Chapter 125 - Investing for Growth: How To Make Money By Only Buying The Best Companies In The World
Today’s Chapter is based on the book “Investing for Growth: How To Make Money By Only Buying The Best Companies In The World” by Terry Smith, an anthology of investment writing from 2010 to 2020.
Terry Smith is an English fund manager, founder, and CEO of Fundsmith, a London-based investment management company established in 2010, known for its long-term, buy-and-hold strategy focused on high-quality companies. Often called "the English Warren Buffett," Smith has achieved strong investment returns, with Fundsmith managing over £35 billion and emphasizing rational, concentrated investing without frequent trading.
Here’s what I have learned:
Seek Quality
“It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
— Warren Buffett
If I needed to summarize Terry Smith’s investment philosophy into one word, I would say it is quality. As a matter of fact, this focus on selecting companies with exceptional financial health and resilience forms the cornerstone of his strategy. Smith’s approach challenges the conventional wisdom that higher returns necessitate higher risks, advocating instead for the steady, predictable growth offered by high-quality businesses. His philosophy is rooted in the belief that the best investment opportunities lie in companies that have proven their worth over decades, delivering consistent returns and maintaining competitive advantages.
Smith argues that true value creation occurs when a company earns returns above its cost of capital. As such, he believes that the key metric to identify when evaluating investment opportunities is the return on capital employed (“ROCE”). For example, a company that earns a 10% annual ROCE, pale in comparison to companies that can achieve 20% or 30% ROCE. Smith explains that “A good company is one that regularly makes a high return in cash terms on capital employed, and can reinvest at least part of that cash flow in order to grow its business and compound the value of your investment. Bad companies do not do this. They make inadequate returns on the capital they employ.”
As Charlie Munger once said, “Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return -- even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you'll end up with one hell of a result.”
“Return on capital employed is one of the most important measures of corporate performance—it is the profit return which the management earns on the capital shareholders provide.”
— Terry Smith
Furthermore, Terry Smith mentions that another way of identifying quality businesses is by looking at their longevity. As a matter of fact, the average company in Fundsmith is usually in business since a long time. As such, they usually have a long proven track record. In fact, in his Fundsmith Annual Shareholder Letter of 2011, Smith mentions that “the average company in our portfolio was founded in 1883. We are investing in businesses which have shown great resilience over a long period of time—in most cases surviving two world wars and the Great Depression.”
Finally, Smith mentions that once you find a high quality business that has a high return on invested capital, it would be a mistake to not invest in it due to a high valuation. As he mentions, "If you are a long-term investor, the return on capital which a company can generate, and its ability to reinvest at a superior rate of return, is more likely to determine how well its shares do–and not the valuation at which you buy or sell it."
The reasoning behind this is the concept that even if you paid a premium for a high quality business, because of the company’s high return on invested capital, you’d still make money in the long run. As Warren Buffett once said, “Time is the friend of the wonderful business, you keep compounding. Time is the enemy of the lousy business.”
“A good company is one that regularly makes a high return in cash terms on capital employed, and can reinvest at least part of that cash flow in order to grow its business and compound the value of your investment. Bad companies do not do this. They make inadequate returns on the capital they employ. You may think you should invest in these poor companies as they are going to improve because the management will change, or they will be taken over, or their results will pick up with the economic or business cycle. But each day you wait for such events, these companies destroy a little bit more value. Good companies do the opposite. With a good company, time is on your side.”
— Terry Smith
Avoid Diworsification
“By the way, I call it ‘diworsification,’ which I copied from somebody. And I’m way more comfortable owning two or three stocks, which I think I know something about and where I think I have an advantage.”
— Charlie Munger
In his anthology, Terry Smith stresses the importance of investing in businesses that you understand. This means taking the time to thoroughly research and analyze a company's business model, competitive landscape, and financial performance before investing in its shares. He advises us to ”stick to investing in things you understand. I have never found anyone who disagrees that this is an essential ingredient for success. But investors are terrible at defining what it is they understand narrowly enough.”
As such, Smith also cautions against over-diversification. While diversification is generally considered a prudent investment strategy, Smith argues that too much diversification can lead to "diworsification," a term coined by Peter Lynch to describe the negative effects of excessive diversification. In fact, while diversification reduces risk, overdoing it dilutes yourself knowledge and forces you to compromise on quality.
