Revisiting my Terry Smith screen: should investors give up on quality?

Should investors dismiss the idea of quality investing?

As Ed highlighted in his 2025 StockRanks review, the quality factor underperformed (again) last year.

High profile exponents of the quality approach such as Terry Smith and Nick Train also endured a torrid time in 2025, underperforming both cash and most equity benchmarks.

Smith’s flagship Fundsmith equity fund has lagged its chosen equity benchmark for the last five years. In 2025, the fund’s accumulation units generated a return of just 0.8%:

Source: Fundsmith factsheet 13/01/26. Equity benchmark is MSCI World Index.

It’s always easy to demonise well-paid active fund managers who underperform the market. As this classic investing book asks, Where Are the Customers’ Yachts?

I don’t plan to wade into the debate about active fund management costs today. But I think it is fair to say that Terry Smith’s efforts probably have paid for some of his customers’ yachts – at least those of his long-term customers.

By the end of 2025, Fundsmith had delivered an annualised total return of 13.8% since the fund’s inception in November 2010. That’s comfortably ahead of both the fund’s MSCI World Index benchmark (12.1%) and the FTSE 100 Total Return index (7.7%) over the same period.

To put this in context, an investment in Fundsmith of £10,000 in November 2010 would have been worth £70,277 at the end of 2025.

That compares to £56,004 for the MSCI World Index and £30,614 for the FTSE 100.

Why quality ‘should’ still pay off

Critics of Smith will suggest that his early success was due to good timing and the broad re-rating of many quality stocks during the low interest rate era. These factors certainly helped, in my view.

However, I can’t help feeling that a strategy focused on buying shares in high quality companies with growth opportunities and holding them for a long time still makes a lot of sense.

One reason for this is highlighted by this quote from Warren Buffett’s late partner, Charlie Munger:

Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns.

Companies with high ROCE that can reinvest at high rates should create value above their cost of capital. In theory, this should translate into attractive shareholder returns over time.

The caveat here is “long term”. Over shorter periods, popularity and momentum can outweigh many fundamental considerations.

The challenge for would-be quality investors lies in identifying true quality businesses and having the conviction (or bravery!) needed to hold them long enough for the compounding effect I’ve described above to deliver results.

Inevitably, some will fail to deliver. Spotting these as early as possible and cutting losses is an important skill.

Difficult market conditions

Recent market conditions have made life difficult for dedicated quality investors. The concentration of the US index and the popularity of passive index funds have created a powerful momentum effect that may yet have a lot further to run.

In his 2025 letter to shareholders, Terry Smith points out that the top 10 stocks in the S&P 500 (including the Magnificent 7) accounted for 39% of the index’s value at the end of 2025. Those same 10 stocks delivered 50% of the return generated by the index last year.

Market concentration in the US is now apparently at the highest level since 1930:

Source: Fundsmith 2025 annual letter

Passive = momentum?

The market’s concentration on the Mag 7 has also exacerbated the tendency of index funds to act as leveraged momentum plays.

In his letter, Smith argues that passive is probably a misnomer. He cites some 2021 research from the US National Bureau of Economic Research (NBER) which found that money invested into index funds increases the value of the stocks purchased “by an average of five times the amount invested”.

The technical explanation of this is “the inelasticity of demand and supply for equities”.

Said differently, index funds have no discretion over what they buy, especially amongst the most heavily-weighted stocks (i.e. the Mag 7).

Given that index funds already hold more than 50% of US equities, marginal purchases of heavily-weighted stocks are drawn from a shrinking pool of liquidity. This means the price of the stocks being purchased can rise out of proportion to the money being invested.

Explaining or complaining?

Smith is a talented writer as well as a skilled investor. I always find him quite compelling to read.

Naturally, the explanation of his underperformance in this year’s letter is also intended to shore up investor support. After all, he has a £16bn fund to run.

Even so, I think the headwinds described in this year’s letter probably do stand up to closer examination.

In addition, I think it’s fair to say similar factors – including the impact of USD weakness – will have affected many UK private investors last year.

Dusting off my Terry Smith Screen

I mentioned above the difficulty of identifying true quality businesses. Back in 2023, I created a Stockopedia screen that was designed to try and identify UK shares with the kind of characteristics Terry Smith describes in his Fundsmith Owners Manual.

Two years later, it feels like it might be an interesting time to revisit the screen results and see how some of my original picks from the screen have fared.

My original aim was to come up with a shorter list of plausible stocks as a starting point for further research. Here’s a quick refresher of the screening rules I used – you can see the full screen here:

I discussed the construction of this screen in detail in my first article in January 2023. I also introduced five stocks I thought seemed likely choices for a Fundsmith-type portfolio of UK-only shares (the majority of Fundsmith’s actual shares are US-listed).

