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“Buy good companies, don’t overpay, do nothing.” This is the mantra that made Terry Smith reportedly a billionaire and, if on a smaller scale, produced riches for many who invested in his flagship fund, Fundsmith Equity.
Smith said the way to build long-term wealth was to identify “quality” companies – by which he meant those whose sustainable competitive advantages allowed them to make large percentage returns on their assets, produce those returns in cash and do so without excess borrowing – and to simply buy and hold them, taking care not to overpay.
It’s a strategy admirable for its simplicity and, when assessed over the long term, for the returns it has produced.
This column must admit to a niggle about it, however, albeit not one restricted to Smith but one that would apply to any fund manager who says he or she will take pains not to overpay when a holding is added to their portfolio.
The niggle is this: Smith or his rivals may indeed manage not to overpay when they buy their holdings, but that’s not to say their investors won’t overpay when they invest in the fund.
We can hardly blame Smith for the fact that his Smithson investment trust, for example, soared in value during the pandemic, but the fact remains that anyone who bought the trust at the peak in December 2021, before inflation turned everything on its head, has suffered a severe loss.
That loss remains even if Smith avoided overpaying for any of his holdings.
This column had tipped the trust at the beginning of that year, when the share price was considerably lower, so the loss for readers who followed that tip is correspondingly smaller, if still painful at 26pc.
The right course of action for Questor would, of course, have been to take note of the rapid rise in the trust’s shares in 2021, decide that its holdings had become overvalued and advise readers to take profits.
However, as a writer at a rival publication amusingly put it this week, the performance of Hindsight Investment Management is always excellent.
We can only apologise for our failure to sell and assess whether, at the current price, shareholders should hold on or indeed buy more.
The question we must ask ourselves, in view of what we have said above, is this: if we buy Smithson now, are we in effect overpaying for its holdings?
One of the most important principles to keep in our heads at all times is that a good company is not always the same thing as a good investment.
Questor has every confidence that the trust’s holdings are indeed excellent businesses and meet the “quality” definition that Smith stands by. But do they make excellent investments at their current valuations?
One number from the trust’s interim report for the six months to June stands out: the free cash flow yield of the Smithson portfolio was 2.3pc. Simon Barnard, the lead manager, said certain short-term factors at particular holdings had depressed the figure and if those factors were adjusted for the free cash flow yield was more like 3pc.
If we also take into account the trust’s discount and the share price fall since the end of June the free cash flow yield relative to the fund’s current market value is likely to be nearer 4pc by Questor’s calculations.
This sounds rather a meagre figure when bonds and cash yield more. However, we must remember that bonds (unless index-linked) and cash offer no scope for growth in their cash returns, whereas Smithson is dedicated to investing in companies that it thinks can grow smartly, sustainably and profitably.
Taking both the current free cash flow yield and the scope for growth into consideration, Questor’s sense is that Smithson is not cheap but about fairly valued.
There is therefore no case to advise readers to sell and crystallise a big loss. Equally, we can’t see the trust as a compelling buy at current levels. Hold.
Questor says: hold
Ticker: SSON
Share price at close: £12.59
Update: Edinburgh
The trust’s manager, James de Uphaugh, is to leave Liontrust, Edinburgh’s fund management company, in February.
His replacement, Imran Sattar, has decades of experience in fund management and has worked alongside de Uphaugh for many years.
“Imran will continue to apply the same flexible investment process that has been the hallmark of the portfolio since March 2020,” the trust said.
We’ll hold, but keep an eye on progress.
Questor says: hold
Ticker: EDIN
Share price at close: 666p
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