Terry Smith, the founder of Fundsmith, is a man I greatly admire. He is an anomaly in the world of investing and finance due to his his straight talking nature. He is a breath of fresh air as he is one of the only fund managers to eschew fees, invest his own money in the funds he runs and doesn’t performance chase for short term gains. His flagship funds performance has been exceptional since its inception with cumulative returns of 260.9% or 19.1% per annum. For reference, the MSCI world index generated returns of 133.3% or 12.3% per annum over the same period. Terry Smith is one of those active mangers that outperforms. It is no wonder that his Fundsmith Equity Fund is one of the only mutual funds I invest in.
When it comes to investing, Terry Smith’s appears to have some stringent criteria. He looks for:
- high quality businesses that can sustain a high return on operating capital employed;
- businesses whose advantages are difficult to replicate;
- businesses which do not require significant leverage to generate returns;
- businesses with a high degree of certainty of growth from reinvestment of their cash flows at high rates of return;
- businesses that are resilient to change, particularly technological innovation;
- businesses whose valuation is considered by the Company to be attractive
Fundsmith invests in companies that have a long history of outperformance – the average founding date of the company’s in the portfolio is 1922! This is why it has come as a surprise that Fundsmith has recently initiated a position in Facebook. There has been much discussion regarding this new purchase with many people commenting that Terry Smith is abandoning his principles for a shiny new tech stock. I personally have been thinking hard about this purchase. Below are my thoughts about Facebook entering the Fundsmith portfolio.
Technology Stocks Have Historically Been Shunned By Buy And Hold Investors
Much of the debate surrounding Facebooks entry into the Fundsmith portfolio is to do with it being a technology stock. Historically, technology stocks have been a bad investment for a buy and hold investor due to the rate of technological change and quick nature in which businesses become obsolete. In his Brilliant book “Stocks for the Long Run”, Jeremy Siegel research indicates that high-tech investments have a strong tendency to fizzle out over time.
If you look at the best performing businesses over the past sixty years, they tend to sell products that are similar to what was being sold in the 1960s. I recently did a post on consumer staple stocks and why they have been so successful. It shows that company’s selling repeat everyday items that don’t change from year to year have made the best investments. Just look to Coca Cola, Colgate Palmolive and H.J Heinz for proof of this.
On the other hand, due to the rapid rate of change the occurs within the technology space, you don’t really know whether a company will still be relevant in two years, let alone 10 years! Just look at how fast companies like Nokia, Blackberry, Myspace and Yahoo have fallen into the abyss. This is why buy and hold investors have historically shunned investments in the tech space.
But the times they are changing. My expectation is that the future will be different for tech sector investors (a dangerous phrase, I know!) because tech companies are sitting on so much cash that they can effectively insulate themselves from technological obsolescence when their now-successful product lines fade away. Just look at what Facebook has done to keep it self relevant by buying out WhatsApp and Instagram for billions! Just 15 years ago, that would never have happened. Apple as well is another example of a company with huge cash reserves. It is more than theoretically possible that iPhones could cease to exist in twenty years and Apple stock could still deliver 8-10% annual returns for shareholders because the $200+ billion cash position could cobble together not-yet existence business lines that will provide the cash gushers of the future. Technology stocks of yesteryear did did not have these cash buffers and that is why they were not able to invest heavily in research and development and/or buy out the competition.
Just look at the start-up tech stocks of today, they have realised that the major players have so much cash and there strategy is to get bought out rather than disrupt. In the past, technology startups would appear in order to dislodge the incumbents. Google came up to take on Yahoo. Facebook came up to take on Myspace. But today, start-ups don’t want to change the status quo but want to get bought out. That is why you see the startups that get the most funding from venture capitalists are those that can add value to the likes of Alphabet (Google), Amazon, Apple, Cisco, Facebook and Microsoft to name a few.
The other factor about the large technology companies today is that they are harder to dislodge. This is because they have created an ecosystem. Take Apple for instance, it benefits by locking its customers in its eco system. By this I mean that if you have $200 worth of music for instance, you are likely to stick with iTunes as opposed to move to a different provider as you have already sunk in money. Furthermore, when it comes time to buying/upgrading a phone, you will stick to an iPhone because you would rather carry over your $200 worth of music (apps) from the iTunes store than start afresh using something like google play. This is just one example but there and many other things Apple is doing to lock in customers for life. Whilst this is not good as a consumer, it is great as an investor.
I don’t know what Apple, Facebook and Microsoft are going to look like in 2040, but I have a feeling that they’re still going to be around and pumping out cash. Their cash reserves are so high, and provide so many opportunities for business line diversification, that I cannot presume otherwise.
Facebook makes sense in the fundsmith portfolio.
The more I think about modern technology stocks, the more I aim inclined to think that Facebook stock fits perfectly with Terry Smiths philosophy. Looking at the criterial above:
- Facebook certainly generates high operating margins and returns on capital employed. The company is asset light so has very little capital expenditure – that is why it scaled so quickly. Being asset light also means that Facebook has a high level of Free Cash Flow that can be showered on to shareholders via dividends and stock buy backs. Just look at my write up on Fidessa for this.
- Facebook is definitely a business that is hard to replicate. It has a strong network effect as almost a quarter of the worlds population use it. It would be too difficult for another platform to prize away users from Facebook. Furthermore, any new user would join Facebook as opposed to any other platform as all their friends are on facebook. Additionally, many people have invested too much time and memories in facebook via posts, photos and videos making it too hard a platform to quit. In short, the company has a great ecosystem and fantastic lock in.
- Facebook has a bullet proof balance sheet with net cash on its balance sheet making it a strong investment candidate.
- Facebook offers a high degree of predictability. It is an addictive product – just count how many times you check facebook a day to see this! facebook commands eyeballs and that is what advertises want.
- Change in the technological industry will always exists and this problem is higher in this industry than any other. But as I mentioned earlier, Facebook has a large cash hoard and has a strong network effect making any dislodgement difficult.
- Whilst shares in facebook have increased almost five fold since its ipo in 2012, Facebook is arguably a better company now and worth paying up for. During the recent volatile period, Facebook shares had a Price To Free Cash Flow (P/FCF) of below 30 making it cheaper than it has been for a while – you need to understand the difference between value and price to appreciate this concept.
Looking at the above, Facebook is certainly a wonderful company and it is easy to see why Terry Smith bought share in it for his Fundsmith Equity Portfolio. Whilst I don’t own shares in Facebook, I have a similar investing philosophy to Terry Smith and have a number of tech stocks in my portfolio. To see what stocks I own and would buy given the right valuation, have a look at my stocks list.