Source: Smart Investors

Terry Smith (Terry Smith) is the founder and chief investment officer of the fund company Fundsmith. He is also one of the most successful fund managers in the UK, and is known as “Warren Buffett of the UK”.

Smith worked for Barclays Bank and UBS in his early years, and later became the CEO of Delevingdon and Gollinster securities companies.

I have been in the business for 50 years and have experienced many rounds of stock market cycles. Fundsmith was founded in 2010.

He knows how difficult it is to keep a calm mind in a bear market, so he focuses on a few high-quality stocks. Usually he holds 20 or 30 stocks in one fund, and generally avoids cyclical industries or areas where large amounts of leverage are needed to generate attractive returns.

Moreover, the turnover rate is extremely low, basically maintaining 5% to 10% a year.

Since its establishment in November 2010 to the end of 2023, Fundsmith's cumulative return on equity funds was 549.7% (15.3% annualized), and the cumulative return on the MSCI World Index for the same period was 316.7% (11.5% annualized).

By the end of the quarter, Fundsmith had a management scale of £29 billion (approximately RMB 268.5 billion), making it the largest active equity fund in the UK.

(Note: According to 13F, Fundsmith's latest holding has a market value of US$25.55 billion. (According to Smith's 2023 letter to shareholders, the US market accounts for about 69% of the management scale, with an estimated total size of 37 billion US dollars.)

In addition to the annual shareholders' meetings and immovable shareholder letters, Smith also really likes to write investment notes. The book “How to Invest in Growth Stocks” is his collection of investment essays from 2010 to 2020.

But he doesn't come out for interviews very often.

In May of this year, Smith was rarely interviewed by “The Market NZZ”. He unequivocally talked about the advantages of the biggest seller, Novo Nord and NORD, which stocks he liked in the “Big Seven” and which stocks he would buy if they were cheap.

Among Fundsmith's holdings in 2023, Meta, Microsoft, Novo Nordisk, and L'Oréal contributed the most to performance. However, in the distribution of the industry, the largest holdings are consumer necessities and healthcare, accounting for about 60% of the total holdings.

“For us, most companies are uninvestable,” the stock market veteran said.

Smith also revealed how he discovered good stocks and what targets he recently bought.

“We love companies that make money from lots of routine, repetitive, and relatively predictable businesses,” he repeatedly emphasized.

It is worth mentioning that in this year's shareholder letter, Smith quoted Munger's closing words, representing his views on today's world affairs, “If you're not at all confused about what's happening, you don't understand it.”

Smart Investors shared an accurate translation of this interview with everyone.

01 About stock selection criteria

Q Your goal is to run the best equity fund in the world. How do you pick the stocks that deliver the best results?

Smith, to be precise, the best fund we're talking about means that it still has the best performance even after risk adjustments.

Of course, if you have a “red fried chicken,” your performance will definitely be better than ours.

The problem is that once there is a risk, like in 2022, when some stocks fall by 30%-50%, you cause huge fluctuations for investors, which could cause you or them to make very wrong decisions.

For us, it's important to get a reasonable and stable return over a period of time, as well as an above average return.

Q. So how do you choose stocks to achieve this goal?

Smith, we have a long list of standards. In summary, there are two:

First, we look for companies with a high return on capital. The average return on capital of the companies in our portfolio is around 30%. This means that for every dollar of capital we hold in these companies, they can generate 30 cents in profit. This is probably 70% or 80% above the market average.

Furthermore, we are still looking for sources of growth, otherwise there would be no good return to invest. If a company simply returns money to shareholders, then what we actually get is a high-yield bond.

There is no compound interest on high-yield bonds.

Companies can generate compound interest value; they use part of the proceeds for us to better allocate assets.

Q What else would you like the company to have?

Smith has a certain degree of predictability.

The companies we love often allow us to make money from lots of everyday, repetitive, and relatively predictable events and deals. We don't like targets that rely on one-time opportunities, such as film companies. Will one film sell big? It's actually hard for you to predict.

There are also large-scale construction projects, which are similar.

We prefer toothbrushes, bathroom supplies, dog food, or medical tests, or operating systems like Microsoft Windows, etc. These businesses are relatively easy for you to predict and determine if they are sustainable.

