Fundsmith Equity Fund

What about growth in FCF?

The topic is addressed annually in Fundsmith letter to shareholders. Example 2023:
"The second leg of our strategy is about valuation. The weighted average free cash flow (‘FCF’) yield (the free cash flow generated as a percentage of the market value) of the portfolio at the outset of the year was 3.2% and ended it at 3.0%. The year-end median FCF yield on the S&P 500 was 3.7%. Our portfolio consists of companies that are fundamentally a lot better than the average of those in the S&P 500 so it is no surprise that they are valued more highly than the average S&P 500 company. In itself this does not necessarily make the stocks expensive, any more than a lowly rating makes a stock cheap. "

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Since Fundsmith focuses on quality companies, wouldn’t a MSCI World Quality be more appropriate? But this would also be problematic, because every strategy can somehow be replicated by an index, which would mean one would automatically underperform because of higher active management cost.

Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns . If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”

“A great business at a fair price is superior to a fair business at a great price.”

Charlie Munger

Fundsmith select stocks that they think will maintain a much higher ROC that the market and they hold them. There is a kind of “insurance” since if successful in predicting high ROC then mathematics dictates they will beat the market anyway even if the price paid seemed high

My point is that with smaller companies I think it is more difficult to predict whether high ROC will be maintained. The Smithson fund manager acknowledges it in the video.

Thats what I wanted to express with my blahdiblub above. They buy very profitable companies but with low Free Cash Flow Yield. In their presentation, they never mentioned anything that indicates FCF Growth. The story only works if they:
i) Identify Companies with high ROIC
ii) either:buy then at high Free Cashflow Yield AND the ROIC stays high (but no growth) AND they can hold the company long term
iii) OR: they buy them at medium-low Free Cashflow Yield (as they do) but they manage to grow the FCF AND they can hold the company long term

They didn’t show any signle figure that indicates FCF was growing in their companies… so we can’t expect them to deliver superior performance. Clearly, I don’t assume it but lets say these were perls with high Free Cash Flow but they distribute 100% of it as they can’t re-inest it profitable; such company would experience zero growth even after centuries.

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In their AGM presentation on the website their KPIs (Key Performance Indicators) include ROCE and Cash conversion. If these 2 stay high the cash flow growth should be high (they were both much higher than the market)

Maybe they could also add Cash Flow growth as a KPI, I guess there is a trade off with having too many KPIs though

If I had a gold sh** donkey, I would sit on a business that:

  • Generated Loads of ROCE
  • Had very high Cash Conversion

If I bought this donkey at a Free Cashflow Yield below the stock market, that gold donkey was still a bad investment. Why? It generates loads of free cashflow - but I can neither grow it (its sterile and we can’t clone it), I can’t re-invest the free cash flow at a better FCF Yield and/or FCF Growth Rate elsewhere and all the “value” of the donkey has gone to the one that sold me the donkey at the FCF Yield.

ROCE or Cash Conversion are meaningless, unless you either

  • Buy the ROCE / Cash Conversion at a great FCF Yield
  • you can internally re-invested the cash at comparable ROCE
  • you can externally re-invest the cash in other businesses (which then raises the question why you even bought this gold donkey in the first hand)

Either I get it wrong, and then please tell me so … or I thinkk that the fact that they don’t show any Cash Flow Growth KPIs as quite a reviel.

Correct. Fundsmith strategy is exactly this. Invest in companies with deep moats that they believe can reinvest cash at high ROCE and plan to hold the companies for a long time. They seem to have been able to deliver on it so far. Buffet, Munger followed a similar strategy

Regards Smithson: it seems a reasonable assumption to me that it is harder to reapply to smaller companies because future ROCE is harder to predict. I don’t feel reassured by what the Fund Manager said about this and I don’t plan to add to my SSON holdings

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Ramin Nakisa at Pensioncraft makes excellent videos, he just posted one on active funds, let’s see how they performed…and where is Fundsmith. He also included one passive fund (QQQ!). The trend is clear: US, Tech, Growth (passive or not) has smashed everything the last 10 years. Anyone surprised?

Here’s the vid:


Very good! Now a billion dollars question: what will smash everything from 2024 to 2034?


I am generally wary of a pension fund manager who talks more about the past than the future. Formulating predictions about the past is not that impressive

I am a firm believer that if one is going to deviate from a low cost total market tracker like VT you ought to be clear why.

In my case I own Fundsmith instead of VT because I am confident in their strategy and execution. I believe it is probable it will continue to outperform VT.

If I am wrong I believe the magnitude of any future underperformance vs VT is likely to be limited and would still generate the wealth I need in a time frame I am happy with.

I can’t predict the future and I might have a better outcome by allocating savings to S&P500, Nasdaq or BTC but those all seem to involve higher risks, that I don’t need to take. “A bird in the hand is worth 2 in the bush” etc.

Fundsmith annual letter 2023 :

"Our Fund is still the best performer since its inception in November
2010 in the Investment Association Global sector of 165 funds, with
a return 335 percentage points above the sector average which has
delivered just 215% over the same timeframe.

Outperforming the market or even making a positive return is not
something you should expect from our Fund in every year or
reporting period, and outperforming the market was more than
usually challenging in 2023. The performance of the Nasdaq
Composite Index, which was up 43% in USD in 2023, was dominated
by a few companies, the so-called Magnificent Seven — Alphabet,
Amazon, Apple, Meta, Microsoft, Nvidia and Tesla — which
accounted for 68% of that Index’s gains. Nvidia, the designer of chips
for use in AI applications, alone accounted for 11% of the 43% gain.
We do not own all the Magnificent Seven and would probably not be
willing to take the risk of doing so, even if all of them fitted our
investment criteria."

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I think my post was misunderstood. I was hinting that the obvious reason Fundsmith didn’t beat other funds/benchmarks was because it’s not as overweight in US Tech Growth, which is exactly what Terry Smith says in the excerpt you pasted. In any case, 15% annualized 10-year return is amazing.

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That’s in GBP of course. In CHF probably ~3% p.a. lower (would need to calculate it)

Still, I run my assumptions for the future with 7% per year, but 10-12% would make a huge difference.

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That’s true. However I think he is mostly trying to fulfil the demand from his viewers who constantly need to feel sure that they are doing right thing.

But the whole concept of growth of Index investing is also based on past performance. The conviction grows with realised results even though it shouldn’t.

Even though it might have theoretical basis, people generally follow the money. Since history shows that passive beats active, people gravitated to passive. I doubt many people actually did the future expected returns calculation of passive.

For example -: many people know small caps in very long term beat Large caps. But how much money is in S&P 500 related funds vs Full US market?

The incremental vs. MSCI world is about 4% p.a. over 13.5 years since inception.

Prior to Fundsmith Terry Smith outperformed at Tullett Prebon for ~10 years in a period covering global financial crisis, but I can’t lay my hands on the data

[Edit: Chat GPT tells me Terry Smith delivered 15% p.a. return at Tullett Prebon in GBP terms between 2003 and 2013 when he stepped down to focus on Fundsmith. In the same period MSCI World delivered ~8.4% p.a. also measured in GBP]

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