“Research suggests that 90% of diversification benefits can be obtained in most markets with a portfolio of just over 20 stocks. The more you diversify beyond that, the less you know about each investment.”
— Terry Smith
Furthermore, Smith argues against diworsification due to the simple fact that it would be impossible to find that many high quality companies that would meet his investment criteria. As he explains, “there is a severe limit to the number of good companies available–and the more stocks you own, the more you are likely to have to compromise on quality. It is also a fact that the more stocks you own, the less you know about each of them and I have never found a theory of investment that suggests that the less you know about something, the more likely you are to generate superior returns.”
As such, it is clear that Smith believes that investors should focus on building a concentrated portfolio of their best ideas, rather than spreading their capital too thinly across a large number of stocks. By focusing on a smaller number of high-quality companies that they understand well, investors can potentially achieve better returns and reduce the risk of making mistakes.
This concept of concentrating into your best investment ideas reminds me of what we have previously learned from David Ogilvy, the Father of Advertising. Ogilvy explains that one’s success usually comes from a mere handful of big ideas. Even with his big successes, Ogilvy admits that in his long career as a copywriter, he did not have more than 20 big ideas, if that. In terms of advertising, he explains that “it takes a big idea to attract the attention of consumers and get them to buy your product. Unless your advertising contains a big idea, it will pass like a ship in the night.”
So, how does one identify a big idea? Ogilvy usually asks himself the following five questions:
Did it make me gasp when I first saw it?
Do I wish I had thought of it myself?
Is it unique?
Does it fit the strategy to perfection?
Could it be used for 30 years?
In my opinion, Ogilvy’s biggest reason to success is his ability to identify big ideas and to stick to them. As he once said, “If you are lucky enough to write a good advertisement, repeat it until it stops selling. Scores of good advertisements have been discarded before they lost their potency.” The reason behind is that, once again based on researches, “readership of an advertisement does not decline when it is run several times in the same magazine. Readership remains at the same level throughout at least four repetitions.”
“You aren’t advertising to a standing army; you are advertising to a moving parade. The advertisement which sold a refrigerator to couples who got married last year will probably be just as successful with couples who get married this year.”
— David Ogilvy
Based on this concept of big ideas by Ogilvy, there is a lot that can be learned and implemented into investing. In fact, Warren Buffett at Berkshire Hathaway was also highly concentrated and most of his incredible track record came from a few big hits. In a recent interview, the legendary investor Mohnish Pabrai mentions that even the legendary Warren Buffett have a hit rate of 4%. He explains, “I would calculate in the last 58 years, Buffett’s made at least 400 different investment decisions. He’s saying 12 are the ones that mattered. The God of investing has a 4% hit rate. That’s the God of investing.”
Think Long-Term
“In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”
— Benjamin Graham
Another key lesson from Terry Smith’s investment approach is the critical importance of adopting a long-term perspective. While it is easy to get distracted by quarterly earnings reports and daily market movements, Smith advocates for a long-term strategy aligning investment decisions with the natural lifespan of a business or an economic cycle. As such, he believes that evaluating a business or a fund’s performance over a brief period of time, such as a single year or quarter, is misguided.
One of Terry Smith’s favourite analogy to investing comes from the world of cycling. He believes there is a lot to learn about investing from the Tour de France. He points out that no rider has ever won every stage, nor is it likely, yet the race is won over the entirety of its 21 stages. Similarly, he suggests that outperforming the market in every reporting period is an unrealistic expectation for investors. This is especially true if you are overly concentrated in a few stocks. Instead, the goal should be consistent outperformance over longer horizons, such as a full economic cycle encompassing both bull and bear markets.
“In my view there is a moral here for investors. What we are trying to achieve with Fundsmith is to win the investment equivalent of the Tour de France for you—to outperform over a long period of time. However, we do not expect to outperform all the time or in all market conditions.”
