If you’re a keen investor then you will have almost certainly heard of the Fundsmith Equity Fund and its high-profile manager Terry Smith.
To date, the Fundsmith Equity Fund has produced results that are nothing short of spectacular – a total return of 100% in just over four years. But is such rapid growth sustainable?
Dividend growth is the driver of sustainable growth
With any sort of investment, there are two kinds of value: the market value and the fundamental value (also known as the intrinsic value).
The market value of a house, a classic car or a company’s shares can be pretty much anything. If I want to sell my house for £20 then I can, and that will be the market price. On the other hand, if someone wants to buy my house for £20 million then that will be the market price instead.
The house is essentially the same in both situations but the market price is very different.
The fundamental value of an investment is the price an informed and “reasonable” seller or buyer would be happy to accept or pay.
Fundamental value is still set by investors and so can vary to some extent, but not anywhere near as much as the market value. That’s because the market value is often driven by investors who are neither informed nor reasonable.
In most cases, fundamental value relates mostly to an investment’s ability to pay an income, both today and in the future.
In the case of a house, fundamental value relates to the rental income that a property can reasonably be expected to generate over many years. For shares, fundamental value is driven primarily by the dividend; what it is today and what it is expected to be in the future.
Sustainable growth in market value occurs when that growth is accompanied, in more or less equal measure, by growth in fundamental value. In the case of a house, if rents double over a number of years then it is likely that the fundamental value has doubled as well. It is then reasonable for the market value to double as well (again, more or less, with some degree of variability and uncertainty).
However, if the market value of a house or a company’s shares double while there is no meaningful increase in fundamental value – i.e. rental income or dividend income – then that growth in market value is unsustainable.
Market value cannot double and double again, over and over unless it is accompanied by similar doublings in fundamental value.
Think of the dot-com boom of the nineties and the housing boom of the noughties as good examples of unsustainable growth in market value, where the market value grew much faster than the fundamental value.
In the end, market value stagnated for many years as fundamental value slowly caught up (and for housing, it still hasn’t caught up).
So, the question I’m really asking of the Fundsmith Equity Fund is: has its growth in market value been accompanied, more or less, by equal growth in fundamental value, i.e. its dividend?
Fundsmith’s dividend growth rate
The fund’s T Class accumulation units reinvest all dividends and so the growth of each accumulation unit’s dividend represents total return from a fundamental value point of view. The price of each accumulation unit represents the total return from a market value point of view.
Using the usual market value approach, the Fundsmith Equity Fund T Class accumulation units have gone from 100p at launch in November 2010 to 200p in December 2014 for a nice round 100% total return.
On an annualised basis that’s 18.1% per year, which is an amazing return for such a defensive fund and investors should be very happy.
In terms of dividends, the T Class accumulation units produced:
- 1.4651p in 2011
- 1.6888p in 2012 – an increase of 15.3% on the prior year
- 1.8285p in 2013 – an increase of 8.3% on the prior year
- 2.0495p in 2014 – an increase of 12.1% on the prior year
The total increase in dividends (as a proxy for the fundamental value of the fund) from 2011 to 2014 was 40%, giving an annualised fundamental growth rate of 12%.
A fund whose fundamental value grows at 12% a year is still very impressive, but it’s a long way from the 18% growth rate implied by the fund’s market value.
The Fundsmith Equity Fund’s current market value growth rate is unlikely to be sustainable
Given that the fund’s accumulation units have increased their dividend at 12% a year so far, I think that’s a reasonable estimate of the sort of fundamental growth rate the fund may be able to produce in the future.
On that basis, I do not expect to see the fund continue to grow its market value at 18% a year.
Of course, its market value may continue to grow that quickly for a while, perhaps even many years, but in the long term market and fundamental growth rates must be more or less equal.
In fact, the longer the fund’s market value grows faster than its dividends and fundamental value, the more likely it is that future returns will in fact be below that 12% fundamental growth rate.
If the ratio between market value and fundamental value becomes very stretched, which it will if market value continues to grow faster than fundamental value, then that ratio is very likely to eventually contract until the two are equal once again.
That would cause the fund’s market value to increase more slowly than dividends – or even decline.
While I cannot say with any certainty whether or not the Fundsmith Equity Fund is overvalued at this moment in time, what I can say is that so far it seems a long-term growth rate of 12% a year may be sustainable, but 18% a year is not.
