Terry Smith’s flagship fund – Fundsmith Equity – has not been spared amidst the high volatility in recent months.
Long-term bond yields have continued to inch higher on rising inflation expectations and this has hurt the valuations of the quality-growth stocks that Fundsmith owns.
Addressing these concerns during Fundsmith’s 2022 annual shareholders meeting over the short-term performance of the fund, Smith said: “Everything’s always relative to something, and companies of this sort are going to be compared with the long bond.
“We are inevitably, to some degree, subject to the vagaries to what happens to the discount rate, or long-bond yield.”
A decline in valuations is something Smith has previously alluded to in expressing his concerns about the fall in his fund’s free-cash-flow (FCF) yield, which is down to 2.7% from 5.11% in 2011.
The declining FCF yield can either be interpreted as an indication that the fund is overpaying for certain stocks, or that the current market valuation implies that they have become expensive.
When Smith was asked whether he was comfortable with this declining FCF yield, he said: “Julian [Robins, co-founder of Fundsmith] and I are in a state of continuum discomfort. We invest with a strong sense of paranoia.”
Despite this, the manager reiterated his belief that being invested in quality-growth companies is still the way to go.
By way of example, he said that if an investor were to buy a quality company at a price that implies a free cash flow yield or dividend yield equal to or better than the long-bond yield, it is still a worthwhile investment.
“Just buy it,” he said. “Because that’s the discount rate and the long-bond coupon doesn’t grow, whereas the company’s yield will grow.
“If rates go up an awful lot – more than the market is currently discounting – we will definitely have a torrid period where share prices will react to that.
“But if you are prepared to sit there and take that – you’ve definitely got an equity which is cheap in comparison with the long-bond yield – and therefore in comparison with the only reality you can judge it against.”
Performance of Fundsmith Equity year-to-date
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Source: FE Analytics
Despite the recent decline in performance ahead of the withdrawal of quantitative easing (QE) and interest rate hikes from central banks, Smith said he was not too concerned by the impact these actions will have on long-term yields.
It has been a subject of concern amongst some investors given that many of Fundsmith’s quality-growth stocks are considered by the market to be ‘bond-proxies’ and have suffered notable declines as long-term bond yields have risen.
Smith suggested that if central banks hike aggressively enough, it may affect consumer spending in such a way that it tames inflation in the medium to long-run, therefore taming the rise in the long-term bond yield.
“The Bank of England, and the Federal Reserve don’t directly have any control over 10-year rates, it’s a market rate – it’s what they can sell their bonds at,” he explained. “They do have control over their base rates and the Fed funds rate, but ironically the more aggressive they get with that, the better we may turn out with 10-year rates.
“One of the things we’ve yet to see crystalise is what the effect will be when rates really start to rise on the short end when the central banks do take some action.”
In his view, today’s investors and borrowers are in a completely different state of mind to that of 1981 – when former Federal Reserve chairman Paul Volcker raised interest rates to nosebleed levels to combat inflation.
Smith recalled how Paul Volcker put rates up 2.5% on a Saturday night on one occasion: “If you did that today, Brown-Foreman wouldn’t be able to make enough Jack Daniels for people to drink,” he joked. “We’d make a fortune on the shares.”
According to its most recent 13F filings, Fundsmith Equity has been increasing its position in the American spirits and wine business owner Brown-Forman Corp over the past year.
“What I’m really saying is that I think we’ve yet to see what the consumer sensitivity truly is when the rates start rising,” Smith added.
“It may be quite shocking I think, because people have become quite inured to a pretty comfortable kind of world out there.”
Despite his extensive commentary on the impact of rising interest rates and inflation on his portfolio, Smith emphasised his view that over the long-run, these factors do not matter.
“The commentators often talk about me and Julian being stock pickers, we are not. We are business pickers,” he said. “The thing we’re trying to do is to identify really good businesses and own them at reasonable or better prices for the fund.
“Providing you own good stuff; time is the friend of the good business and the enemy of the bad businesses.”