Q What is the last thing you do when choosing stocks? Putting Smith last doesn't mean it's unimportant. That is, when allocating capital, it is necessary to understand some management skills and thinking.

If you think about it, if you're a senior in these companies, your business has a 30% return on capital, you will sometimes do stupid things, such as brainless mergers and acquisitions.

Therefore, we are looking for smart and responsible people who can allocate capital rationally and honestly.

Q With these restrictions, you probably won't be able to invest in many companies in the first place.

Smith In fact, it's true that we don't invest in most companies.

(Note: Fundsmith's latest heavy-duty stocks include in order$Novo-Nordisk A/S (NVO.US)$,$Microsoft (MSFT.US)$,$Meta Platforms (META.US)$,$L'Oreal SA Unsponsored ADR (LRLCY.US)$,$Stryker Corp (SYK.US)$,$Visa (V.US)$,$Philip Morris International (PM.US)$,$LVMH Moet Hennessy Louis Vuitton (LVMUY.US)$etc.)

02 About industry choices

Q So there are many industries that aren't part of your portfolio, such as mining, oil and gas companies...

Smith utilities, transportation, banking, insurance, real estate? Yes, we don't have any of these things.

Ask them because they don't meet your requirements.

The Smith NYU Stern School of Business conducts regular surveys of thousands of companies each year, and their measure is return on capital use minus weighted average cost of capital (which is also an indicator Bill Miller takes very seriously).

I think this is the most important measure of a company's performance!

That's not what I'm saying; this is what Warren Buffett wrote in his 1979 shareholder letter.

If you take a look at this list and look at companies whose profits exceed the cost of capital, you'll find that they all fall into the following industries:

Mandatory consumption, optional consumption, information technology, medical services, information technology services, business services, etc. Their benefits are higher than the cost of capital. That means they're constantly creating value.

Then, take a look at companies that consistently make less profit than their cost of capital...

Q What are all the industries?

Smith mining and minerals, oil and gas, banking, investment banking, brokerage, real estate, transportation, etc. (not well grasped) are disasters.

In every economic cycle, there will be a period where the mining industry performs well, airlines perform well, or the banking industry makes a comeback, but that is usually one or two out of ten years.

Panthers don't change spots (over a period of one or two years), nor do they change the texture of a company. There are only a few sweet spots in a cycle, and there is a chance for chickens and dogs to ascend to heaven.

03 About the company's valuation

Q We have a framework for choosing a good company, but how can we make sure we don't pay too much?

Smith's valuation is less important than quality.

We looked back at the price-earnings ratio you could pay for some companies over the past 50 years, and these companies still outperformed the S&P 500.

In the case of L'Oréal, you can pay an initial price-earnings ratio of up to 281x.

People aren't good at calculating differences between different compound returns. It's hard for us to tell the difference between a 10% return and a 12% return. We thought there was a 20% difference between the two numbers, but that's not true.

Having a good company is more important than owning an undervalued company.

Q Can you elaborate?

Smith Buffett famously said, “Buying a good company at a reasonable price is better than buying a mediocre company at a lower price.”

If you own a mediocre company at a lower price, and you hope to get back to the correct valuation, it's often difficult to keep up. You have to keep going and look for other targets (to achieve your return).

And only great companies can keep on giving you gifts.

Q But you can't ignore the valuation either, right?

Smith certainly wouldn't ignore it.

We have a very simple rule of thumb, which is to divide the free cash flow generated by a company by its market value, which is the return on free cash flow.

Then estimate what we think will be the medium term growth rate. We're pretty good at estimating because we invest in companies that are more predictable.

If you put the yield and growth rate together, you can roughly estimate the expected return.

Over a long period of time, the stock market returned about 9% to 10%. If we find a really good company, the return will be over 10%. If the return on free cash flow is 4% and the growth rate is 10%, then we can get a return of 14%, which should outperform the index.

As to whether the yield is 1%, the growth rate is 13%, or the yield is 4%, and the growth rate is 10%, it actually doesn't matter.

04 About Novo Nordisk

Q If you look at it now, do you think Novo Nordisk is still attractive? If you look at the price-earnings ratio, it's quite expensive.

What do you compare yourself to, Smith?

Q How is it compared to the market or industry?

Smithsonian and Nord's price-earnings ratio is 45 times. What is the closest comparable company? Eli Lilai.