In August 2023, I revisited the screen and added two more stocks.

The results so far

To track the performance of the stocks I wrote about in 2023, I created a model portfolio with equal amounts invested in each stock on the publication dates of my articles.

Here’s how the individual stocks have performed:

Here’s how this looks as a portfolio performance, measured against the FTSE 100:

The seven stocks I picked in 2023 have gained an average of 30% since 2023 (14% annualised), matching the performance of the FTSE 100. These figures exclude dividends.

However, until the FTSE 100 took off last year, my quality choices had eased comfortably ahead.

Seven stocks is too small for a diversified portfolio. I might also argue that two years is too short a period for a true quality portfolio to outperform. But I don’t see anything in these initial results that’s inconsistent with my view that owning quality stocks can pay off over longer periods.

I think this little experiment is worth persisting with, so I’ve revisited my screen results to see if I can find any new stocks to add.

Today’s screen results: little changed?

Here’s how the results of my Terry Smith screen look at the time of writing:

I am pleased to see that four of the seven stocks I chose in 2023 still qualify today (highlighted green). This is one of the features of quality screening – stocks tend to change less than with momentum of value criteria.

Of the three stocks in my original selection that no longer qualify, a closer inspection suggests to me that they are probably still suitable choices:

• Games Workshop (LON:GAW): this only misses by a whisker, with a P/FCF of 30.2 instead of 30. I don’t see this as a reason to exclude it.

• Unilever (LON:ULVR): the consumer goods group’s operating margin of 14.6% is slightly below my 15% screening threshold, but it passes all the rules otherwise. I’m retaining this selection too. Unilever is also a top 10 holding in the actual Fundsmith portfolio.

• Relx (LON:REL): interest cover was 7.8x over the last 12 months, according to our data, below my screening requirement of 10x. But looking at the bigger picture, I don’t see an issue with leverage here. This one stays, too.

What about new stocks? Can I add any shares from this updated screening result to my Terry Smith portfolio?

I should explain that in this case, unusually, I’m not ruling out companies that are classified as Falling Stars if I feel they have the core characteristics of a long-term compounder. This may seem risky, but I think it’s an integral part of a long-term quality approach.

The stocks I’ve chosen to add to the portfolio are:

• Sage (LON:SGE): the FTSE 100 accounting software group is a similar business to US giant Intuit, in which Fundsmith holds shares. I think it has the core characteristics (and track record) of a quality compounder.

• IMI (LON:IMI): this high-tech engineer doesn’t get much coverage in the UK investing press, but it’s been a five-bagger over the last 20 years. Quality metrics are excellent and the valuation doesn’t look unreasonable to me.

• Auto Trader (LON:AUTO): a similar appeal to existing holding Rightmove. Auto Trader has anecdotally annoyed its dealer customers with a new feature that allows potential car buyers to complete some of the sales process before entering the dealership. But I suspect its dominant market share and brand will remain supreme unless something happens to disrupt the current structure of car ownership in the UK.

• Wise (LON:WISE): this currency transfer specialist looks like an excellent business to me, straddling tech and finance with excellent quality metrics and a long-term vision to become a dominant player in a fragmented market. A planned move to a US listing this year is disappointing for the LSE, but could help drive the valuation higher.

I have excluded MONY (LON:MONY), ME International (LON:MEGP) and James Halstead (LON:JHD) mainly because of their uncertain (to me) growth opportunities. All three have strong quality metrics and generate plenty of cash to support generous dividends, but have struggled to grow the top line in recent years. Their valuations reflect this, so there may be opportunities among these for more contrarian buyers.

Bytes Technology (LON:BYIT) has been a very strong performer since listing, but it’s had some recent difficulties and I’m not sure that a value-added IT reseller fits the description of a Fundsmith-like quality business.

Summing up

Taking a quality approach to investing will inevitably result in periods of underperformance when market trends and investor sentiment moves in a different direction to one’s portfolio. The ability to remain unmoved by short-term events and objective about the performance of the businesses in one's portfolio is essential.

The current situation needs little explanation – AI and tech are sucking in investor capital at an unprecedented rate, leaving many other stocks underperforming the wider market.

When and how this current boom (or bubble) will unravel is unclear. A consensus seems to be forming to suggest that passive investing and other factors could support market momentum for longer than might be expected.

As always, this article represents my views and is intended to provide food for thought and perhaps prompt further research. The stocks I’ve highlighted above are not buying tips and some (or all) of them may end up disappointing investors.

Please let me know what you think in the comments below – does a quality approach still make sense, or do all investors need to pay more attention to momentum to thrive in today’s markets?

Disclosure: Roland owned shares in Unilever, Intertek, Sage, and James Halstead at the time of publication.