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Terry Smith’s tips for picking exceptional businesses & getting hefty returns

Legendary fund manager Terry Smith says the most challenging part of an investment strategy is to have the patience of sitting and doing nothing when the investment climate is not conducive for trading.

According to Smith, investors should look to buy a small number of high quality, resilient, global growth companies that are of good value and which can be held for a long time.

Smith is famous for writing a controversial report ‘Accounting for growth’ which later became a best selling book by the same name. The book basically talked about accounting frauds by listed companies. The report wasn’t very well received by his then employer, UBS who fired him from the company.

Also known as the English Warren Buffett, Smith joined Barclays as a history graduate in 1974. He became prominent as the UK’s top-rated banking analyst throughout the 1980s.

Smith is now best known for his hugely successful career as a fund manager, having set up Fundsmith and managed its flagship Fundsmith Equity Fund since its inception in November 2010. The fund has become the most popular open-ended actively managed fund based in the UK.

The fund has delivered an annualized return of 18.4 per cent between inception and the end of November 2021 far outstripping the MSCI World index which has a comparative annualized return of 12.8 per cent.

Lessons investors can learn from Tour de France

In his book, “Investing For Growth”, Smith discusses investing lessons he learnt from the annual men’s multiple-stage bicycle race, “Tour de France”.

According to Smith, investors have the knack of examining their portfolio performance in every reporting period, as often as every quarter, and sometimes exiting the stocks which underperform.

He says it’s as pointless to expect an investment strategy or a fund manager to outperform the market in all reporting periods and varying market conditions as expecting to find a rider who can win every stage of the Tour.

He says investment performance has to be measured over some time period and a quarter is too short a period to judge performance reasonably.

“To assess an investment strategy or a fund, you need to see its results across a full economic cycle with both bull and bear markets,” he writes in his book.

According to Smith, any strategies which rely upon an element of market timing are the ones to be avoided.

He says there is a lot of evidence to suggest that those investors who like to switch and change investment strategies, invariably get the market timing wrong.

“As the old saying goes, there are only two types of investor: those who can’t time the markets, and those who don’t know they can’t time the markets,” he says.

According to Smith, investment is a test of the endurance of investors and the winners are the ones who find a good strategy or fund and stick with it.

Investment strategy

Smith says investors should have a high quality, concentrated portfolio of 20-30 resilient global growth companies which are held for the long term.

As per him, investors should follow a simple three-step investment strategy, which is-

1. Buy good companies

2. Don’t overpay

3. Do nothing

Smith shared some of the secrets of his success and key investing principles in his book. Let’s look at some of them-

Invest in businesses with intangible assets

Smith says that investors should look to invest in companies that break the rule of mean reversion that states returns must revert to the average as new capital is attracted to business activities earning supernormal returns.

According to Smith, investors should find companies with brand names, high market shares, patents, licenses, distribution networks, installed bases and client relationships as together these define a company’s franchise and its ability to outperform competitors.

“We seek to invest in businesses whose assets are intangible and difficult to replicate,” he says.

Invest in businesses with growth potential

According to Smith, in order to gain superior returns it is not enough for companies to earn a high unlevered rate of return.

He says investors should try to find businesses with a high degree of certainty of growth from reinvestment of their cash flows at high rates of return.

“The businesses we seek must have growth potential. Our definition of growth is that they must also be able to reinvest at least a portion of their excess cash flow back into the business to grow while generating a high return on the cash thus reinvested,” he said.

Invest in businesses that require no significant leverage to generate returns

Smith says investors should invest in companies that earn a high return on their capital on an unleveraged basis in recognition that sometimes credit is withdrawn.

Avoid businesses that are vulnerable to technological innovation

According to Smith, investors should avoid investing in industries which are exposed to rapid technological innovation and therefore obsolescence. This approach renders many sectors uninvestable.

Invest for the long term

Smith says the ideal holding period for a good investment should be indefinite which means investors should hold the stocks in their investment portfolio for a long time.

Don’t time the market

Smith says investors should try to avoid timing the market as it can lead to huge, unnecessary losses.

Follow a high conviction approach

Smith says without deploying a consistent high-conviction approach over time, it is hard for any investor to beat the benchmark for their target sector.

According to Smith too many investment managers have abandoned focused stock picking. He says investors should pick great businesses for investment with high conviction.

Have emotional discipline

“Investors are their own worst enemy.” He says the average equity fund investor significantly underperforms the average equity fund due to their tendency to buy funds at the top and sell them at the bottom of market cycles.

Smith’s timeless lessons can help investors understand the importance of rational and emotionally disciplined investing where often the best course of action is to do nothing.

From Smith’s investing principles it is easy to see why he has found so much success in the investment world. If investors follow these investing tips it can be very beneficial for them to achieve superior returns in the long run.

(Disclaimer: This article is based on Terry Smith’s book “Investing For Growth”)

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