Eli Lilly produces Mounjaro and Zepbound, which are among the other weight loss pills. Lilly's price-earnings ratio is 74 times, which probably means it's valued higher.

There is no point in comparing Novo Nordisk to the market. I'm not even sure if I want to compare it to the pharmaceutical industry.

Novo Nordisk has adopted a unique approach to drug development, which is why Novo Nordisk has been able to get to where it is today.

A price-earnings ratio of 45 times seems expensive, but considering the growth rate, it's not that expensive. Currently, it is growing at a rate of well over 20%, and probably close to 30%. As a result, valuations will quickly drop.

After two years, its price-earnings ratio will be around 20 times, the same as the general market.

Q Can Novo Nordisk maintain this growth rate?

It's clear to Smith that the company has made breakthroughs in obesity drugs and has received quite a few patent protections.

But it also has tag protection. When you develop a drug, you have to go through the FDA's approval process, and you have to get approval to test it.

Ozempic was initially used to treat type II diabetes, then data clearly showed that it also helps with weight loss. But you can't just sell it to weight losers; you have to go back and run new tests on people without type II diabetes to see if it's an effective and safe way to lose weight.

Novo Nordisk is now a few steps ahead of the competition.

Q. Does this medication seem to have any other benefits?

Smith Whether the patient is overweight or diabetic, Ozempic can significantly reduce major cardiovascular events by 20% to 25%, reducing the risk of heart attacks and strokes.

Its remarkable effects in treating the liver and kidneys, treating autoimmune diseases, diseases such as arthritis, lupus erythematosus, gout, and even treating symptoms such as alcoholism may one day be fully recognized.

Novo Nordisk is far ahead in competition in the industry, so it's hard to catch up.

Importantly, we didn't invest in Novo Nordisk because of its diet pills. We invested in Novo Nordisk because of their excellent drug development process, rather than spending a lot of money to bet on what specific drug they have developed.

Of course, not everything can be said accurately. Many things can also be misjudged.

05 About the Magnificent Seven

Q In addition to the popularity of the diet pill concept, the “Big Seven Magnificent Seven” is also very popular. Your fund holds Alphabet, Meta, and Microsoft. Why these three?

Strictly speaking, Smith owns four companies, mainly Apple's holding too few (not in the top ten positions).

Let's talk about Tesla first. Tesla didn't meet any of the buying criteria I just talked about. It's a car company! Even the best car companies in the world — Toyota, BMW, and Volkswagen — aren't getting enough in return.

It's a really bad industry. Ford's return on capital is only 3%, which is a few percentage points lower than US Treasury bonds!

Q. How many other “Big Seven” companies have you bought?

Smith Alphabet's price-earnings ratio is 25x.

We're talking about a company that co-monopolizes the online advertising market with Meta. Unless it does something fatal, its business is still pretty good, and there are currently no signs that it could disrupt this situation.

Meta is a little cheaper and has a 24x price-earnings ratio. Compared to Alphabet's duopoly position in online advertising, it's pretty good.

Meta has 2 billion daily users and is growing. People are complaining that the growth rate is only 3-4%. But Meta has 2 billion users, what more growth rate can you expect?

Microsoft is a global leader in business software, and in the field of cloud computing, it has almost formed a duopoly with Amazon Web Services. It also has the world's leading operating system, and approximately 99.9% of ATMs around the world run the Microsoft operating system.

Although it lost to Apple and Samsung in the mobile field, it has partnered with Activision (Activision) to occupy an important position in the gaming sector,

Microsoft's Surface tablet was also quite successful, which is a very good business. I think Satya Nadella has proven to be a great CEO.

Admittedly, Microsoft's price-earnings ratio is around 35, which is the most expensive of the companies mentioned above.

Q. But in your opinion, this (Microsoft valuation) is still very attractive?

When compared to his peers, take a look at Nvidia, another member of the “Big Seven”, which has a price-earnings ratio of 75. Compared to Nvidia, Novo Nordisk is much cheaper.

(Actually, apart from Nvidia) there are other companies that are also benefiting from the boom in artificial intelligence. Shares like Adobe and Intuit have risen 70% over the past year, even though I really can't see how they make money from artificial intelligence.

