The vulnerability in Terry Smith's Fundsmith strategy

James Mackreides claims that although Fundsmith has made investments in some great businesses, it has had trouble determining when to sell

Terry Smith began applying his knowledge to fund management after establishing a strong reputation as an analyst and business executive. His goal when he started the Fundsmith Equity Fund in 2010 was to enable direct online purchases by investors. He assured them of low fees, a simple investment process, minimal portfolio turnover, no index shadowing, and no attempts to time the market.

Smith made the straightforward argument that "buy good companies, don't overpay, and do nothing." The extremely readable "owners manual" on Fundsmith's website states that the company aims to "invest in a small number of high quality businesses with a sustainably high return on capital, strong cash generation, and assets that are intangible and difficult to replicate, and only own shares that will compound in value over the years."

Smith contends that although these stocks may appear pricey, "stock markets typically value companies on the not unreasonable assumption that their returns will regress to the mean." "Therein lies our opportunity; businesses whose returns do not do this become undervalued.

Investors concurred. Fundsmith Equity expanded swiftly, and by the end of 2021, its assets had surpassed £30 billion. The returns exceeded the MSCI World index by a significant margin. Since then, though, the fund has underperformed for four years in a row, and its assets have decreased to £20 billion. What has gone wrong, considering that Smith hasn't altered his approach to investing?

Fundsmith's strategy raises questions.

Because of Fundsmith's success, the corporate traits it seeks are now widely accepted. As a result, these firms' valuations have increased and their returns have decreased. At the moment, healthcare accounts for 27% of the portfolio, which has not been popular. On the other hand, banks, in which Smith claims he never makes investments, have performed exceptionally well. Despite his doubts regarding its valuation, Nvidia has also done so.

Even good businesses can experience hardships because of poor management or a short-term unfavorable business environment. The price of the shares will drop as a result, particularly if they are now overpriced. This is not taken into consideration by the "buy good companies, don't overpay, do nothing" thesis.

Diageo shares, which Fundsmith has owned since its founding, for instance, reached a high of 40 in early 2022, almost 30 times projected earnings per share, and significantly above their historical range. Then, it became clear that young people might be drinking less and that sales had been inflated during the pandemic. Smith chose to hold off on selling until 2024, when the price had dropped by 40%, even though valuation alone should have been grounds for selling.

LVMH, which has almost halved since trading on a multiple above 30 in early 2023, is still owned by Fundsmith. Additionally, it retains Novo Nordisk, which has lost two-thirds of its market share since mid-2024 as Eli Lilly gains market share in the weight-loss medication industry. The price of Novos' shares was well over 40 times its projected earnings a year ago. Even though it is a good company and might recover, Smith should have sold sooner.

Thus, there are concerns about whether Fundsmith Equity holds onto overpriced stocks for an extended period of time. When good stocks momentarily deviate from the path, it could then be too harsh. There are now chances for recovery from a company like Diageo.

Non-executive directors and analysts would have questioned the holdings and the thesis if this had been an investment trust. Additionally, they would have questioned its 1 percent yearly fee, which seems excessive for a fund of this size. However, it is not as closely examined because it is an open-ended fund.

With the lessons learned from a difficult few years, Fundsmith is likely to get its act together again. However, there isn't any indication of it yet.