Is Fundsmith still a best buy?

With a total return of almost 330 per cent over the past decade, longstanding Fundsmith Equity (GB00B4Q5X527) investors will feel more than satisfied. But the UK’s most popular fund has been more troubled in recent times, underperforming the MSCI World index for three calendar years in a row and attracting criticism as a result. That may leave holders more uncertain about the future than they have been for some time.

Long-term relative performance remains stellar: the fund has comfortably outpaced the 225 per cent gain from the MSCI World over the past 10 years, ranking third among the more than 250 global equity funds available to UK investors –no mean feat in an era dominated by a handful of US tech stocks.

This explains why, having launched in 2010, it has risen to become the biggest portfolio in the UK funds universe. Fundsmith Equity has some £25bn in assets, frequently crops up on investment platform bestseller lists, and commands a huge following. Investors hang on the words of Terry Smith, be it via his twice-yearly letter to shareholders or the firm’s well-attended annual general meetings.

For some, this success raises questions of its own, the main concerns centring on whether the fund has become too big or whether Smith’s success would be possible to replicate in the event of him stepping back. Recent performance has also invited some dubious accolades, such as the fund’s inclusion, for the first time, in Bestinvest’s Spot the Dog report, identifying investment vehicles with a three-year record of underperformance. A portion of investors have also been voting with their feet, with Morningstar data showing that the fund bore net outflows of nearly £2.5bn in 2022 and almost £1.5bn last year. Morningstar’s own analysts recently downgraded Fundsmith Equity for reasons relating to sell discipline, among other factors.

Smith has done much to defend his record, be that by highlighting the fund’s strong long-term performance or by discussing the unusual market movements of recent years, including the concentration of market returns in the ‘Magnificent Seven’ stocks last year.

But investors will still wonder why the fund has had a rough period and, more importantly, what the future holds for the portfolio. Clearly, there is no crystal ball available. Yet understanding how the fund has evolved over time and what its defining characteristics are should help investors to correctly assess its place in a portfolio.

Holders are likely to be familiar with the fund’s more obvious traits, from the general principles – a buy-and-hold mentality – to how this manifests in individual positions such as long-term holding Microsoft (US:MSFT). But much remains unknown: the fund, for one, does not disclose its position sizes, and it can take time for details to emerge about new buying and selling activity. Investors would also do well to understand the characteristics of the portfolio beyond its most prominent investments.

With the help of holding disclosures provided by Morningstar, dating back to the end of 2012, our analysis of the fund and its evolution over time attempts to shed some more light on the nature of the portfolio.

Topping up tech

While Microsoft has long been in the fund, specialists do wonder if Fundsmith Equity has become too reliant on tech as a sector. The most prominent US tech stocks have certainly occupied more space within the portfolio over time. As the first chart shows, the overall allocation to this cohort has risen thanks to the presence of Meta (US:META), Alphabet (US:GOOG), Apple (US:AAPL) and, somewhat briefly, Amazon (US:AMZN). As with many other fund managers, this could, in part, show some recognition of the career risk involved in not holding the biggest constituents of the index as they have raced ahead over many years.

This group accounted for roughly 18 per cent of the portfolio at the end of September 2023 (the latest date for which data is available), via a 9.4 per cent position in Microsoft, 5.2 per cent in Meta, 2.9 per cent in Alphabet and 0.9 per cent in Apple. The fund has also recently held a small position in cyber security company Fortinet (US:FTNT). The likes of Visa (US:V) and Automatic Data Processing (US:ADP) have also been classed as technology companies in the past, although both were moved out of this category under the widely followed Global Industry Classification Standards (GICS) last year.

A few points are worth bearing in mind here. While the fund’s biggest sector allocations are still to consumer defensive stocks and healthcare, its tech exposure means it does now have more in common with growth-focused portfolios, and the US and global equity benchmarks.

That suggests it would suffer in the event of a growth sell-off such as that of 2022. Fundsmith Equity took a hit to the tune of 13.8 per cent that year versus a 7.8 per cent fall for the MSCI World. Conversely, it did outperform the index in 2020, a year marked by large gains for classic growth stocks.