Even if they can build artificial intelligence into graphics software and accounting software, don't they have large language models? Aren't they just paying a huge amount of money to the supplier?

As a result, Intuit's price-earnings ratio increased 64 times, and Adobe's price-earnings ratio increased 38 times. By comparison, Microsoft seems pretty cheap.

Of course, the “Big Seven” have their own differences. We invest in companies that are cheaper and more predictable.

Q: “If we can buy well-known shovel manufacturers, like Nvidia, to produce the chips needed to run large language models, then we don't need to know who will win the AI revolution in the end.” What do you think of this statement?

Smith I don't think Nvidia's GPU demand will continue to grow exponentially.

They are doing a great job now and have provided plenty of shovels as well. But if no one digs for the gold, I don't think you need more pickaxes and shovels.

Also, competition exists. Nvidia has gone through two transformations in its life, and of course, a very successful transformation. But during these two transformations, the stock price fell 80% twice.

06 About some other targets

Q: You also invested in the tobacco company Philip Morris. Is this company really growing?

Over the past few years, Smith's sales have increased by about 10% a year.

We are retaining Philip Morris because it is a low risk target and a global leader in providing heated non-combustible tobacco products.

You can buy a device called IQOS (I Quit Ordinary Smoking, short for “I quit regular smoking”), and you put a HEET stick in it, it looks like a small cigarette, and it heats the tobacco as soon as you smoke it.

It does not burn tobacco and does not produce smoke. The FDA (US Food and Drug Administration) isn't friends with big tobacco merchants, but they also say this tobacco reduces the harm of smoking by 95%.

Also, unlike e-cigarettes, it doesn't appeal to young people because it tastes like tobacco. In fact, it targets smokers, and allows them to use safer smoking methods.

The company is also a global leader in oral products, and its Swedish match product Zyn is a nicotine pouch. There's no tobacco in it at all. It's a nicotine product, but the annual growth rate is likely to reach 75%.

As a result, although the traditional cigarette business is not growing much in volume, Philip Morris' business is still growing.

Ask you don't have any Swiss companies in your fund. Are they too expensive?

Smith We are interested in some Swiss companies, but we don't currently have any holdings. Possible companies include Nestle, TTM, Sonova, SGS, Geberit, and our colleagues who manage medium-sized funds are watching companies like Inficon and VAT.

Isn't Xinda (a large Swiss multinational lift and escalator supplier and service company) attractive enough?

Smith, we bought TTM, but later switched to Otis because I think TTM has lost its way a bit.

If you compare it to its rivals Otis or KONE, you'll find that it has performed relatively poorly over a long period of time. We saw this, and management didn't seem to have a good response.

Q What about Nestle?

The same goes for Nestle Smith. We are skeptical about the current health promotion strategy because it doesn't really increase free cash flow. You could say we're old antiques, but we'd like to see some real results.

I'm not opposed to owning Nestlé shares, but currently we are more optimistic about other stocks, such as Unilever. But Nestlé won't leave our observation pool.

07 About new entrants and potential targets

Q: Your turnover rate is extremely low. What was the last stock you bought?

Smith, we bought two things this year.

One of them hasn't been revealed yet because we're still buying it. The other one is$Fortinet (FTNT.US)$, Internet security business.

If you have a firewall on themarket.ch, then there's about a 1 in 2 chance that you're using a Fortinet router to keep you safe.

As far as security is concerned, the competition between Fortinet and Palo Alto Networks can be described as a loss for both.

Cybersecurity is clearly a big area of growth. The company has experienced a relatively long period of annual growth of around 20%. Later, when everyone worked from home during the pandemic, the company's annual growth rate jumped to 40%, and the stock price skyrocketed.

After soaring, its sales fell back to 10%, and although there were no problems with the basic business, the market fled the ship.

Q Are there any good companies on your radar screen that just haven't met your valuation criteria?

Smith, I have a simple answer: Hermès. This is a very good company. It doesn't have as many luxury brands as the LVMH Group, but it's positioned very accurately.

Q You wrote in your January letter to shareholders that the stocks that get the most criticism from customers are usually the best stocks. Which company received the most negative reviews this time around?

What's interesting about Smith is that this time the feedback was much milder. This year, our holdings have not been criticized or complained about like Meta or even Microsoft before.

Editor/Somer