Terry Smith defends fourth year of underperformance

Terry Smith has defended his investment strategy after another year of underperformance.

T Class units (which have a 1.04% fee) of Fundsmith Equity returned 8.9% in 2024, below the 20.8% return of the MSCI World index. This means that Smith has underperformed his benchmark for four years in a row now. I Class units are available on the ii platform and cost 0.94% compared with 1.04% for T units.

However, since launch in late 2010, Smith is still way ahead of the benchmark, returning 607% compared with 403%.

Writing in his annual letter to investors this week, Smith again blamed his underperformance on the strong returns from the so-called Magnificent Seven shares, which are not a large part of his portfolio.

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Smith calculates that just five stocks Nvidia, Apple, Meta, Microsoft and Amazon provided 45% of the returns of the S&P 500 index in 2024, and Nvidia alone produced over 20% of the S&P 500 returns in 2024.

He said: “Outperforming the market or even making a positive return is not something you should expect from our fund in every year or reporting period, and outperforming the market was more than usually challenging once again in 2024.

“Our fund owns some, but not all, of these stocks and it was difficult to perform even in line with the index unless you owned them at least in line with their index weighting.”

The goal of Fundsmith Equity, according to Smith, is: “To produce a high likelihood of a satisfactory return rather than the chance of a spectacular return, which could be spectacularly good or spectacularly bad.”

Source: Fundsmith, data to 31 December 2024. Past performance is not a guide to future performance.

In 2024, Smith sold his stakes in Diageo, McCormick and Apple. He added two new names: Atlas Copco and Texas Instruments.

Over the calendar year, the bottom five detractors were: L'Oréal, IDEXX, Nike, Brown-Forman and Novo Nordisk.

His best shares were Meta Platforms, Microsoft, Philip Morris, Automatic Data Processing and Stryker.

Smith defended some of his losers last year. He said Nike suffered from an increasing dependence on fashion and less on traditional exercise uses, but the appointment of a new CEO could help turn around the business.

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On Novo Nordisk, Smith adds: “In investment it is always better to travel hopefully than to arrive and there is certainly an arms race going on among drug companies to develop competitor drugs. Yet we are still dealing with a company in Novo which is the market leader and holds production and labelling advantages which should sustain that position, with revenues that are growing at 20% a year.”

Despite relatively poor performance, Smith says that his portfolio owns “better” businesses than indices based on financial metrics.

For examples, he cites the 30% operating profit margin of his companies compared with 16% for the typical S&P 500 firm and 15% for the typical FTSE 100 firm.

This, however, leads to Smith’s portfolio being more expensive than the indices.

Smith says: “Our portfolio consists of companies that are fundamentally a lot better than the average of those in the S&P 500, so it is no surprise that they are valued more highly than the average S&P 500 company. In itself this does not necessarily make the stocks expensive, any more than a lowly rating makes a stock cheap.”

On Apple and Nvidia

Fundsmith Equity dropped Apple in December after holding the tech stock for around two years. Smith began purchasing shares at about $156 per shares, and they now trade at $242, so he banked a profit of around 60%.

Two years ago, Apple’s valuation was below the S&P average but now it is higher.

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Smith explains the reasons for the sale: “We correctly foresaw a number of reporting periods ahead when sales growth would be lacklustre and so bought a small stake hoping to add to it as the poor sales performance came to pass. We were right about the sales performance — its sales grew just 2% last year — but wrong about the share price which rose strongly, placing the shares on a rating about 50% higher than the S&P 500.”

Smith also explained why he is happy to own Meta but not Nvidia, even though both companies have been very volatile.

One reason is that Meta has more than three billion accounts and several million advertisers, while Nvidia depends on just a few companies to buy its computer chips.

Another reason for Smith is that before its share price fall in late 2021, Meta was on a price-to-earnings ratio (p/e) of 28, whereas Nvidia is currently on a p/e of 54.