I’ve read your article and I think it’s quite good, but I have a different opinion. It’s clear that Terry Smith has been underperforming for five years, but I don’t think the main reasons for this underperformance are the ones you mention. Part of it has to do with his portfolio composition. The rally of the last few years hasn’t come from the outperformance of all companies, but from just a few. The S&P equal weight, or the index without the major tech names, hasn’t done particularly well. A large portion of Fundsmith’s portfolio is made up of consumer staples and healthcare, two sectors that have been heavily hit in recent years. And still, his Sortino ratio is significantly better than the market average. This is very relevant, because as Warren Buffett said in his early letters, the key to his success wasn’t so much outperforming every year, but rather falling less than the rest in bad times, and Terry Smith continues to deliver on that.
Moreover, if AI really is a financial bubble, it’s possible that this underperformance could completely reverse.
Another element to consider is that the factor he invests in the quality factor, has underperformed the market, but that relates to what I said earlier. This factor typically does worse in bull markets but much better in bear markets. Also, if we compare him with the most similar class of funds (Seilern, for example), Terry Smith hasn’t done worse, quite the opposite.
There’s another part of your argument that I don’t buy: the idea of putting all your money into Apple and having made a 33x return in that time. Doing that would have meant taking on much more risk than investing in a portfolio of 20+ companies across different sectors and revenue sources. Berkshire is more comparable because it can be considered a pseudo–investment fund, but arguments similar to the ones made about Terry Smith were also made about Warren Buffett for many years just look at what people were saying about him in the years leading up to the dot-com bubble.
I do agree, though, on the importance of understanding the future, the ROIIC, and the reinvestment rate. That said, I believe he can continue delivering double-digit returns over the long term with very low volatility and low fees (although if someone prefers to invest in an MSCI Quality ETF, it might well be a better alternative, to be honest). Many of the companies he owns are over a century old, still have room to grow, and remain leaders in their current markets. Their slower growth compared to other companies is due to supply-chain issues and affordability crises. They have low debt, lots of cash, and strong returns characteristics that help them fall less during difficult economic periods.
P.S.: Another reason for this year’s large underperformance is the undervaluation of the dollar. Terry Smith doesn’t hedge currency risk, which makes sense for a long-term investor. Although yes, he also would have underperformed even without the dollar depreciation. Anyway, great article, lots of interesting ideas, and I’m looking forward to reading your thoughts!
Great thoughts, thank you for the detailed engagement, it’s great to read well constructed counter arguments.
Here is what I think:
1) I agree that key to success isn’t outperforming every year. As I have said, I think quality investors will likely go down after portfolio reconstructions or big buys given that we want the price to be attractive, and of the price has become attractive, there was a downtrend, and trends tend to continue for some time. We don’t bottom fish, we buy when it’s good enough, so it’s likely that we suffer from further downtrend and completely understandable.
However, when I look at his companies, I don’t think that underperformance can be explained by quality factor or other things. I can agree with those arguments if he was holding things like let’s say Adobe. But no, his companies are simply not growing enough. When you adjust for inflation, their real growth is often around 1-2%. This is the main reason in his outperformance in my view, rather than the sector allocation or something else.
Also, you are right about holding solely Apple, I know it was just there to make a point. This is why I added Buffett example.
You also said same arguments are made for Buffett, which is right, but as I said, Buffett could overcome this because of the holding structure. Terry Smith couldn’t.
I completely agree—high returns on capital mean very little if a company has no opportunities to reinvest that capital. And, of course, it is extremely favourable when a business can reinvest substantially more. Still, I believe the Terry Smith investing approach works over the long run. As someone mentioned in the comment section, AI drove a large share of market gains over the last five years, so using that period to claim the Terry Smith approach doesn’t work isn’t a strong argument. If this underperformance persists through a market downturn or another five-year stretch, then perhaps criticism will be justified—but it’s too early to draw that conclusion now.
