Terry Smith has a loyal following amongst private investors. His Fundsmith fund has been highly successful, doubling investors money since its launch in 2010 with annualised returns of 19%.
The fund has a distinctive investment style, identifying good quality companies and holding them long term. Quality is measured by:
- Sales of small-ticket items with a high repeat business and defensive nature;
- High Return on Capital and cash conversion;
- Competitive advantages that are difficult to replicate;
- Ability to generate returns without significant leverage;
- Ability to grow through reinvestment;
- Resilient to change, particularly technological innovation;
- Attractive valuation.
Whilst Imperials products are, bluntly, addictive, Unilever and Reckitt are consumer durables companies par excellence. The products people devour, clean with, bathe in and pamper themselves with are very much necessities of 21st century life, and seem resilient to trading down.
Intangibles are valuable
All three companies have tremendous market power and hence pricing power through their strong consumer brands, established distribution channels and bargaining power over retailers. Mr Smith emphasises the value of such intangible assets. Private investors often prefer tangible asset backing but when intangibles represent true market power, rather than a history of expensive acquisitions, they are of real value.
Both Unilever and Reckitt generate outstanding returns on invested capital, 28% and 21% respectively, within the top 10% of all UK companies. Imperials more modest 11% is within the top 30%. All three companies throw off cash, with operating cash flow per share higher than earnings. Gearing is low at Reckitt (24%), moderate at Unilever (73%) and higher at Imperial (168%) after it borrowed to acquire market share in the US.
In recent years emerging markets have provided the ideal platform for Unilever and Reckitt to grow: Unilever had a great initial advantage thanks to the Lever Brothers overseas forays in the 19th century some competitive advantages really endure but Reckitt has been playing catch-up.
Imperial, too, expanded in emerging markets, but Im not sure I share Mr Smiths confidence in the ability of Big Tobacco to resist technological change. Imperials sales are shrinking and it is being milked for cash: long-term prospects depend on capitalising on the disruptive technology of e-cigarettes and not being cannibalised by it. Its a moot point whether the new technology needs the old players competitive advantages.
Thats recognised in Imperials cheaper valuation: a prospective PE of 14.9, against 22.1 and 23.8 for Unilever and Reckitt Benckiser respectively. Quality doesnt come cheap. Fundsmiths approach to valuation is based on free cash flow yield (free cash flow per share as a percentage of the share price).
Some of the success of Fundsmiths performance is undoubtedly due to the rise in valuation multiples in the US, which accounts for 60% of the fund. Some think thats getting toppy. But the philosophy of buying and holding good quality companies is one I wholeheartedly endorse.
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