Laith Khalaf, head of investment analysis at AJ Bell, comments on the latest annual shareholder letter from Terry Smith:
“Terry Smith’s latest shareholder letter is characteristically combative and engaging, despite a rare year of underperformance from his Fundsmith Equity fund. This year Smith takes aim at a familiarly favourite target, Unilever, while also challenging the more arcane practice of removing share-based executive compensation payments from certain profit measures.
“Smith also rails against the flaccid response he has received to attempts to engage with companies as a large and long term investor, especially when compared to the elevated status often quickly conferred on activist investors. He may well have a point here, as activist investors are likely to be viewed as a potentially noisy and disruptive threat to management, whereas large, long-term shareholders don’t generally want to rock the boat in public, and are perhaps consequently taken for granted.
“2022 was by far the worst calendar year of performance the Fundsmith Equity fund has endured since launch in 2010, both in absolute terms and relative to the global stock market. Higher inflation and rising interest rates have prompted the market to turn against the growth stocks favoured by Smith and other fund managers with a similar investment philosophy. All active managers will endure such periods of underperformance and particularly those like Smith, who have a distinctive style bias expressed through a concentrated portfolio.
“The big question is how long the current anti-growth coalition in the market will last, and act as a headwind to the performance of Fundsmith and peers. If selected judiciously, a high quality growth portfolio should do relatively well in terms of business performance in a recessionary environment, but there is still a risk from a deflation in valuations, especially with more interest rate rises in the post. In line with many other global funds, around 70% of Fundsmith Equity is invested in US stocks, and while valuations in this market have moderated in the last year or so, they still remain above long run averages. So valuations could fall further without defying the laws of statistics, and in an economic slowdown, profit growth can only be expected to pick up so much of the slack.
“Fundsmith investors shouldn’t therefore bank on an immediate return to the glory days of yore. Terry Smith has plenty of credit in the bank for past performance, and in the long run his simple, well-grounded investment philosophy is likely to deliver results. But Fundsmith investors may need to exercise more patience than they have needed to up to this point. Given the high regard in which Terry Smith is held by shareholders, that forbearance will almost certainly be forthcoming. All fund investors should seek some diversity in the approaches of the managers in their portfolio however, because as the recent value rally has demonstrated, even style trends which are deeply entrenched can be disrupted in dramatic fashion.”