I continue to believe investors should look for companies that earn high returns on capital and have decent reinvestment opportunities. Consider two companies: one earns a 10% return on capital, and the other earns 20%. Both maintain these returns going forward. Company A can reinvest 50% of its earnings; Company B can reinvest 25%. The compounding rate for both ends up roughly the same: 5%. However, Company B—with fewer reinvestment opportunities—returns 75% of its earnings to shareholders, while Company A returns only 50%. And this is before considering scenarios where returns on capital rise well beyond 20%.
Of course, this framework doesn’t always hold. Ideally, you would have invested in an Amazon—lower returns on capital early on, but the ability to reinvest nearly 100% of earnings back into the business. The challenge is that analysing such companies is much harder and often riskier, because reinvestment frequently requires expansion far beyond the original business model. Businesses able to reinvest at high rates within their core operations tend to be smaller, faster-growing firms. Identifying those future winners is far more difficult and, in most cases, riskier. With the Terry Smith approach, you are not trying to find the next winners—you are buying the companies that have already won.
As you are in the business of picking exceptional companies, Oguz, would you exclude the possibility for your picks to develop into High-ROIIC compounders? Maybe in reality you are the Wayne Gretzky amongst ROIIC aficionados?
I would stay humble. I think I am much more oriented toward intangibles, and I like to invest when neither ROIC or ROIIC are clear, if I am investing for growth.
Truly exceptional companies that can deploy large amounts of capital at high returns are very rare, as Buffett says. They aren’t one in a hundred; they are one in a thousand.
.
Remark:
PDX deploys large amounts of capital at very high ROA & ROIC.
I’ve read your article and I think it’s quite good, but I have a different opinion. It’s clear that Terry Smith has been underperforming for five years, but I don’t think the main reasons for this underperformance are the ones you mention. Part of it has to do with his portfolio composition. The rally of the last few years hasn’t come from the outperformance of all companies, but from just a few. The S&P equal weight, or the index without the major tech names, hasn’t done particularly well. A large portion of Fundsmith’s portfolio is made up of consumer staples and healthcare, two sectors that have been heavily hit in recent years. And still, his Sortino ratio is significantly better than the market average. This is very relevant, because as Warren Buffett said in his early letters, the key to his success wasn’t so much outperforming every year, but rather falling less than the rest in bad times, and Terry Smith continues to deliver on that.
Moreover, if AI really is a financial bubble, it’s possible that this underperformance could completely reverse.
Another element to consider is that the factor he invests in the quality factor, has underperformed the market, but that relates to what I said earlier. This factor typically does worse in bull markets but much better in bear markets. Also, if we compare him with the most similar class of funds (Seilern, for example), Terry Smith hasn’t done worse, quite the opposite.
There’s another part of your argument that I don’t buy: the idea of putting all your money into Apple and having made a 33x return in that time. Doing that would have meant taking on much more risk than investing in a portfolio of 20+ companies across different sectors and revenue sources. Berkshire is more comparable because it can be considered a pseudo–investment fund, but arguments similar to the ones made about Terry Smith were also made about Warren Buffett for many years just look at what people were saying about him in the years leading up to the dot-com bubble.
I do agree, though, on the importance of understanding the future, the ROIIC, and the reinvestment rate. That said, I believe he can continue delivering double-digit returns over the long term with very low volatility and low fees (although if someone prefers to invest in an MSCI Quality ETF, it might well be a better alternative, to be honest). Many of the companies he owns are over a century old, still have room to grow, and remain leaders in their current markets. Their slower growth compared to other companies is due to supply-chain issues and affordability crises. They have low debt, lots of cash, and strong returns characteristics that help them fall less during difficult economic periods.
P.S.: Another reason for this year’s large underperformance is the undervaluation of the dollar. Terry Smith doesn’t hedge currency risk, which makes sense for a long-term investor. Although yes, he also would have underperformed even without the dollar depreciation. Anyway, great article, lots of interesting ideas, and I’m looking forward to reading your thoughts!
