Terry Smith 2024 letter: recent trades, underperformance and Nvidia

Fundsmith founder Terry Smith published his annual letter to shareholders last week. As well as being a high-profile stockpicker, Smith is an entertaining writer. Regardless of whether you agree with his views and stock choices, I find his letters well worth reading – especially for investors pursuing a compounding quality strategy.

Among the topics covered in this year’s letter are why Smith sold Apple (NSQ:AAPL) and Diageo (LON:DGE) last year, plus what could go wrong for NVIDIA (NSQ:NVDA) shareholders.

He also touched on the issue of the fund’s four years of underperformance and explained why – in his view – this is not necessarily at odds with the successful delivery of his strategy.

4 years of underperformance

Fundsmith’s flagship Equity Fund underperformed the global market for the fourth consecutive year in 2024, although the fund’s long-term performance since inception in 2010 remains excellent:

Source: Fundsmith website 11/01/25

Perhaps a little more worrying for me is why Fundsmith has underperformed rival fund managers in IA Global Sector for most periods under five years:

Looking back at past factsheets suggests this underperformance has only crept in during 2024. Perhaps this indicates that many rivals succumbed and bought Nvidia last year!

Smith says he is maintaining his disciplined long-term strategy and (presumably) believes he will be vindicated over time with further index outperformance.

He suggests – and I’d agree – that some investors may be suffering from recency bias with regards to the Mag 7. In other words, they are assuming the current growth trajectory will continue indefinitely.

On the other hand, Smith’s critics (and he has a few!) suggest he has failed to understand tech and may be running out of excuses for his fund’s underperformance.

Time will tell. I agree that active fund managers should be under pressure to answer for their own underperformance.

But it’s also worth noting that Fundsmith’s top 10 holdings include three of the Mag 7. A fair chunk of Fundsmith’s underperformance last year may simply be down to the fund not owning Nvidia. More on this below.

Source: Fundsmith website 14/01/25

The reality is that without taking a concentrated bet on a handful of the largest US tech stocks, it’s been difficult for a large cap institutional portfolio to outperform any meaningful index benchmark in recent years.

More broadly, all genuinely active strategies are likely to underperform an index benchmark sometimes. Ed discussed this here.

2024 winners & losers: should Smith surf the StockRanks?

Smith begins with a look at the biggest detractors and contributors to the Equity Fund’s performance last year. I thought it might be interesting to view these through the lens of the StockRanks.

While Smith’s strategy weights momentum less heavily than the StockRanks, there are many areas of overlap. For example, a focus on return on capital employed, cash generation and a reasonable valuation.

Here’s a dummy portfolio showing Fundsmith’s five worst performers last year – these were the stocks that had the greatest negative impact on the Equity Fund’s performance:

It’s interesting to see all of these underperformers have a StockRank under 60, with neutral or negative styles (except Novo Nordisk’s home listing in Denmark).

Checking back to January 2024, all of these shares have seen their StockRanks fall over the last 12 months. In most cases, they’ve also been downgraded from High Flyer to Falling Star.

For example here’s the 1y chart for L’Oreal - note the falling StockRank:

Contrast this with the five biggest contributors to the Equity Fund’s performance last year:

All five stocks have positive StockRank Styles and three boast StockRanks of 80 or more.

Smith’s view is that negative returns from L’Oreal, weight loss drug pioneer Novo Nordisk and IDEXX (which makes pet healthcare diagnostic products) are “a blip in their long-term record”. He thinks they are “too good to sell and risk being uninvested when the tide turns”.

This may well be true. But as private investors we need to know whether our strategy is to buy-and-hold through the “blips”, or to trade more regularly.

My unscientific sampling of Fundsmith’s quality stocks does seem to suggest that investors could do worse than to avoid low-ranked Falling Star stocks. Instead, it may be sensible to focus on those with stronger StockRanks and styles that are more commonly associated with outperformance.

2024 stock trades: 2 buys, 3 sells

Fundsmith’s motto is “Buy good companies, don’t overpay, do nothing”. Of course, as with Warren Buffett’s view that “our favourite holding period is forever”, this does not mean zero trading.

In 2024, Fundsmith sold three shares out of 27 holdings at the start of the year. That’s 11% of the stocks in the portfolio, which doesn’t seem like doing nothing. However, these appear to have been fairly small holdings, as they represented portfolio turnover of just 3.2%. That’s pretty low.

Fundsmith stocks sold in 2024

Three stocks were sold from Smith’s £24bn Equity Fund last year:

McCormick: the consumer goods group sells branded food products, traditionally a reliable performer.

However, Fundsmith says McCormick’s margins have suffered as it has been slow to pass on cost inflation and seen consumers trade down to cheaper own label products.

Diageo: shares in the drinks giant have fallen by nearly 40% from their 2022 peak. Its shares are now trading close to their March 2020 lows.

Well known to UK investors as a quality stock, Smith says Diageo has suffered management problems since the current CEO took charge in June 2023.

He also makes repeated mention of the potential risk to drinks firms from weight loss drugs, which are apparently also proving effective at helping problem drinkers reduce consumption.

His concerns sounded exaggerated to me at first. But an interesting statistic is that in the US, 10% of drinkers consume more than half the alcohol sold each year. Similar findings have been reported in Australia and I imagine this holds true in most developed markets.

Mathematically, if the heaviest 10% of drinkers halved their consumption, alcohol sales could fall by 25%.

Smith isn’t giving up on booze altogether. He’s retained family-controlled Brown-Forman (which owns Jack Daniels) in his portfolio, noting that it survived Prohibition and will hopefully manage this threat.

