Guru investor Terry Smith,  founder of the phenomenally successful Fundsmith in the UK, has a remarkably simple investment philosophy based on three investment rules:

  • Invest in a good business
  • Pay a fair price for the business
  • Do nothing!

I will touch briefly on rule 1) and 2), but the point of this article is rule 3), which Terry Smith claims is the hardest of the three to get right, notwithstanding that it sounds the simplest.

The investment industry spends an inordinate amount of time and money on identifying and valuing good businesses, which is the cornerstone of active management and entails in-depth financial analysis and fundamental bottom-up research before investing in a quality business.

The quality of a business is usually associated with the predictability of future earnings, the more predictable the earnings the higher quality business and the higher the price an investor is prepared to pay for the certainty around earnings.  Lower quality companies are associated with more unpredictable earnings, which are usually more cyclical by nature.

For an example to illustrate the difference between predictable and unpredictable earnings is to compare an oil & gas company to a consumer staple business.  Terry Smith is likely to invest in Nestle, which sells chocolates and coffee, but unlikely to ever invest in Shell or BP who are dependent on the prevailing oil price for earnings.  So, when OPEC and Russia get into a fight and the oil prices collapses so does Shell & BP’s profits.  But not Nestle as we cannot do without our daily coffee and chocolate treat, which provides Nestle with a competitive advantage of predictable earnings based on a strong brand and loyal consumer.

Rule 2) is a little trickier owing to the risk of overpaying for a good quality company.  Good companies are few and far between and therefore they should command a premium, which may or may not be justified, but this will depend on future earnings, which is unknown irrespective of the perceived higher predictability of earnings.   But the tricky part is that price and value is seldom in line as investor sentiment can drive the share price of a company well above or below the intrinsic value of the business in the short-term.

If we assume all the asset managers have the same information and can hire the best and the brightest analysts, what differentiates the top managers from the rest.  Well Terry Smith will probably say rule 3), the ability to do nothing when it feels like you should be doing something, and your clients are demanding that you do something.  This talks to investor behaviour and why the likes of Terry Smith and Warren Buffet have distinguished themselves from the rest.   Best explained by one of my favourite Warren Buffet quotes “successful investing in simple to understand, but not easy to do”.

 

Mark Williams
Mcomm, CFP®, HdipTax
T. 021-205 1133
Email. service@mwwealth.co.za

 

Do nothing is the hardest rule of all to get right