Three simple questions to help you identify a winning fund

Terry Smith is a canny operator. The analyst, author (he wrote the seminal investment book Accounting for Growth) and financial services entrepreneur (he's built up vastly different businesses, such as broker Collins Stewart and fund manager Fundsmith) has spotted yet another great opportunity.

The launch of his new investment trust, Fundsmith Emerging Equities Trust (FEET), has been brilliantly timed. I've been thinking about raising my exposure to developing-world stocks, and would seriously consider using this trust.

But before I buy into the Fundsmith way' (Smith is one of a growing number of investment entrepreneurs, including Neil Woodford, who are building their brands around an individual), I want to run you through a thought process I believe all investors should follow to improve their discipline. I like to ask three simple questions about any new fund I'm considering, before I invest.

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1. Do I like the asset-class opportunity?

2. Do I like the way the fund is achieving its objective of growing my wealth?

3. Do I like the look' of the manager, and is the fund properly structured to capture the opportunity, at a reasonable cost?

The first question boils down to: are emerging markets cheap enough yet?

I'll look at this in more detail in my next article. For now, my answer is that I think they are, but with some key caveats.

I believe that value investors will do well, as will those who focus on businesses that are paying a robust, growing dividend income. I also think you will be better off favouring certain countries over others.

On the downside, I'm concerned we've still got some nasty shocks in store. But in broad terms, now is a good time to start growing your emerging-markets exposure just remember that you'll need some courage and fortitude to stick with it.

So, Fundsmith's new closed-end investment trust arrives at a good time.

The fund has raised a sensible amount of money just under £200m which should be easily investable over the next few months. So the answer to my first question is yes' (with my cautions and caveats noted).

Why not use an index tracker?

The second question is about the strategy. In Fundsmith's case, the trust focuses on individual stockpicking. It's biased towards consumer stocks, and looks for growth at a reasonable price'.

That might sound complicated, but it's really what US investment giant Warren Buffett preaches great businesses, with great brands, making sensible use of capital, delivering decent rates of return and not carrying too much debt, all with the prospect of decent growth on top as they look to serve the vast and growing developing-world consumer market.

Below, I've highlighted these key investment screens' they're all sensible ideas, based on the blueprint provided by Fundsmith's existing non-emerging-market fund.

But the devil is always in the detail what valuation metrics are being used? Are measures such as the price-to-book ratio, or the dividend yield, useful? These seem like nerdy questions. But they matter, because high-quality emerging-market-based consumer stocks are hardly the lepers of the investment world.

Smart investors with a long track record in this sector such as Singapore-based Hugh Young from Aberdeen Asset Management have been ploughing this furrow for decades. They complain it's become a very crowded area, and as a result investors are paying potentially expensive prices (20 to 30 times profits) for the consumer giants of tomorrow (and today, for that matter).

The contrarian in me also argues that if you believe quality consumer giants are the way forward, then why restrict yourself to emerging markets? Why not have one fund that invests globally in developed and developing markets and be done with it, perhaps using an index-tracking exchange-traded fund (ETF)?

But Smith makes a fair point when he says that many ETFs are too broad brush and too market-cap-weighted to achieve the focus needed to tap into the emerging-market consumer opportunity.

So, I think that active stockpicking does work in this particular sector. But ideally I'd want my margin of safetyfrom investing in these obviously risky markets to come from buying into selected stocks where the price is low.

This would mean looking for a more value-orientated strategy, probably one with some smaller businesses lurking in the portfolio. It would also mean looking for a more contrarian stance, one that focuses on countries, sectors and themes that are unloved.

But this value approach is rarely applied in this area, so I think that the only answer is either to work hard at identifying particular opportunities within the vast emerging-market universe yourself or just to make your life simple and go for the long-term strategy of buying quality consumer names using the same approach as FEET and Aberdeen.

What about the manager?

My third question do I like the look of the manager and the fund's structure? introduces more awkward questions.

Obviously, Smith is a great investor who rightly attracts a lot of positive media attention and is also hugely respected in the Square Mile. He's also gone out of his way to outline a succession' plan in case he's hit by a bus while crossing one of those City roads.

But I'm rather more intrigued by questions related to how a London and US-based team will be managing a portfolio based in the developing world.

How many meetings will there be with local managers? Wouldn't it be better to have local fund managers on the team? And will Smith's magic rub off on his team of analysts as they do their day-to-day work? I've no idea how these questions will be answered the good old test of time is the proper answer.

There are also some practical questions on cost. The fund will charge 1.25% a year. Total cost of ownership is likely to be around 1.6% to 1.75%. This isn't unreasonable, but it's not cheap for the average emerging-market investment trust.

For example, the Templeton Emerging Markets Investment Trust (LSE: TEM) has a management charge of 1.1%, while the Advance Developing Markets Fund (LSE: ADMF) has a 1% charge.

Meanwhile, many ETFs in this sector tend to have a total expense ratio (TER) of around 0.5%-0.7% a year, so FEET will need to beat these index trackers by at least 1% a year to make a difference. You're also currently buying at a premium to net asset value.

The last time I looked it was about 8%. That's not too bad for a fund from such a well-known manager. But I suspect that premium might wilt if there was another emerging -markets panic as there might be, for example, if China was to undershoot its already modest growth targets.

So overall, I'd say that the FEET fund answers my first two questions in the affirmative, but I'm not completely convinced on the third question. It's not cheap (on either a premium or charges basis) and it hasn't proved its model compared to the Aberdeen funds or Templeton (and not forgetting Angus Tulloch and his First State Asian funds).

I already own a decent slug of the Aberdeen funds and won't be selling them just yet. But I'll probably start adding some FEET shares at the margin and start watching its performance.

The Fundsmith way

When you invest in a fund manager, you really need to understand exactly how they pick the individual stocks in their portfolio.

You need a detailed description of the methodology used, alongside some real-world examples of what they won't invest in, and what they will. FEET and Fundsmith are very clear about their methodology and here I've pulled out what I think are their key ideas.

Invest in high-quality businesses "a high-quality business is one that can sustain a high return on operating capital employed. In cash... we are not just looking for a high rate of return. We are seeking a sustainable high rate of return.An important contributor to this is repeat business, usually from consumers."

A focus on a particular theme or sector. "A company that sells many small items each day is better able to earn consistent returns over the years than a company whose business is cyclical, like a steel manufacturer, or lumpy', like a property developer, a movie studio, or even a drugs company."

Identifying the moats of competitive advantage' that businesses have. "We seek to invest in businesses whose assets are intangible and difficult to replicate."

Balance-sheet issues and debt. "We avoid companies thathave to use leverage to make an adequate return on equity.We only invest in companies that earn a high return on theircapital on an unleveraged basis."

Cheap, value shares or a more growth-orientated model?"The businesses we seek must have growth potential."

At what price should stocks be bought? "Our aim is toinvest only when free cash flow per share as a percentage of acompany's share price (the free cash-flow yield)is high relative to long-term interest rates and when comparedwith the free cash-flow yields of other investment candidatesboth within and outside our portfolio."

Time horizon? "We aim to be long-term, buy-and-holdinvestors. We seek to own only stocks that will compound invalue over the years."

What about currency risks? "Our policy is generally notto hedge... currency exposure, just as we don't hedge theexposure of the Fundsmith Equity Fund. The exception in FEET[is] where we think significant depreciation of a currency hasbecome likely but wish to continue owning the companies."

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