Multi-Disciplinary Reading – Book Reviews

Investing for Growth, Terry Smith, 2020 – Have heard a lot about Terry Smith and his fund Fundsmith’s strategy of investment. This books covers 10 years of the fund’s performance (2010-2020) through the Annual letters Mr.Smith has written during the period and other communication in-between. It deals with a variety of topics from buybacks, capital allocation, business quality, active vs passive, emerging markets and of course investing in quality companies for the long-term with low churn.

My notes –

• Bond proxies – Stocks which produced profits and cash flows like bonds

• A stock may have a low valuation and an even lower intrinsic value (On value investing being interprited as low P/E investing)

• You could have paid 281x for L’Oreal, 126x for Colgate and 63x for Coca-cola in 1973 and still beaten the index return (MSCI World Index)

• Growth should be a component of value (WB). Growing a business with inadequate returns is sending good money after bad

• Cyclicals recover strongly from an economic downturn. High quality businesses have nothing to recover from and hence cyclicals do well in recoveries

• Low multiple doesn’t mean cheap and high multiple doesn’t mean expensive

• Most forecasters do so not to predict events but to influence them

• A man hears what he wants to hear and disregards the rest – S&G’s ‘The Boxer’

• Those who don’t know and those who don’t know that they don’t know – two classes of forecasters

• All your knowledge is about the past and all your decisions about the future. No amount of sophistication can fix that. – Ian Wilson, GE

• “Foreseeable future” – Is an oxymoron

• Performance fees do not work. They extract too much of the return and encourage risky behaviour. Ensure your fund manager invests in the same fund and on same terms as you

• The avg. fund manager in the UK turns over their fund 80% per annum

• Small-ticket consumer non-durables which aren’t purchased on credit and where the Customer has no opportunity to bargain on price, or defer consumption by prolonging life of the product make for great investments (say Pet foods)

• Churning portfolio is hard since finding an equivalent good investment for your cash is hard

• Share buybacks only create value if the shares purchased are below their intrinsic value and there’s no better use for the cash that generates better returns

• Buybacks should be viewed in the same way as if the company bought shares in another company. One should use RoE to analyse impact of buybacks rather than increase in EPS which is inevitable

• When management does things they dont want examined, they use polite euphemisms to camouflage the reality of the situation

• Murdoch’s News Corp paid $580m for MySpace which it then sold for $35m (on poor capital allocation)

• Financial crisis of ’08-’09 wasn’t solved but made into a soverign debt crisis. In ’08 govt. saved the banks, in ’11 we wonder who will save the govts.

• When banks, investment banks and brokerage firms combine operations where they trade their own account and also acted as an agent for clients, the client always loses (conflict of interest)

• Fundsmith uses the weighted average FCF yield as the primary valuation yardstick for portfolio (My take – May not be applicable for developing growth markets like India. One has to visualise OCF vs FCF – what is growth capex vs maintenance capex. What the business generates on incr. Capital invested etc.)

• Least volatile decile of stocks generated higher annualised total returns than most volatile decile thereby questioning the belief that higher returns come at higher risk (Risk measured as volatility)

• CROCI – Cash Return on Cash Invested. Higher CROCI = Better investment returns (Goldman study)

• If you can’t understand what an investment does, it is because you are not meant to understand it

• Giffen goods – Demand paradoxically rises as their price increases

• Never invest just to avoid tax. These investments perform poorly (Like our LIC whole life plans). Its often cheaper just to pay the tax

• Never invest in poor-quality companies. With a good company, time is on your side (Time is a friend of the wonderful business, enemy of the mediocre as WB puts it)

• There’s a limit to the number of good businesses available. So the more stocks you own, the more likely you are to compromise on quality

• Dont invest in orgs with “steering committees”. You don’t steer a boat or car through consensus arrived by a committee. They are unlikely to do good

• Straight-talkers are rare – invest in them. Domino’s published harsh criticism like ‘Pizza was like cardboard’ in 2009. You only do that if you intend to change. Since then Dominos is up almost 50x

• Fundsmith portfolio companies produce their earnings with significantly less capital (high RoCE than market) and deliver more of their earnings in cash (excellent cash conversion)

• There are no new jokes. Only those who haven’t heard them before

• EROEI – Energy return on energy invested. Used to be 100:1 in 1930s. For shale its 5:1 (Lot more energy needed to extract)

