Five years ago, the largest UK investment trust launch in history took place when Fundsmith’s Smithson came to market. The younger cousin to renowned stockpicker Terry Smith’s Fundsmith Equity has had a strong start to life.
It has been the second best performer of the five trusts in the IT Global Smaller Companies sector, up 23% over this time and despite being a tenth of the size of its larger open-ended counterpart, with a sizeable market capitalisation of £2.2bn, it dwarfs the size of its rivals.
Below, managers Simon Barnard and William Morgan explain how keeping an eye on transaction costs actually hindered them last year, why they vote against almost a third of company remuneration packages and how an “erratic” chief executive was behind their worst performing stock this year.
Total return of trust vs sector and benchmark since launch
Source: FE Analytics
What is your investment process?
Barnard: We buy good companies, we don’t overpay and then we try to do nothing to reduce the turnover by as much as possible. During periods of market dislocation such as we find ourselves in today however we do of course take action when necessary.
A good company is one that is very high quality and growing. A key metric for us is return on invested capital and the average company in our portfolio has a return on invested capital of around 40%, which is far superior to our reference index, which is on an average of 11%.
Morgan: A key non-financial metric is to have barriers to entry such that our companies can continue to make high returns.
Why should investors pick your fund?
Barnard: We give investors the opportunity to invest in a concentrated portfolio of high-quality, growing small- and mid-cap companies globally and I don’t think there is another fund that invests like that – most are regional.
This is an advantage because there are not that many good companies in the world. We found only around 87 companies that we would consider buying – so restricting to a region or buying around 100 positions would lower the quality of the trust.
How would you sum up your performance over the first five years?
Barnard: We had a very strong first three years but a terrible year in 2022, which was macro driven. As we moved from ultra-low rates to more normalised rates, every asset sold off but growth equities were hit the hardest and we suffered from that.
There was no combination of the companies that we look at that would have allowed us to outperform the index last year. Even then it was only the first six months of last year that were bad – we were in line with the index in the second half. We have only underperformed in six months out of five years.
Were there any mistakes you made during this time?
Barnard: There were a few companies that we maybe could have sold at the end of 2021 that we were trimming because of valuation. They were at the upper limits of our comfort.
Looking back we wish we had sold them at the time, which was maybe a mistake that we have learned from. We sold a company at the end of last year based on valuation simply because of the learnings of 2021.
Why didn’t you sell?
Barnard: We are always conscious of having a low turnover because of the transaction costs associated with selling. Trimming companies is a very rare event. That we had brought ourselves to trim these companies might have sent alarm bells ringing but turnover and the costs that come with it – which is what we are always trying to avoid – stopped us selling them at the time.
What have been your best and worst stocks over 12 months?
Morgan: The best performer has been Simcorp, which is a Danish provider of software to the asset management industry. Shares were up 68% because it got acquired. We don’t tend to buy companies based on the expectation that they might be bought, but obviously if we own good companies there is always that possibility.
The next best was Fever-Tree, which was up 35%. We get asked about it a lot as it had a tough time during the post-pandemic cost inflation. It makes tonic and ships it around the world – so higher freight costs weighed on margins. Some of that pressure has eased, although it is not fully visible in the numbers yet. We think the market is starting to expect margins to improve.
Barnard: The worst has been Massimo, a US medical device company focused on blood oxygenation monitoring. We sold out recently because we believe it entered into poor capital allocation. It bought a company that we felt didn’t fit very well with the business. The founder and CEO was becoming increasingly erratic, we felt, so we sold out as we could no longer justify the position. It was down around 30%.
Do you use environmental, social and governance (ESG) principals in the trust?
Barnard: We don’t purport to be an ESG fund but it is quite important to our process because when you are holding these companies for five-to-10 years and hoping they compound in value, the most important thing is that their returns, margins and growth are sustainable. For that to be the case, they have to be operating in a sustainable way.
We are very focused, for example, on emissions, which are substantially lower in our fund than the index.
Where we engage most with our companies is on corporate governance and we are very critical of most remuneration packages. We have voted against almost 30% of remuneration packages in our companies over the past year because we have clear ideas of what should and should not be included.
Why do you use the investment trust structure? What is your gearing and discount policy?
Morgan: The main reason is we are dealing with smaller companies and want to be long-term investors, so don’t want to find ourselves in a situation during a time of market dislocation when we would be forced sellers. We felt the trust structure was the most efficient to allow us to take these positions.
Barnard: We have never used gearing, although it is available up to 15% of the net asset value. There is a cost associated to using it and it is more likely to make the fund volatile and we don’t want to do that.
On the discount, the board has been buying back shares for 18 months and they will continue with that. The board is extremely keen to get it even narrower if they can.
What do you do outside of fund management?
Barnard: I have a young family so I spend a lot of time at the weekends with them, but am also a keen golfer.
Morgan: Having spent a career largely indoors looking at spreadsheets, getting outside is first and foremost. I spend a lot of time hiking, fishing or anything else to do with the great outdoors.