Terry Smith on why Feet will outperform Fundsmith Equity

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Terry Smith certainly knows a thing or three about money: how to make money, how to make it look as though he is making money, and how to avoid losing money.

Investors in the Fundsmith Equity fund that he manages would find it difficult to disagree with the first of those three assertions; readers of his controversial 1991 book Accounting for Growth will be familiar with the second; and as for the third, the general investing principles that Smith and his team follow mean investors can reasonably expect to suffer no more than short-term setbacks.

- Can quality growth stocks continue shooting the lights out?

However, while early investors in Fundsmith Equity have enjoyed gains of 181 per cent since launch in August 2011 (or an annual average gain of 19.7 per cent over five years), investors in the smaller, newer Fundsmith Emerging Equities Trust (Feet) have had much less to celebrate since its launch in June 2014.

THREE YEARS OF MALAISE

At the net asset value (NAV) level, Feet has gained just 8.1 per cent since launch. This has to be viewed in the context of the wider malaise in emerging markets over the past three years, while developed markets - led by the US - have raced ahead.

This year, however, has produced the kind of performance numbers that investors have come to expect from Smith. Feet's NAV gained 11.6 per cent over the trust's half year to 30 June (the shares were up 6.2 per cent).

Such gains are not to be sniffed at - but investors in a passive index tracker could have done better. The trust's benchmark, a mixture of the MSCI Emerging Markets and Frontier Markets indices, was up 17.1 per cent over the half year.

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One month on, to end July, however, the shares have raced up to a 17.4 per cent gain on the year as they regain their premium rating.

Smith is keen to point out that the trust has actually outperformed the index since the portfolio became fully invested in May 2015. He also has a ready explanation for the trust's relatively poor show in the first half of this year.

Somewhat ironically, he says, investors sought out the 'safe haven' of emerging markets stocks over European stocks in the first half of 2016, as concerns over Brexit grew.

These investors bought either large liquid stocks such as Tencent, Taiwan SemiConductor and Samsung - the three largest in the MSCI Emerging Markets index, which between them saw average gains of 26 per cent in sterling term - or emerging market exchange traded funds.

'The beneficiaries of the revival of interest in emerging markets have unsurprisingly been stocks of companies which are large and therefore easy to deal in, and are mostly in sectors in which we would not invest,' adds Smith.

'It is not surprising that in the early stages of renewed interest in emerging markets, the large cyclical stocks and sectors benefit most.'

These are the sorts of shares that Feet (and Fundsmith Equity) will never own because they do not comply with Fundsmith's dominant principles of investing in companies with high and dependable returns on capital, high levels of free cash flow growth and high barriers to entry.

The trust puts these principles into practice mainly by investing in consumer-oriented stocks.

DIFFERENT FEET

Indeed, independent portfolio analysis by Morningstar shows that Feet is quite different from its investment trust peers in the emerging markets space. Most take a 'core value' or 'core growth' approach by investing predominantly in 'giant' companies.

Feet's 'high growth' investing style seems to be at odds with the composition of the portfolio, which is dominated by the consumer staples sector.

Companies that manufacture these bare necessities of life are traditionally viewed as boring; it's a sector to scurry to when economies and stock markets are weak.

That is a common misconception, says Smith, particularly in emerging markets, where urbanisation and consumerisation are producing excellent growth rates for the consumer staples companies that account for over 80 per cent of Feet's portfolio.

'Even last year, when emerging markets were in a trough, the consumer staples companies in our portfolio recorded revenue growth of 14 per cent and earnings growth of 20 per cent,' he says. 'These are high growth areas.'

Smith concedes that the sector can suffer short-term underperformance in a cyclical upturn, but the long-term trend is a consistent one where revenues and cash flows are strong and rising.

Smith is more than hopeful that the recent strength in those big, easily tradeable emerging market stocks will soon filter down to the stocks that Feet owns.

'If it presages an improvement in the fundamental economic conditions in the developing world, we expect this to lead to superior fundamental and share price performance from our portfolio companies in due course.'

Reasons to be cheerful in this respect also come from the International Monetary Fund's (IMF) recent growth forecasts. The IMF expects emerging markets economic growth to increase in each of the next five years, rising from over 4 per cent to more than 5 per cent in aggregate.

In contrast, there is a growing body of opinion that developed markets are entering a period of secular stagnation, evidenced by ultra-low interest rates and below-trend economic growth. The IMF does not see aggregate growth in advanced economies surpassing 2 per cent before 2021.

ECONOMIC GROWTH

Smith reckons this is one of the prime reasons to invest in emerging markets today, and that it helps to explain why consumerisation - 'all the things that people aspire to use as they grow wealthy' - is the predominant theme on which Feet focuses.

Ageing populations such as those in Japan and Europe, he adds, spend less as they get older.

However, the growth of the emerging consumer is not particularly well represented in popular indices - the MSCI Emerging Markets index has only a 20 per cent weighting to consumer staples, says Smith.

So, with its 82 per cent weighting and a further 11 per cent of the portfolio invested in consumer discretionary stocks, 'Feet is something you can't buy anywhere else'.

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It is a theme that is finding favour with investors in the UK. In Feet's half-yearly report, chairman Martin Bralsford announced that since the trust implemented a share issuance programme in March, it had raised a further £12.4 million at a premium to NAV, boosting its market capitalisation to £220 million.

There are, of course, no guarantees that emerging markets can build on their strong performance of the first half of 2016.

