-Fund underperforms benchmark by 6% in 2022
-Long term outperformance remains intact
-Companies need to engage more with long term shareholders
Terry Smith’s 13th annual letter to shareholders doesn’t pull any punches as he reflects upon the performance of the company’s flagship Fundsmith Equity Fund (B4Q5X52).
Smith is unapologetic about underperforming the benchmark in 2022 with the fund down 13.8% compared with 7.8% for the MSCI World Index.
The manager commented: ‘We have consistently warned that no investment strategy will outperform in every reporting period and every type of market condition.’
The actual loss incurred seemed inevitable last year given the only S&P sector to record a gain was energy. Over the long term the fund remains the top performer in the Investment Association Global sector, beating the average return by 299% since inception.
HIGHER RATES IMPACT PERFORMANCE
The end of ‘easy’ money and quantitative easing accompanied by higher interest rates has had a detrimental effect on highly rated companies which discount earnings ‘further into the future’.
The list of top five detractors from the fund’s value was topped by Facebook owner Meta Platforms (META:NASDAQ) and payments company Paypal (PYPL:NASDAQ) which the fund sold during the year.
Smith said Paypal and IDEXX (IDXX:NASDAQ) started the year with valuations which were ‘particularly vulnerable’ to higher rates.
However, in Smith’s view Paypal’s ‘lamentable’ share price performance was due to management’s disregard for newly acquired customers and overpaying for acquisitions.
He relates the problem back to easy money saying this is what happens when managements conclude that investments do not need to make an ‘adequate’ return.
Meta isn’t spared criticism either with Smith urging the company to stop spending shareholders’ money on the metaverse.
LONG TERM INVESTORS IGNORED
One of the biggest gripes in this year letter is the lack of company engagement with long term shareholders.
Smith said: ‘What I find questionable is that companies mouth platitudes about wanting to attract long-term shareholders yet based on our experience, we tend to get ignored, whereas an activist who has held shares for fewer months than we have held in years gets invited to board meetings.’
The manager is referring to activist investor Nelson Peltz who was given a board seat at consumer goods giant Unilever (ULVR) a few months after announcing a stake. The same criticism is made of Paypal where activist Elliot Management was given a board seat and an ‘information sharing agreement’.
For Smith it is about holding company management to account.
SHARE BASED COMPENSATION DELUSION
Smith argues firms distort the investment landscape by removing share-based compensation from earnings. The manager offers up the example of Microsoft (MSFT:NASDAQ) and accounting software company Intuit (INTU:NASDAQ).
The former includes share compensation while the latter doesn’t. Adding back roughly $1.8 billion of compensation expenses to make an apples-to-apples comparison pushes Intuit’s price to earnings multiple to 43 times from 28 times.
This means Intuit trades at a 72% premium to Microsoft which isn’t apparent if investors use analyst’s earnings forecasts.
Looking to the future the manager said the fund’s portfolio of companies is more lowly rated than last year and should provide a resilient performance should the economy enter a recession.
