Does inflation on the rise make Fundsmith Equity a 'buy'?

buy-yes-or-no

News that inflation is on the rise will inevitably cause some investors to re-think their portfolios and find ways to inflation-proof their investments.

Inflation shot up to 1.8 per cent last week - its highest level in two and a half years - with predictions it will burst through the Bank of England's 2 per cent target in the coming months. Most economists and forecasters expect inflation to end the year at the 3 per cent mark.

This, too, is a view shared by Tom Stevenson, investment director for personal investing at Fidelity International. Stevenson reckons inflation will be pushing 3 per cent by the end of the year, driven by a potential further wobble in the value of sterling.

This will put a further strain on the purse strings of the UK consumer and, according to Colin Morton, manager of the Franklin UK Equity Income fund, impact dividend yields. For this reason, he sees opportunities opening up in defensive sectors such as utilities.

PRICING POWER

This has led some investment experts to predict the renaissance that 'value' stocks have enjoyed over the past year will be short-lived. Instead experts are of the opinion that the so-called 'bond proxy' trade will resume their run of popularity in 2017.

The obvious beneficiary of this, says Ryan Hughes, head of fund selection at AJ Bell, will be Fundsmith Equity, managed by Terry Smith.

The fund focuses on companies with pricing power that are able to generate high margins, consistent earnings and robust cash flow over the long term.

This will enable said firms to deliver 'the reliable and growing dividends that provide such a large percentage of long-term total shareholder returns, especially once they are reinvested'.

'By contrast,' Hughes adds, 'firms without pricing power - such as producers of commodities like paper, pulp or steel - tend to churn out more volatile earnings and more volatile dividends.'

It seems somewhat disingenuous to suggest investors should now 'buy' Fundsmith on the back of the opinions of experts, considering Smith railed against such predictions in his letter to shareholders at the end of 2016.

Explaining that the slight drop-off in his fund's performance over the second half of 2016 was due to a 'rotation' out of the sectors in which he is invested, which lead to share price underperformance, Smith says he has no way of knowing whether this trend will continue.

'But then again neither do any of the analysts or commentators who are involved in opining on the matter,' he added.

He went on to describe such commentary as 'simplistic', in regard to predictions that bond proxies will do badly once US interest rates begin to rise, which looks ever-more likely.

'Of course, I have no idea when or by how much the Fed or any other central bank will subsequently raise interest rates,' he continued.

'Neither, I suspect, do any of the commentators or analysts judging by their track record thus far - but that will not stop them making predictions and suggesting that you should make investment decisions based upon them.'

NO CAUSE FOR CONCERN

Now, though, the case is being made for Fundsmith Equity, with Hughes claiming Smith's strict investment criteria should help investors beat inflation.

Adrian Lowcock, investment director at Architas, agrees, asserting that Smith has a clear and simple investment process that is unlikely to be affected by changes in market sentiment.

The fund experienced more volatile performance than usual in the second half of 2016 due to the effects of the US election campaign and produced performance figures that could be described as pedestrian by its own high standards - it returned 28 per cent in 2016 versus its MSCI World benchmark's 26 per cent.

Over the past year the fund is 34 per cent versus the average global fund return of 37 per cent, while on a six-month view the fund is up 5.8 per cent, behind the average rival fund return of 9.8 per cent.

While the outperformance in 2016 was markedly less than most investors had come to expect since the fund was launched in 2011, Lowcock says this should not be a cause for concern for investors.

Since launch, the fund has almost tripled investors' money, with its 198 per cent gain to 31 January translating to annualised returns of 19.7 per cent. As Lowcock asserts, though, 'such returns were unlikely to continue indefinitely'.

Lowcock adds: 'The switch to value has, to some extent, already played through and investors are turning back to the long-term growth stocks they have admired for the past five or more years.'

This should benefit Smith and his focus on buying good companies at reasonable prices and holding them for the long term will reward investors who can ignore short-term blips in performance, Lowcock says.

OTHER INFLATION-PROOFING IDEAS

What our monthly round up of the most-bought funds on our sister website Interactive Investor has taught us over the year, though, is that Fundsmith Equity is an extremely popular choice with investors, having topped the table for the past 10 months.

To that end, investors might need to look elsewhere for ways to benefit from the spectre of rising inflation.

Morton adds that companies that pay sustainable and growing dividends will also benefit, with the weaker pound likely to impact the proportion of FTSE 100 firms that pay their dividends in US dollars.

Hughes agrees and picks Artemis Income as a beneficiary and explains its current yield of 4.2 per cent looks attractive.

'The fund is well diversified and looks to produce a rising income ensuring that it focuses on companies that offer dividend growth rather than just an outright high yield.'

Although Hughes points out it would be reasonable to expect stocks to outperform bonds in a rising inflation environment, index-linked or floating-rate bonds provide some element of protection.

He suggests a couple of M&G products in these spaces: its Index-Linked Bond fund, managed by Ben Lord, and its Global Floating Rate High Yield fund, managed by James Tomlins.

Lowcock, though, says these traditional inflation-proofing assets have already priced in much of the anticipated rise in inflation. He suggests sticking to the aforementioned strategy of looking to sources of growing dividends.

This could be provided by alternative income assets such as infrastructure. The John Laing Infrastructure fund, he explains, currently yields a meaty 5.2 per cent, having grown its dividend by an average of 2.2 per cent per annum over the past five years.

'The fund invests directly in the equity of a globally diverse range of private finance initiative projects,' he adds, including owning a 35-year concession to operate and maintain 23 service stations in Connecticut that have 30-year leases with McDonalds and 15-year leases with Mobil, Subway and Dunkin Donuts.

'This is a defensive fund and has a diversified portfolio which should pay a predictable, inflation-protected yield. Investors should expect steady, low-risk income with some small potential for capital growth.'


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