It’s also worth noting that Terry Smith has long taken issue with the simplistic nature of “tech” as a label, and does so again in a response to our points. “Tech is a widely used but often unhelpful term when we look at the stocks we own,” he tells us, adding that the fund’s ‘tech’ names have a diverse source of revenue, Microsoft’s presence in operating systems, cloud computing and gaming, Meta’s focus on social networks, communication and advertising, Apple in mobile devices and services or Amadeus (ES:AMS) in travel reservations.

Are big winners too big?

Fundsmith Equity’s 2023 performance, which amounted to a gain of just over 12 per cent, is clearly respectable even if it lagged the ‘Magnificent Seven’-heavy MSCI World index. Aside from the names that the portfolio shares with this grouping, such as runaway recovery story Meta, notable performers last year also included Novo Nordisk (DK:NOVO.B), the company whose GLP-1 weight-loss drugs have helped remind investors that European shares can also be at the forefront of global returns.

But investors should be aware of the fact that the fund can be fairly concentrated and highly exposed to the ups and downs of individual companies. It held 28 stocks at the end of March, a number that has remained fairly consistent over time, and as our chart below shows the fund’s top five positions accounted for 35.9 per cent of the portfolio at the end of September 2023. This is the highest amount over the period of analysis, the low point being a weighting of 24 per cent at the end of 2016.

Even this is much less concentration than we might find in certain racier funds. A different statistic is more striking, however. Novo Nordisk, as the biggest position in the fund, accounted for a substantial 9.8 per cent of the portfolio at the end of September according to Morningstar. It’s accompanied by another large position, with Microsoft making up 9.4 per cent of the fund.

Both positions are well above the historical averages. Part of this may well simply be down to both shares having had an especially strong run, but it’s striking for two reasons. Firstly, the stock-specific risk is increased. Secondly, both position sizes are approaching the 10 per cent cap enforced by Ucits fund diversification rules, meaning Fundsmith may ultimately be forced to cut back on the holdings. Terry Smith’s point on this is simple: “We are advocates of running your winners, however we always have complied with the concentration limits and obviously always intends to do so.”

Holding size is an issue in a different sense, too, in that the sheer size of the fund and the need to ensure good levels of liquidity have arguably forced it, over time, to buy companies with a bigger market capitalisation. Strong performance is also likely to have bumped those market cap averages up, too – the dip in 2022 is also potentially explained by the sell-off of that year. 

The average market cap has risen from roughly £19.5bn at the end of 2012 to £144bn in late 2023. That’s something that, by Smith’s own concession to the IC in a podcast in late 2021, could prove a challenge for the fund: a company the fund was able to buy in 2010 (such as a £2bn market-cap business) would now be “too small”. Smithson (SSON), the investment trust launched for Fundsmith to target global small and mid-cap names, had a median holding market cap of £7.4bn at the end of March.

Home and away

Fundsmith fans will be familiar with its US slant: it had a 70.5 per cent allocation to North America at the end of September and that weighting was also north of 70 per cent at the end of 2022, 2021 and 2020. This is perhaps unsurprising given the success of US large caps, and puts the fund roughly in line with the MSCI World’s own allocation.

Other parts of the portfolio have shifted more notably over time. The fund once had a much bigger allocation to the UK, with domestic shares making up nearly a quarter of the portfolio at the end of 2012. The fund’s UK-listed holdings at that point were Reckitt Benckiser (RKT), Imperial Brands (IMB), InterContinental Hotels (IHG), Unilever (ULVR) and Diageo (DGE). Only the latter two remained in the portfolio at the end of September 2023 and the overall UK weighting has fallen markedly over time, dropping from 17.5 per cent at the end of 2019 to 8.9 per cent a year later and 4.9 per cent a year after that. The North America weighting has risen over the period of analysis, as has the allocation to Europe, which came to nearly a quarter of the portfolio at the end of September.

When asked whether the team thinks there are fewer good UK companies out there than a decade ago, Smith responds: “We really don’t think about it that way. We invest in companies not regions and we believe that where a company is listed is mostly of little consequence and tells us little or nothing about its sources of revenue.”

