next (LON:NXT)

The sector breakdown from the most recent Fundsmith factsheet shows the fund is weighted most heavily to Consumer Staples – equivalent to Consumer Defensives on Stockopedia:

Source: Fundsmith website (28/07/23)

My screen doesn’t return any true defensives at this point in time, but I think Next may be the next best thing.

I admit that Next is clearly a discretionary or consumer cyclical stock. But I think it’s fair to say that for a sizeable part of the UK population, shopping at Next is part of the ordinary fabric of life, regardless of the economic climate.

This business also has some other attractive characteristics, in my view. It’s very well managed and is a sector leader in integrating physical and online retail.

Next’s growing marketplace business – which sells many third-party brands – also means that it may be gaining some degree of platform status.

Finally, Next’s finance offering helps to create a stable, loyal customer base, and makes a substantial contribution to the group’s high profit margins.

Next scores well with the StockRanks. The combination of high quality and momentum scores suggest it could offer the quality-growth focus that Fundsmith is known for:

Profitability and cash generation are also consistently strong:

Trailing free cash flow of 440p gives a free cash flow yield of 6.3%, comfortably above the current base rate.

The main weakness of the business is perhaps its growth potential. Next’s profit growth has been inconsistent in recent years and it’s not clear to me whether the business as a whole can continue to scale.

Personally, Next is a stock I’d want to buy on the dips. But I do have a lot of respect for its quality pedigree and long track record of strong returns.

Rightmove (LON:RMV)

Rightmove needs no introduction for any of us, I suspect. This firm has an 86% market share and is the default choice for most house-hunting activities.

Competitors such as Zoopla and OnTheMarket run a distant second and third place. From a user perspective, they seem to serve no useful purpose other than to motivate Rightmove to continue to develop and expand its service.

I would argue that Rightmove is to the UK housing market what Meta Platforms (NSQ:META) and Alphabet (NSQ:GOOGL) are to internet advertising. Estate agents have little choice but to use Rightmove's service.

Meanwhile, the company’s steady expansion into new home sales, mortgages, lettings and commercial property means that its market reach is continuing to grow.

Rightmove’s profitability is legendary, with returns on capital employed in excess of 100% and a steady 70% operating margin:

Strong cash generation has been consistently funnelled into small dividends and big share buybacks over the years. As a result, the number of shares outstanding has fallen by about 18% over the last decade. This has added around 22% to earnings per share over the same period.

Rightmove’s ever-increasing prices do reportedly create some resentment among its core customer base of estate agents. This is a risk, in my view – abusing the pricing power of a near-monopoly is a sure way to stimulate innovation and competition.

Even so, I think the Rightmove is only likely to lose its dominant position if it is mismanaged.

The shares boast a free cash flow yield of about 4.3% at the moment, so they’re slightly more expensive than my target level of 5%.

I wouldn’t bet against Rightmove stock falling a little further over the coming months. This is perhaps reflected in its High Flyer rating and StockRank profile:

But on a long-term view, I don’t see any reason why Rightmove won’t remain a quality compounder for the foreseeable future.

Games Workshop (LON:GAW)

I’m not going to attempt too much analysis of this wargaming business. I know there are many expert and devoted investors (and customers) among the Stockopedia readership.

For now, I’ll just say that Games Workshop owns the intellectual property for a number of popular wargames, and manufactures and sells all the products that players need to take part in this hobby.

The group is now also beginning to exploit the franchise potential of its IP, licensing it for use in video games and television/films.

After many years in the wilderness, the shares have 20-bagged since CEO Kevin Rountree took charge in 2015:

The business boasts the kind of high returns and strong cash flow that Terry Smith seeks:

I would argue that the commitment and regular purchase habits of Games Workshops’ client base do provide some of the franchise qualities Smith looks for in consumer businesses.

Like Rightmove, Games Workshop’s current valuation is slightly above my target range, with a free cash flow yield of about 4.2%.

Consensus forecasts on Stockopedia suggest growth could slow somewhat this year. However, the consensus trend has been positive in recent months:

Games Workshop shares are arguably priced for perfection at the moment. I’d suggest any disappointment could trigger a sell off.

There’s also the broader possibility – impossible for me to gauge – that the company’s products will fall out of favour at some point or be mismanaged.

Even so, I would say that Games Workshop doesn’t seem fundamentally overvalued to me, based on recent performance.

On a medium-term view, I think this business could continue to provide market-beating returns, albeit at a slower rate than in recent years.

Disclosure: Roland owns shares of Moneysupermarket.com, ME International and EMIS.