We explore how it has achieved nearly 19% return in 12 months
A year ago Smithson (SSON) became the largest ever investment trust launch, raising £822.5m to invest in quality small to mid-cap companies. Investors lapped up the shares in the hope they would deliver similar success to its sister fund, Fundsmith Equity (B41YBW7).
Their faith has been rewarded with Smithson having achieved 18.8% return since launch on 19 October 2018 versus 19.7% from the flagship Fundsmith fund over the same period.
This great start will have certainly been helped by the timing of Smithson’s launch which happened during a weak period for the stock market, thus valuations were lower for many companies. That’s advantageous when trying to build a portfolio.
A good start will boost sentiment towards the trust but it will take several more years before you can truly start to judge its performance.
Smithson was created to take advantage of good companies that would be too small for Fundsmith Equity as the latter focuses on very large businesses. A team was assembled and they spent a year writing approximately 150 reports on stocks that matched the same criteria used for Fundsmith Equity, namely a focus on aspects such as free cash flow.
Many of these potential companies were subsequently rejected, leaving a much smaller investable universe which currently stands as 77 stocks. Of this universe, Smithson currently has positions in 29 companies.
A focus on quality is interesting as investors have been prepared to pay high multiples for seemingly top-notch businesses for many years on the stock market. Late August this year saw a sudden rotation where investors switched to buying value stocks, namely companies on very cheap valuations.
So far it looks like this could be a short-term switch. But if quality did go out of favour, it would arguably also leave Smithson out of favour given its quality focus.
Portfolio manager Simon Barnard insists such an event wouldn’t prompt him to change his style as he believes any shifts in the market are ‘irrelevant’. He comments: ‘Our strategy is fairly clear – buy good companies, don’t overpay, do nothing.
‘Sometimes the market throws up opportunities, sometimes it doesn’t. We aren’t aiming to outperform in every period, we are aiming to outperform in the long term. It would seem crazy to change a long term strategy that works for a short term change in the market.’
THE VALUATION DEBATE
Barnard says he is looking for value, just not really cheap and potentially inferior businesses. The fund manager says he often gets asks by investors why he has invested in what look like very expensive companies such as Halma (HLMA) and Rightmove (RMV). His answer is that investors may be looking at the wrong valuation metric.
‘We focus on free cash flow yield. Rightmove generates a lot of free cash flow; when you look at it on that metric it is not that expensive compared to other things on the market.’
Assistant portfolio manager Will Morgan says at Smithson’s half year stage (30 June 2019), the portfolio valuation was the same as the reference market which is the MSCI World Small and Mid-Cap index. ‘We think we are getting at the same price much higher quality businesses that also grow about 1.5 times the rate of companies in the reference index,’ he comments.
‘If you were to look at the portfolio on aggregate, our companies on average have nearly four times the return on capital employed of the reference market. They tend to have much higher operating margins, significantly higher cash generation and much lower leverage so we can be fairly confident that the quality of the businesses we own are significantly ahead of that in the market.
‘Even though the headline multiples might appear high to some, there is a difference between being highly rated and being expensive.’
TERRY SMITH’S ROLE
The tremendous success of Fundsmith Equity – which has delivered 18.6% annualised returns since launch in November 2010 – means that Smithson’s fund managers were under pressure from day one to deliver equally strong returns. In particular, there was also the fact that Fundsmith Equity’s architect and fund manager Terry Smith wouldn’t be running Smithson.
‘Expectations are high internally and externally,’ admits Barnard. ‘Ultimately all we care about is the performance.
‘At the end of the day we are investing people’s life savings. The fact that we get to meet a lot of our investors helps to remind us of that – it is very motivating. We are very focused on executing the strategy to the best of our ability.’
Investors may find some comfort that Smith is still closely involved with Smithson despite not being behind the wheel. ‘Day to day we just get on with it. On big issues like selling a position outright or making an investment in a company for the first time, we would always consult him in his role as Fundsmith’s chief investment officer, but I as portfolio manager make the final decision,’ clarifies Barnard.
Both Barnard and Morgan joined from investment bank Goldman Sachs where the former was a fund manager and the latter an analyst. They were recruited to launch Smithson, alongside Fundsmith analyst Jonathan Imlah, due to their expertise.
Combined they have covered many different sectors which is handy as Smithson doesn’t have a specific sector or geographic market focus.
For example, they are comfortable analysing and investing in Spirax-Sarco (SPX), a UK steam engineer. ‘Steam is used in the manufacture of almost any product you care to imagine,’ says Morgan. ‘Spirax has a highly skilled salesforce who are highly qualified engineers and who are embedded in their customers’ businesses.’
The fact Smithson’s investable universe is only 77 stocks at present means the fund managers can focus on those businesses and read large amounts of relevant material. ‘Warren Buffett famously said you only need moderate intelligence to understand all of this; you just don’t want to be making mistakes,’ says Barnard. ‘These are not complicated businesses (in the portfolio).’
It also helps that its portfolio companies are at a mature enough stage so the managers can have comfort in their business models. ‘These are companies which are highly profitable and have good track records,’ remarks Morgan. ‘The numbers tell you something.
‘If we were looking at speculative businesses or speculative technology, pre-revenue or pre-profit, then we might need some expertise to guess if the thing is going to work. That isn’t a game we are going to play. We are looking at companies that have already won.’
Smithson's top holdings
Among the top holdings is Verisk Analytics, a data provider for the insurance and natural resources industries. It has the world’s largest database of insurance claims information. ‘When you are doing anything in insurance – writing a contract, managing your claims, doing fraud detection – data is absolutely key,’ says Morgan.
‘Insurance companies buy the data from Verisk and generally do so via long-term subscription contracts. If an insurer goes to buy data from Verisk, they first have to also give them all their data.
‘The bigger the data pool the better, so as they grow the barriers to entry keep getting bigger, like a network effect.’
Dealing with portfolio detractors
Smithson’s performance is really impressive but like all funds there are weak spots. It recently sold US auto industry software provider CDK Global after a change in management and strategy left the fund managers lacking confidence in the firm.
The investment trust has also had to stomach recent share price weakness in Ambu which makes disposable endoscopes. ‘So far the market has been reusable ones, but the problem is that they are expensive to buy in the first place and very expensive to clean. There is also a risk that the cleaning process is not adequate and therefore a high risk of contamination,’ explains Morgan.
He says Ambu has developed a disposable endoscope which at the moment costs the same as it would do to clean a reusable one, with the added benefit of removing the risk and liability of contamination.
‘It is in fairly early stage of what we expect to be long term growth. Ambu has had issues with timing of product launches and a change in CEO which has led to concerns that the long term market opportunity is not as big as people once thought. But we believe the opportunity is as big.’
SHARES SAYS: Smithson is certainly delivering for investors and it is always welcome to see a fund that is transparent about what it does and how it aims to make money. We rate this as a core holding for a diversified investment fund.
DISCLAIMER: The author owns shares in Smithson