(This article was inspired by Richard Beddard’s recent article, “Is Fundsmith Equity overvalued?“)
The way I think of it is that Terry Smith from here could be the next Neil Woodford or the next Anthony Bolton. With so many fund managers trying to beat the market you’re always going to get some who shine for long periods of time but the problem is you don’t know who they are until after the fact and past performance is also not an indicator of future performance.
One thing I do know though is that IMHO if I save the expenses I’d be paying these guys and just buy the market then I’ll probably perform better than most of them. That’s good enough for me.
Hi RIT, I think there’s a good chance that Smith’s strategy will work well, like Woodford’s. Those are the two active investment guys who I unofficially benchmark myself against (officially I benchmark against the All-Share).
Woodford is the only one with a long-term record (of about 12% I think?) so that’s a good ballpark to aim for with relatively defensive investments.
I guess I wrote this article because I’ve hear a lot of investors say they’re getting into Fundsmith because of the whole 100% in 4-years thing, so I wanted to temper that a bit with some reality.
And yes, a passive global equity/bond index is still probably the best option for 99% of people.
“For shares, fundamental value is driven primarily by the dividend; what it is today and what it is expected to be in the future.”
This is not strictly correct in that it matters not whether a company pays a dividend or not. The issuance of a dividend has no implied impact on the fundamental value of the company. The only thing that effects the intrinsic (fundamental) value of a company is it’s growth in earnings and it’s ability to convert those earnings to cash.
Growing a dividend by 12% a year does not mean that the intrinsic value of the company can not be growing at a higher rate as the company may chose to invest some or all of the earnings in growing the company. It is not therefore a valid measurement criteria that can determine the valuation of the Fundsmith portfolio or a yardstick that correlates between the market cap or market value of the company compared to the intrinsic value of the company.
LR
Hi LR,
Interesting points, but I’m afraid I’ll have to largely disagree (which I guess isn’t much of a surprise).
In terms of your first point, the fundamental value of a company is the discounted value of all future cash returns to shareholders (which I’ve called the dividend, although it could include spin-offs, takeovers, etc). If a company never ever pays a dividend until the end of time (or a nuclear war, etc) when its share price becomes zero, then it was essentially worthless all along as investors have effectively had zero return from that investment (which would be true even if the company was Berkshire Hathaway). Of course investors wouldn’t have known that beforehand that they would never see a return, which is why Berkshire’s share price isn’t zero, i.e. BH investors or investors in any non-dividend paying company expect some sort of cash return as some point (and I don’t mean by selling the shares). Earnings only have value if the related cash actually makes it back into the hands of shareholders at some point.
Your second point I agree with to some extent; dividend growth does not necessarily equal fundamental value growth, and fundamental growth could be higher than dividend growth. However, it is usually still a good proxy and that’s especially true for well established, large, defensive companies like those in the Fundsmith fund. And even more so when you aggregate a collection of about 30 of them. I doubt that many of the century-old companies in the Fundsmith fund are deliberately holding back dividend growth in order to reinvest for even faster growth in the future. In those sorts of companies dividend growth is typically progressive and set at a level that management thinks is sustainable over the longer term.
So I still think dividend growth is a far better measure of fundamental value growth, and the growth rate that can be reasonably expected in the future, than is market value growth. Of course if a company doesn’t pay a dividend today then you would need to look at other things like free cash flow, earnings and so on in order to guess what future dividends might be, but the Fundsmith fund does pay a dividend, and so do most of the company’s in it.
Hi John, The value return for shareholders of non or low dividend paying shares is simply the opportunity to sell some of the shares that have grown in value and that is the return. Look at Berkshire Hathaway $19 in 1965 — $146K today — the value in the company has grown and this is obvious but the company doesn’t pay a dividend.
The dividend does not directly equate to the increase in the value of the company or otherwise since it could be unsupported by earnings or a companies ability to convert those earnings to cash. I can’t see how that can be disputed but each to their own I guess.
Ultimately there is no real argument here, all we need to know is the companies metric are all heading north (e.g. earnings (without unnecessary debt increase); cash increases; dividend where paid, revenue).
