Fundsmith Equity: a setback for a high-quality portfolio

The Fundsmith Equity fund consistently ranks as one of the most popular equity funds among investors in the UK, and it’s easy to understand why.

Managed by star fund manager Terry Smith, since inception on the 1st of November 2010, the fund has produced an annualised return of 15.6% compared to 11.3% for the MSCI world index (in sterling).

However, 2022 was by far the worst calendar year of performance for the fund since its launch, both in absolute terms and relative to the global stock market.

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It lost 13.8% last year compared to a loss of -7.8% of its benchmark. This year, the fund has performed marginally better, although it has still underperformed. In the six months to the end of June, Fundsmith returned 8.5% compared with 8.9% for the index.

Fundsmith's performance in 2023

Writing in his half-year letter to investors, Smith explained Fundsmith’s holdings in Waters Corp, Mettler-Toledo International, and cosmetics group Estee Lauder weighed on returns in the first half. 

“Waters and Mettler-Toledo have both been affected by the slowdown in laboratory expenditures post the pandemic. In neither case are we bothered by this. In fact, we hope it presents an opportunity for us to buy more,” the fund manager explained in the update. 

But he seemed more concerned about the performance of Estee Lauder. 

He said: “While domestic travel has returned, it seems that Chinese consumers are buying watches, handbags, and other luxury goods first which it was harder to shop for online during the lockdown. It has revealed some severe weakness in Estée Lauder’s supply chain with no manufacturing capability in Asia.”

This “debacle” could lead to Estee Lauder’s ejection from the portfolio, unless the company can turn the situation around. Smith doesn’t often sell holdings, but he’s been quick to eject companies from Fundsmith’s portfolio if they start to lose direction. 

For example, Smith recently dumped the fund’s position in Amazon, locking in a loss after first buying the stock in July 2021. In his half-year update, the fund manager explained that he’d made the decision to sell after the group’s new CEO, Andy Jassy seemingly decided to push the business in a different strategic direction. 

Smith said: “It is always easier to talk the talk than it is to walk the walk and the CEO’s pronouncement that he wanted Amazon to seek routes to get bigger in grocery retail ran counter to all these principles.”

“Where companies choose to invest outside a powerful core franchise in which they already have expertise we believe they are likely to destroy value, and especially so where they are entering a sector which already has poor returns,” he added. 

Buy and hold quality

Fundsmith has always been focused on buying and holding quality companies, a strategy explained by Fundsmith’s three-step investment strategy (1. Buy good companies; 2. Don’t overpay; and 3. Do nothing) is the best way to approach the market.

Fundsmith has even gone so far as to write an ‘Owner's manual’ to explain to its investors what it’s trying to achieve and how it will achieve it.

This whole process is designed to help investors focus on the fundamentals of the companies in the underlying portfolio, and ignore short-term market conditions.

One of the ways Smith does this is with a table in the Fundsmith annual report showing “what Fundsmith would be like if instead of being a fund it was a company and accounted for the stakes which it owns in the portfolio on a ‘look-through’ basis.”

On this basis, at the end of 2022, Fundsmith as a company had a return on capital employed - a measure of profit for every £1 invested in the business - of 32%, double the average of the FTSE 100 and nearly double the average of the S&P 500. It also had a gross profit margin of 64% compared to a mid-40s range for the indices.

These healthy margins have helped the companies in the portfolio absorb higher manufacturing and input costs that have hurt so many businesses over the past two years. 

As Smith explained in his note, “Procter & Gamble Co used to ‘make things’ for $0.50 and ‘sell them’ for $1.00, but now it costs $0.53 to make them. McCormick & Co Inc used to make things for $0.58 and sell them for $1.00, but now it makes them for $0.63. Estée Lauder used to make things for $0.20 and sell them for $1.00, now it costs $0.28 to make them.”

“This still leaves our companies’ gross margins way above those of the market average, which means their bottom lines are better protected, but they cannot completely offset these headwinds.”

But despite rising costs and squeezed margins, Smith isn’t changing strategy. 

The fund’s best-performing holdings in the first six months were Meta (up 140%), Microsoft (up 40%) and L’Oreal (up 30%). 

The author holds the Fundsmith Equity fund.