Apple: Fundsmith’s decision to sell Apple last year echoes that of Warren Buffett, who has sold two-thirds of his (giant-sized) holding in the iPhone maker since the end of 2023.

Terry Smith says Fundsmith started buying Apple at $156 a couple of years ago “when the P/E was below the S&P 500 average”.

He expected that poor sales performance would provide an opportunity to expand the position, but instead Apple shares shot higher despite sluggish sales growth.

This left Fundsmith with a sub-scale position in a stock that was too expensive to keep buying, according to last week’s letter:

placing the shares on a rating about 50% higher than the S&P 500. We were not going to buy more stock against that background and it was occupying a place in our portfolio and so we sold our stake.

I don’t follow Apple closely, but I see from the StockReport that the stock’s trailing free cash flow yield is currently 3.3%.

While the shares are certainly not cheap, this FCF yield is slightly higher than the Fundsmith portfolio average of 3.1% reported in last week’s letter. So by the fund’s standards, it does not seem obviously too expensive.

Perhaps the bigger issue here is the question over whether Apple will release any genuinely innovative new products in the next few years. I don’t have a view on this, but the stock’s High Flyer styling and slowing momentum do suggest some slight risk of a de-rating to me:

Fundsmith 2024 buys

To fill the gaps created by the sales above Fundsmith added two new stocks to the Equity Fund last year:

Atlas Copco AB (STO:ATCO A) : this Swedish industrial group makes products such as compressors and vacuum equipment. It boasts excellent quality metrics thanks to outsourced manufacturing and a decentralised structure (600 subsidiaries). The company boasts long-term family ownership.

Smith notes that Atlas Copco has been in business for 151 years. The long-term chart is certainly deeply impressive, suggesting this business could be a quality compounder:

Stockopedia’s algorithms style the stock as a High Flyer, with strong quality and momentum scores. Value is weak though, reflecting the forward P/E of 27.

Texas Instruments (NSQ:TXN): this well-known microprocessor manufacturer could be a beneficiary of the onshoring trend in the US. Smith says Texas Instruments also has a good record of cyclical timing:

a long history of investing well ahead of upswings in demand and producing handsome returns from it.

The current investment phase is shown clearly on the StockReport, in the cash flow section. Capex has risen sharply over the last few years:

This has not yet translated to increased profits – operating profit over the 12 months to June 2024 was $5.6bn, down by nearly 50% from the record $10.1bn reported in 2022.

The StockRanks are lukewarm towards Texas Instruments at the moment:

But the stock’s High Flyer styling and excellent quality metrics suggest to me that there’s a clear opportunity for strong profit growth, if Texas Instruments can capture an upturn in demand in some of its key markets.

With a forward P/E of 32 and a trailing price to free cash flow ratio of 118, Texas Instruments looks far more expensive than Apple and requires a leap of faith to buy.

But Smith’s logic seems reasonable to me. Texas Instruments has also been a very strong long-term performer:

Smith on Nvidia

Nvidia has been something of a bogeyman for active managers who have not held its shares over the last two years. The AI chip giant’s share price has risen by 680% in 24 months:

In 2024, the S&P 500 rose by 25%, with Nvidia contributing 22% of this increase:

Source: Statista

Smith has a couple of points to make about Nvidia in particular. I think these are worth considering, whether you are bullish or bearish on this remarkable business.

Volatility: Nvidia shares fell by two-thirds in 2021-22. Investors who continued to hold have benefited considerably. But he suggests investors should question how they might behave in this scenario:

Would we or you feel comfortable owning it in such circumstances, and if not, might that share price performance cause us to make poor decisions?

I think this is a fair question. Smith notes that Meta (a Fundsmith holding) fell by 76% in 2021-22. The fund continued to hold Meta, “to our current benefit”. But he admits that given how difficult it can be to own a volatile stock of this kind, “maybe one is enough for our portfolio at any one time”.

Consumer/supplier considerations: last week’s Fundsmith letter also highlights another key difference between Meta and Nvidia.

Whereas Meta serves 3.3bn consumers and several million advertisers, Nvidia’s customer base is dominated by “a literal handful of so-called hyperscalers”.

Investors often worry about owning consumer stocks in a downturn. They can certainly underperform. But Smith suggests that in these circumstances, we should actually be more worried about owning shares in companies that supply the consumer businesses – by implication, including Nvidia:

If you think the performance of consumer companies is a worry in a downturn wait until you see what happens to their suppliers, especially the suppliers of capital equipment like factory machinery. A 5-10% downturn in sales revenues at the consumer companies can translate into a cessation of orders for some suppliers.

I think this is a good point, although of course Smith is naturally talking his own book.

Broker forecasts are currently suggesting Nvidia’s stratospheric growth rate will continue, with earnings rising by 143% in 2025 and almost 50% in 2026:

This may happen. But with the shares trading on 53 times trailing earnings, I think it’s also worth considering what might happen if this momentum falters.

When and why this might happen is open to debate – I certainly have no idea. But history suggests such strong runs of growth often end at some point, usually unexpectedly.

Smith finishes his letter by concluding that the Fundsmith Equity Fund’s goal is to produce “a high likelihood of a satisfactory return” rather than “the chance of a spectacular return which could be spectacularly good or spectacularly bad”.

Not all investors will agree with that statement, but I think it’s a useful reminder that we should all have a clear idea of what our investing goals are – and how much risk we’re willing to accept to try and achieve them.