Great thoughts, thank you for the detailed engagement, it’s great to read well constructed counter arguments.
Here is what I think:
1) I agree that key to success isn’t outperforming every year. As I have said, I think quality investors will likely go down after portfolio reconstructions or big buys given that we want the price to be attractive, and of the price has become attractive, there was a downtrend, and trends tend to continue for some time. We don’t bottom fish, we buy when it’s good enough, so it’s likely that we suffer from further downtrend and completely understandable.
However, when I look at his companies, I don’t think that underperformance can be explained by quality factor or other things. I can agree with those arguments if he was holding things like let’s say Adobe. But no, his companies are simply not growing enough. When you adjust for inflation, their real growth is often around 1-2%. This is the main reason in his outperformance in my view, rather than the sector allocation or something else.
Also, you are right about holding solely Apple, I know it was just there to make a point. This is why I added Buffett example.
You also said same arguments are made for Buffett, which is right, but as I said, Buffett could overcome this because of the holding structure. Terry Smith couldn’t.
I completely agree—high returns on capital mean very little if a company has no opportunities to reinvest that capital. And, of course, it is extremely favourable when a business can reinvest substantially more. Still, I believe the Terry Smith investing approach works over the long run. As someone mentioned in the comment section, AI drove a large share of market gains over the last five years, so using that period to claim the Terry Smith approach doesn’t work isn’t a strong argument. If this underperformance persists through a market downturn or another five-year stretch, then perhaps criticism will be justified—but it’s too early to draw that conclusion now.
I continue to believe investors should look for companies that earn high returns on capital and have decent reinvestment opportunities. Consider two companies: one earns a 10% return on capital, and the other earns 20%. Both maintain these returns going forward. Company A can reinvest 50% of its earnings; Company B can reinvest 25%. The compounding rate for both ends up roughly the same: 5%. However, Company B—with fewer reinvestment opportunities—returns 75% of its earnings to shareholders, while Company A returns only 50%. And this is before considering scenarios where returns on capital rise well beyond 20%.
Of course, this framework doesn’t always hold. Ideally, you would have invested in an Amazon—lower returns on capital early on, but the ability to reinvest nearly 100% of earnings back into the business. The challenge is that analysing such companies is much harder and often riskier, because reinvestment frequently requires expansion far beyond the original business model. Businesses able to reinvest at high rates within their core operations tend to be smaller, faster-growing firms. Identifying those future winners is far more difficult and, in most cases, riskier. With the Terry Smith approach, you are not trying to find the next winners—you are buying the companies that have already won.
As you are in the business of picking exceptional companies, Oguz, would you exclude the possibility for your picks to develop into High-ROIIC compounders? Maybe in reality you are the Wayne Gretzky amongst ROIIC aficionados?
I would stay humble. I think I am much more oriented toward intangibles, and I like to invest when neither ROIC or ROIIC are clear, if I am investing for growth.
It's ROIIC, not ROIC, stupid.
True
Truly exceptional companies that can deploy large amounts of capital at high returns are very rare, as Buffett says. They aren’t one in a hundred; they are one in a thousand.
.
Remark:
PDX deploys large amounts of capital at very high ROA & ROIC.
I’ll check it out! Thank you!
Great piece and great insights! Bravo!
Thank you so much!
Bravo, excellent critique! This is why we subscribe!
Thank you so much! Glad you liked it.
Your Welccome! I find your take on markets/individual securities fascinating. Love brewing a cup of coffee & reading you!
Ah the mini skirt analogy, luv it.. 😂
I think it originally belongs to Sir Alex Ferguson.
He said it in a post game interview for stats when he was managing Man UTD.
P/E ÷ CROIC or P/E ÷ ROIC are better yardstick than FCF Yield on the Investor Side (FCF/Price).
CROIC is the FCF Yield on the Business Side (FCF/IC).
.
Terry Smith's valuation methodologies still have rooms to get improvement.
ROIC is a better yardstick than ROCE.
Agreed