Global investor sentiment remains fickle, with short-term concerns over China's burgeoning debt pile and the negative effects of rising US interest rates trumping other positive factors such as the superior economic growth rates and low valuations that emerging markets offer.

However, there is one increasingly important prop for valuations in developing markets: the global hunt for yield. And it is not short-term traders who are leading the charge.

This time around, the big investors such as pension funds and sovereign wealth funds, severely crimped by falling yields on developed market equities and bonds ($12 trillion of which now provide no yield at all), are in the vanguard.

They are directing more long-term money to emerging markets to provide them with the income they need to meet their future liabilities.

That is something emerging market bonds and equities can provide, and it helps to explain why a further $16 billion (£12.3 billion) has flowed into emerging market bond funds since the UK voted for Brexit.

For Smith, the trough in commodity and energy prices is a far more relevant indicator of the strength of developing economies than the direction of US interest rates, which 'are not going up majorly'.

The economies of commodity-producing nations such as Brazil, Nigeria and Russia are 'learning to live with low prices', he says.

More importantly, big commodity and energy importers such as India, where Feet has 34 per cent of its portfolio, 'are the biggest net beneficiaries', he says.

Overall, Smith says that in comparison to Fundsmith Equity, Feet's holdings are more highly valued and have a lower initial yield, but have higher growth potential.

Bearing in mind Smith has said he expects Feet to handsomely outperform Fundsmith Equity over the medium term, fans of the Fundsmith method should consider putting a foot in both camps, so to speak.

MANAGING FEET AND FUNDSMITH EQUITY: WHAT'S THE DIFFERENCE

Fundsmith Equity, the £7.9 billion global equity fund and Feet, the £220 million investment trust, are both run on the same principles and are predominantly invested in consumer-related stocks. But it is the trust that arguably takes up more of the team's time.

That is because, unlike Fundsmith Equity, macro-economic, currency and political considerations are just as important for Feet as choosing the right stocks.

With 47 holdings, it also has twice as many stocks as Fundsmith Equity because the risks are greater. 'We haven't stepped on any landmines yet, but it could happen,' Smith says.

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Events in Nigeria earlier this year are an example of the extra work that goes into managing Feet and the problems that can arise.

Smith says that although his team foresaw the devaluation of the Nigerian naira and decided to sell the two weakest of Feet's four holdings in the country, 'we had to get in line at the central bank with everyone else and wait for foreign exchange to be available, so we still suffered from the devaluation'.

Understandably, however, Smith was pleasantly surprised to see Fundsmith Equity's NAV get 'a half-billion pound boost for doing nothing' when sterling collapsed during the week after Brexit.

Nearly all of Feet's gains in the first six months of 2016 also came in the last week of June through the currency effect.

Nevertheless, Smith thinks that trying to hedge against currency movements, particularly in emerging markets, is 'a mug's game', as hedging is expensive and can prove worthless if the timing is wrong.

Gaining an understanding of the local market, and assessing political stability and standards of corporate governance - reasons why Feet has very little invested in China - add an extra layer of work for Smith's team.

'In Feet we are often in partnership with governments, conglomerates, multi-national companies or families,' he says. Each has its own dynamic.

Some governments, for example, have direct and indirect (via taxation) stakes in tobacco companies, while Smith says family controlled businesses often have a superior long-term strategic approach.

Investing in the local offshoots of multinationals such as Unilever brings a different dimension, 'because they charge royalties'. Healthcare is a theme Smith wants to pursue, but it is a difficult one to execute in emerging economies.

'Private hospital groups have returns which are encumbered by real estate, and some of their revenue is derived from medical tourism rather than the rise of local consumers, which is what we are seeking to benefit from,' he says.

Instead he has been buying medical diagnostics businesses such India's Dr Lal Pathlabs.

It took nearly a year for Smith to invest the proceeds of Feet's own IPO, and a further example of the patience he is willing to exercise comes from Feet's new holding in Vietnam Dairy, which he had been eyeing since 2014.

'We got our stake at a 3 per cent discount rather than the 20 per cent premium we'd been quoted previously,' he says.

PROCTER & GAMBLE SOLD

Although Smith's favourite activity once he's bought a holding is to sit back and do nothing, he says a fair amount of chin-scratching still goes on, particularly when it comes to assessing the impact on his holdings of 'disruptors'.

One such example is the meteoric rise of Dollar Shave Club, the online men's razor merchant, which has contributed to a rare decision to sell Procter & Gamble (P&G), one of Fundsmith Equity's long-term holdings.

'It was on to its third internally sourced chief executive in as many years and had the wrong price point on some of its products. Security tags on razor blades are a bad sign and the wrong place to be in the age of austerity.'

In what is seen as a direct challenge to P&G, Dollar Shave Club has just been bought by Unilever - for a reported $1 billion.

Smith says he would ideally like to raise more capital for Feet to take advantage of some of the opportunities he can perceive, though he is not averse to implementing gearing when the opportunity arises.

But he confirms that he would only borrow money to invest in a specific investment opportunity; not to act on a general change in investment sentiment.

As for those people who are worried that Fundsmith Equity might suffer as a result of a change in sentiment towards the so-called bond proxies - big, safe global companies paying a decent dividend - that feature heavily in its portfolio, Smith has two words of advice: 'Don't invest.'

But he warns: 'Where else might you go? Cash and bonds yield nothing. Cyclical stocks and financials might benefit from a short-term bounce, but the consumer brands in the Fundsmith Equity portfolio are not as highly valued as many suspect on a long-term view.'

*Andrew Pitts has holdings in both Fundsmith Equity and Feet.


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