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?“)