Market value growth is meaningless unless it is supported by the fundamental value of the company, growth in assets, be they IP related, hard assets or whatever. In the case of Berkshire Hathaway the fundamental value of the companies far outstrips the market value, as most of the original assets in the underlying companies have never been revised upwards, only the acquisitions.
LR
Hi LR
I think we just disagree on the details but not the big picture, e.g.:
“Market value growth is meaningless unless it is supported by the fundamental value of the company, growth in assets, be they IP related, hard assets or whatever.”
Which I totally agree with.
I’m leaning towards the comment above… Companies don’t have to pay out a dividend in the first place.
That being said, for dividend growth investors, who often invest in fairly defensive companies, it’s obviously a crucial metric.
Do you think terry is really that talented, or has the rising market boosted him above and bring his stock picking abilities?
Cheers
Hi M
You might want to read my (long!) reply to LR for a detailed reply.
As for Terry Smith’s talent, I think if the 12% return is sustainable then that’s pretty good, and more or less equals Woodford, but of course Woodford did it for 25 years or so, while Smith has been at it for just four or five.
The difference between the fund’s 12% dividend growth and 18% market value growth is all to do with the flood of income-seeking money that has moved into defensive dividend paying companies as it searches for yield. So if I were to split luck and skill I would say the 6% gap between 12% and 18% is luck and the 5% gap between 12% and the “expected” global market rate of return of 7% (5% expected real return + 2% inflation) is skill.
Although really we’d need 10 years of history to say much about skill with any degree of confidence.
I see, that’s a fair assumption on the luck/skill split I think. Cheers.
M – Only time will tell with Terry, and all are agreed here that 4 years is too short a period and I think that is probably more the point that John is focussed on unless I’m barking mad. (I toddled along to his annual meeting last week – was quite interesting). The dividend issue seems to be clouding it a little because it has nothing to do with the growth in the underlying company value – we should park that one in a box because I enjoy these articles from John and I don’t want him banning me (sure he won’t he’s a good guy).
Anyhow one of the key points Terry Smith makes and is a major focus for him is the companies ROCE and substantial profit margins in companies that are hard to knock off their perches. Sometimes they get ahead of themselves but in reality many of the companies, whilst appearing to have high P/Es are hugely cash generative and go on to grow faster than the market.
One thing that is a concern with Terry is he is very much a conviction guy which is a good thing in many respects but often people who are too polarised in their thinking can trip up.
I don’t think Terry will though, because his principles are sound and the fact his fund is only 4 years old is possibly irrelevant as he performed the company pension funds for 20 years on the same principle and they grew consistently. This is noted in his video on his web site where he presented at the Institute of Directors (https://www.fundsmith.co.uk/video.aspx) – worth a watch – entertaining.
LR
Thanks for following up LR. I think that’s a pretty important note to consider about him having performed elsewhere for several years, and that we should look at that rather than worry too much about the 4 years.
Cheers
There is certain that Terry has a gift. I followed his FT articles well before he started his fund and invested my clients from nearly begining in his fund.
However we need to see the performance of his fund in context and first compared with MSCI Word benchmark, which is to be honest a pretty hard benchmark to beat, but nevertheless available through iShare ETFs.
The fund outperformed this benchmark by 2% per annum in the first 3 years and only last year it outperformed by 10%. For a fund that plays the profitability and minimum volatility factors there is an expectancy of 2-3% per annum outperformance.
You also have to understand that the outperformance was not only due to stock selection but also to asset allocation, because US stocks outperformed the rest of the world. Obviously for Terry this was by accident as he does not use asset allocation.
I expect this year to be its first year of underperformance, given last year higher outperformance, expecialy if the US value and small cap will start to outperform.
I do not know how to answer your question in regard with 12%. In the end this is an arbitrary figure. However I expect that Terry’s fund will outperform in the MSCI Word in the long run by 1%-2% per annum net of fees and that is good enough for me.
well i guess terry has me sold I have all my eggs in the fundsmith basket ….
Time will tell if I enjoy my retirement thanking terry or cry into my economy beer if all goes wrong….
Hi Colin, yes Fundsmith has certainly had another good year. I might update this analysis to take account of the fund’s latest dividend growth figures, although having said that I don’t want to obsess over Fundsmith as I’m competing against the FTSE All-Share, not Mr Smith and his team.
Another excellent year desoite the overall market falling…
still smiling so far