The flaw in Terry Smith’s strategy at Fundsmith

Terry Smith built a formidable reputation as an analyst and business executive before setting out to apply what he had learned to fund management. When he launched the Fundsmith Equity Fund in 2010, he wanted investors to be able to buy directly over the internet. He promised low fees, an easy-to-understand investment process, low portfolio turnover, no shadowing of indices and no attempt to time the market.

Smith’s thesis was simple: “Buy good companies, don’t overpay, do nothing.” Fundsmith seeks to “only own shares that will compound in value over the years, investing in a limited number of high quality businesses with a sustainably high return on capital, strong cash generation and assets that are intangible and difficult to replicate”, says the highly readable “owner’s manual” on his website.

Such stocks may look expensive, but “stock markets typically value companies on the not unreasonable assumption that their returns will regress to the mean,” argues Smith. “Businesses whose returns do not do this become undervalued; therein lies our opportunity.”

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Investors agreed. Fundsmith Equity grew quickly, with assets approaching £30 billion by the end of 2021. Returns far outpaced the MSCI World index. However, the fund has seen four consecutive years of underperformance since then, and assets have shrunk to £20 billion. Given that Smith hasn’t changed his investment style, what has gone wrong?

Questions over Fundsmith's strategy

The success of Fundsmith has made the corporate characteristics it seeks become widely popular. This has pushed valuations up – and hence returns down – for these companies. Currently, 27% of the portfolio is in healthcare, which has been out of favour. Conversely, banks – which Smith has says he never invests in – have done very well. So too has Nvidia, despite his scepticism about its valuation.

Good companies can also go through difficult times due to managerial mistakes or a temporarily adverse business climate. This will lead to a falling share price, especially if they have become overvalued. The thesis of “buy good companies, don’t overpay, do nothing” doesn’t cater for this.

For example, Diageo shares – held by Fundsmith since inception – peaked at £40 in early 2022, nearly 30 times prospective earnings per share, well above its historic range. It then became apparent that sales had been inflated during the pandemic and that young people might be drinking less. Valuation alone should have been a reason to sell, but Smith waited until 2024, when the price had fallen 40%.

Fundsmith still owns LVMH, which has nearly halved since early 2023 when it traded on a multiple above 30. It also hangs onto Novo Nordisk, which has fallen by two-thirds since mid-2024 as it loses market share to Eli Lilly in the market for weight-loss drugs. A year ago, Novo’s shares were trading at well over 40 times prospective earnings. It is undoubtedly a good company, and it may bounce back, but surely Smith should have sold earlier.

So there are questions about whether Fundsmith Equity hangs on too long to stocks that have become overvalued. Conversely, it may then be too unforgiving of good stocks that temporarily stray off track. A company such as Diageo could now provide opportunities for recovery.

If this were an investment trust, non-executive directors and analysts would have asked questions about the thesis and the holdings. They would also have queried its 1% annual charge, which now looks high for such a large fund. However, as an open-ended fund it isn’t subject to the same scrutiny.

Fundsmith will probably get its act together again, having learned hard lessons from a tough few years. But there is no sign of it yet.

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