• Asset life is critical to assess all investments

• If you see a bandwagon, its too late – Jimmy Goldsmith

• Revenue growth is a higher quality source of value creation than share buybacks or cost control (No limit to revenue growth but the other two are finite)

• One of the clearest trends after WW-2 has been the rise of the middle class or consumers. While there are several definitions, $10/day of disposable income is a good indicator. (300m / 2.5b people in 1950 vs 2.4b / 6.4b in 2010)

• Growth rate in consumption in emerging markets is more than 3x developed world

• When RoCE drops, it may mean that new capital invested is generating inadequate or negative returns

• “Hedge funds” dont stand for any particular methodology of investment. It now describes a fee structure that benefits the manager

• Coca-cola holds stake in its bottlers to control distribution but the whole reason the bottler exists is because that business is capital-intensive

• ROCE as used by Fundsmith = OCF/(Equity + Net Debt) (Note, no EBITDA and its net debt, ex. cash. I presume this is because of excellent cash conversion of these businesses and policies for div payouts where this will converge with traditional RoCE).

• A company can be busy destroying shareholder value deploying incremental cash in subpar rates of return while still increasing EPS (what most see). Creating shareholder value != Making share price go up.

• Three steps to heaven. 1. Invest in good companies 2. Don’t overpay 3. Do nothing

• “Where’s the beef?” – Idiom / catchphrase to question substance of an idea, event or product. Without a business selling something the customer wants, no amount of financial wizardry will create lasting value.

• 97% drugs in pre-clinical tests never made it, neither did 95% in phase-1 trials or 88% in phase-2. Only in phase-3 prospects improve to 46%. So probability of a molecule getting to market is (1-0.97) x (1-0.95) x (1-0.88) x (1 – 0.46) = 0.00001

• Investors should be wary when a long-standing and highly successful chief executive leaves a business (Tesco’s Leahy years’ problems surfaced much later – Probably why market has been apprehensive on HDFC Bank after Aditya Puri’s exit)

• Its better to be concentrated among high-quality investments than to be diversified among low-quality investments

• People ask “if a stock is cheap” more often than they ask “if the business is good”

• The best investments are often the most obvious. Eg. Dominos. High RoCE is very good, especially if the business operates through franchises where the revenues are generated on other people’s capital. Delivery business can operate from cheaper premises.

• You should always run your winners (Despite extreme low churn and preaching this, Fundsmith made the mistake of selling Dominos twice, only to buy it back again)

• Equity returns are enhanced when a company pays down debt and value is transfered from debt to equity

• Emerging markets ETFs aren’t good investments (as compared to active EM funds) because EM ETFs are filled with large companies with sub-par RoCEs (Can’t doubt Mr.Smith here as many Adani stocks are in MSCI indices)

• Retained earnings invested at good rates of return is what enhances shareholder equity. For this the business must have great growth opportunities. Dividends paid out should be re-invested in business until incremental cash invested in business is earning good rates of return

• Long depression of 1873-96 was caused when a new industrial power (America) came onstream and produced goods cheaper than the Old World. It caused a collapse of the banking system. (China repeated the same in the 2000s)

• Fundsmith prefers consumer staples, some consumer discretionary, healthcare and technology

• Investors should not look for high dividend yield stocks which lack growth. They should look for growth even if the business pays no dividends. They should be ready to sell a bit of the stock for cashflow instead

• Just 5 companies out of 25,967 companies account for 10% of total wealth creation in 90 years. Just over 4% of companies account for all wealth created

• Bull markets do not broaden as they age – they narrow. Switching can be harmful in a late-stage bull market

• Meeting managements is not a primary test of whether a business is sufficient quality to invest. Good businesses are identifiable by the numbers they produce. (Of course, depends on where you fish and what your appetite is)

• Crisises including pandemics (Book came out in Oct ’20 post Covid-19) exacerbate existing economic trends. Assembly line for Ford Model-T was conceived to deal with the reduced workforce during Spanish Flu

Mr.Smith’s fund has outperformed with a CAGR of 18.6% vs 12.9% of MSCI World Index from ’10 to ’21 (570% vs 287% overall return) investing with the simple strategy of buying good businesses and holding them with negligible churn. He has had no style drift from 2010 to 2022 and doesn’t look like he will change strategy as he seems prepared for underperformance if it ever comes.

The book covers the simplicity and elegance in the approach which heavily borrows from the late 70s onward Warren Buffett – something to which he gives credit enough and more times. As a book though, since these are just a collection of Annual letters, there’s way too much repetition. 8/10