— Terry Smith
Smith’s long-term approach to investing leads him to also criticize the concept that one is able to time the market. He believes that this is nearly impossible to master. As a matter of fact, in his anthology, Smith illustrates the peril of missing even a handful of the market’s best days, showing how such missteps can drastically erode returns. For example, he cites data from the S&P 500 over a decade, where missing the best ten days reduced the annual return from 12.07% to 6.89%, turning a $10,000 investment into just $19,476 instead of $31,260. This evidence underscores his belief that staying invested in quality companies over time is far more effective than attempting to time the market.
As a matter of fact, Smith emphasizes the compounding effect of holding quality investments over extended periods. He references the remarkable performance of companies like Colgate-Palmolive and Coca-Cola, which delivered compounded growth rates significantly higher than the market over 30 years, allowing investors to pay premiums far above market P/E ratios and still match or exceed index returns. This highlights the transformative power of patience and the reinvestment of retained earnings at high rates of return.
“It is always a mistaken strategy to wait for the shares to get below the point at which you sold them before repurchasing, or the even more common trait of waiting for a loss-making share purchase to get back to break-even before selling. As I am fond of saying, the shares are unlikely to follow this desired pattern since they do not know whether you own them or not or at what price you bought or sold.”
— Terry Smith
As such, one of Fundsmith greatest feature is the extremely low portfolio turnover reflecting Terry Smith’s long term approach to investing. In fact, Smith believes that frequent trading is detrimental to investment performance, as it incurs costs and increases the risk of making mistakes. Smith writes that “Minimising portfolio turnover remains one of our objectives and this was again achieved with a portfolio turnover of 2% during the period. It is perhaps more helpful to know that we spent a total of £496,507 or just 0.014% (1.4 basis points) of the fund on voluntary dealing which excludes dealing costs associated with fund subscriptions and redemptions as these are involuntary. Why is this important? It helps to minimise costs, and minimising the costs of investment is a vital contribution to achieving a satisfactory outcome as an investor.”
This concept should reminds us on the power of compounding. As Warren Buffett once said, understanding of compounding interest is the first and most important mathematical concept to learn. Not only is it important in investing, but it is also useful in terms of seeking wisdom and obtaining good habits. As a matter of fact, a one percent improvement every day leads to 37x improvement in a year. Similarly, it is very possible to become wealthy even if our investments grow at a small rate as long as it happens on a long period of time. As we have previously learned from Edward Thorp, “Over a sufficiently long time, compound growth at a small rate will vastly exceed any rate of arithmetic growth, no matter how large!”
The power of compounding reminds me of Charlie Munger’s Lollapalooza Effect where multiple forces are even more powerful when combined together:
“… really big effects, lollapalooza effects, will often come only from large combinations of factors. For instance, tuberculosis was tamed, at least for a long time, only by routine combined use in each case of three different drugs. And other lollapalooza effects, like the flight of an airplane, follow a similar pattern.”
— Charlie Munger
The rules of compounding are very simple once you get the concept: start early and do not ever interrupt it. As Charlie Munger famously said, “The first rule of compounding: Never interrupt it unnecessarily.” Edward Thorp understood the importance of compounding beyond the stock market. As a matter of fact, it is this principle that encouraged him to lead a healthier lifestyle. For every hour he spent on fitness was one less day he would spend in a hospital: “If you are like me and want better health, you can invest time and money on medical care, diagnostic and preventive measures, and exercise and fitness. For decades I have spent six to eight hours a week running, hiking, walking, playing tennis, and working out in a gym. I think of each hour spent on fitness as one day less that I’ll spend in a hospital. Or you can trade money for time by working less and buying goods and services that save time. Hire household help, a personal assistant, and pay other people to do things you don’t want to do.”
Beyond the Book
Read "Charlie Munger's Legacy: ROIC, Quality, and Berkshire's Success" by BRK-B Fanpage
Read "Quality Businesses" by Investment Masters Class
Watch "Charlie Munger: Why Diversification Is Total Nonsense" on YouTube
Read "The Surprising Power of The Long Game" by Farnam Street
Read "Tiny Gains. Massive Results." by Farnam Street
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Great roundup, Daniel. I’m with you on Market Briefs — quick to read, but surprisingly helpful for spotting trends before they hit the headlines. And I had the exact same ‘egg and chicken wing’ moment last year!
Also really appreciate your reminder about patience. I’ve seen too many investors bail at the worst possible time. It’s not the $1 loss that kills you — it’s the missed rebound.