But he adds: “There are very few large UK companies that satisfy our stringent quality requirements. We still own some of them but in other cases we have opted for their US or European competitors, and so far that worked out well.” Here he notes a preference for Church & Dwight (US:CHD) and Procter & Gamble (US:PG) rather than Reckitt Benckiser, Philip Morris International (US:PM) instead of British American Tobacco (BATS) or Imperial Brands, Marriott International (US:MAR) instead of InterContinental Hotels, and Novo Nordisk instead of AstraZeneca (AZN) or GSK (GSK).

Twists and turns

The Fundsmith team has tended to buy into companies at moments of weakness, sometimes with good results. Meta in particular is one business that the team bought to much consternation from investors but which has since performed very strongly. But not all investments have worked out so well: the team held Amazon for a relatively short time before selling out (the shares have fared well since), and has called time on other holdings after a relatively long period of difficulty.

Decisions like these were part of the rationale for Morningstar’s recent decision to downgrade the fund, with analyst Daniel Haydon raising concerns about the team’s sell discipline. “We tend to see this kind of thing happen for buy and hold managers when they see some outflows,” he said.

“What I see as a slight lack of rigour is really something that I’ve taken a look at. So PayPal (US:PYPL), Terry Smith says he sold that too late, and there are a number of management missteps there. Estee Lauder (US:EL), which had some difficulties in China, was similarly painful for the fund. These were sold too late. On the other hand, there are also a couple of positions that were sold too early, or at least according to Terry. These were fundamentally justified, but then the price took off afterwards in part due to the massive tailwinds from AI. That was Amazon and then also Adobe (US:ADBE).”

Smith told the IC in response: “I think Morningstar’s criticisms are valid. In fact we have been very open about the problems operating the sell discipline and covered this in depth at our annual meeting.

“In my view the most important thing when you get something wrong is to learn from it in effort to avoid repeating mistakes. The trouble is that our analysis of the sales of Estée Lauder and PayPal, which would have been better had they been earlier, suggested that engagement with management who were performing poorly had not worked. This caused us to take earlier action with Adobe over the Figma acquisition and Amazon over the CEO’s comments about wanting to get big in online grocery, both of which we still maintain were damaging. So the problem is that we have contradictory indicators: Estée Lauder and PayPal: sell at the first sign of trouble, and Adobe and Amazon: be more patient.

“The lessons are therefore not obvious. What we think we should learn is: be wary of selling when there is a tailwind from some market theme that everyone is excited about [AI]. And don’t necessarily react to what people say but what they do. Adobe abandoned the Figma acquisition and Amazon has not gone big in grocery.

“Investment is a constant learning process which is one of the things I like about it.”

Investors may well worry about any churn in the fund, especially given its “do nothing” buy-and-hold mantra. Turnover has certainly ticked up somewhat, reaching 11.1 per cent in 2023 versus 7.4 per cent in 2022, 5.6 per cent in 2021 and 4.1 per cent in 2020. The team has downplayed this, however, with Smith writing in the 2023 shareholder letter: “We sold our stakes in Adobe, Amazon and Estée Lauder and purchased stakes in Procter & Gamble, Marriott and Fortinet. As last year, this may seem a lot of names for what is not a lot of turnover as in some cases the size of the holding sold or bought was small. We have held 10 of our companies for more than 10 years, five of which since inception in 2010.”

As such, investors will be watching the fund for consistency. Future disclosures should show whether the team is sticking to its knitting, but it’s clear the portfolio has changed over time, be it via the size of its holdings, its exposure to the UK or its focus on some of the most prominent companies in the US.

That does have implications for investors. It could be even more exposed to a growth sell-off than it once was. Its focus on larger companies could limit the scale of returns (if with less volatility), but the fund is still heavily influenced by a handful of stocks, from Microsoft to Novo Nordisk. And yet the process is consistent in other senses, with a focus on companies that generate a strong return on capital employed. That metric came to 32 per cent for the portfolio in 2023 versus 18 per cent for the S&P 500. Importantly, that matches the level for the portfolio from 2022 and exceeds the level from previous years too.

The fund, in short, should continue to do its job for investors. Holders should nonetheless recognise that the portfolio has changed over the years. This is not a case of ‘style drift’ – big tech stocks’ large cash flows and healthy returns on capital, among many other attributes, mean they comfortably qualify as quality shares. But investors may wish to ponder whether Fundsmith’s own mantra of “do nothing” is as appropriate for holders as it once was.