Fund manager Terry Smith has issued his latest annual letter to investors in the Fundsmith Equity Fund. Smith is not known for holding back, so after a difficult year for companies of all shapes and sizes, it was always likely he would say something of note.
Here are selected highlights.
On FTX and Easy Money
This final round of easy money post the pandemic led to all the usual poor investments which people make when they are led to assume that money is endlessly available and costs zero to borrow or raise. We can see the unwinding of these unwise investments, for example, in the collapse of FTX, the cryptocurrency ‘exchange’ (sic) and the meltdown in the share prices of those tech companies with no profits, cash flows or even revenues.
On Meta
In some cases these share price falls have become more pronounced because of events surrounding the business. Meta has its well-publicised problems with the regulatory and competition authorities and has announced a large spend on developing the so-called metaverse, which it changed its name from Facebook to reflect.
On PayPal
PayPal seems intent on snatching defeat from the jaws of victory. It has taken a leading position in online payments and parlayed that into a lamentable share price performance. The elements in this would appear to be a disregard for engagement with the customers newly acquired during the pandemic and no obvious attention to or control of costs. This is hardly surprising given the attention devoted to pursuing some clearly over-priced acquisitions. That is what happens when management start to conclude that investments do not need to earn an adequate return.
On Tech Stocks Generally
A slowdown in the growth of tech spending is hardly surprising after the massive growth caused by digitalisation during the pandemic. Moreover, the cyclicality of tech spending and online advertising is probably about to become evident as the economy slows and maybe falls into recession. It may be greater than in the past simply because tech spending has become a much larger proportion of overall corporate and personal spending. However, there may be a silver lining in this cloud (no pun intended) as this pressure on revenue growth may cause some of the tech companies we invest in to stop behaving as though money is free and halt some of the less promising projects outside their core business, such as:
- Alphabet – Its hugely loss-making "Other Bets". Lightning does not strike twice. It has a good core online search and advertising business;
- Amazon – It has already withdrawn from food delivery and technical education in India (who knew?). It has a highly successful ecommerce and cloud computing business on which to focus;
- Meta – Stopping or cutting spending on the metaverse?
- Without that spend we would own a leading communications and digital advertising business on a single-figure Price/Earnings ratio (P/E).
On Cash Accounting
Cash conversion remains depressed for our portfolio companies but is currently based upon some unusually volatile conditions caused by the pandemic’s disruption to supply chains leading to stockouts and subsequent hoarding of stocks by some companies.
Cash flow is an acid test of a business but it is also a more volatile measure than profits which are based on accrual accounting and spread some cash flows between periods. We will have to wait a year or two before something approaching normality is restored and we can gauge how well our companies are doing on this measure.
On Relationship With Unilever
Last year I wrote about Unilever and attracted a virtual tsunami of comment for my remarks about Unilever, purpose and Hellmann’s mayonnaise. Events soon overtook this commentary insofar as Nelson Peltz’s Trian Partners announced that it had bought a stake in Unilever and he was invited to join the board. We are asked to suspend disbelief that this was in no way linked to the subsequent announcement that Alan Jope will be leaving the CEO role. This explanation sounds like it was lifted from the script of Miracle on 34th Street.
As I have previously pointed out, our Fund has held Unilever shares since inception and was about the 12th largest shareholder when these events happened. Yet for the first eight years of our existence as a shareholder we did not hear from Unilever. The first contact was when we were asked to vote in favour of moving the headquarters 11 and listing to the Netherlands. As I remarked at the time, it is not a good way to manage relationships to ignore people until you need their support. Once contact had been established with Unilever we then tried to make some points about what we saw as problems with the performance of the business and the focus of the management, which were duly ignored.
This is a business making a return on capital in the mid to low teens, below the market average, where you could measure annual growth if you could only count to three, and which missed every target it set out when it summarily rejected the Kraft Heinz bid approach. So it’s not like there weren’t some questions to answer.
Then came the near-death experience with the abortive GSK Consumer bid. I don’t know how long Trian held its stake before Mr Peltz was invited to join the board or how big that stake was, but I would guess that they held it for far fewer months than we have held it in terms of years. We have no objection to Mr Peltz’s involvement. He at least seems to have the sense to become involved in good businesses which need some improvement, whereas some activists pick on poor businesses and all they can hope to achieve is a better-run bad business. Where we have seen him involved in companies we have owned we have sometimes agreed with and admired his contribution – as in the operational improvements which accompanied his time at Procter & Gamble – and sometimes not – as when he promoted the idea of splitting PepsiCo into separate drinks and snacks businesses.
What I find questionable is that companies mouth platitudes about wanting to attract long-term shareholders yet based on our experience, we tend to get ignored, whereas an activist who has held shares for fewer months than we have held in years gets invited to board meetings.
On 'Virtue Signalling' Companies
Returning for a moment to Mayonnaisegate, amongst the outpouring of comments last year were a number of apologists for Unilever who were at pains to point out that the Hellmann’s brand has been growing revenues well and this was proof that "purpose" works. Of course there is no control in that experiment; we don’t know how well it would have grown without the virtue signalling "purpose". It also confuses correlation with cause and effect. There may be a positive correlation between stork sightings and births but that doesn’t prove that one causes the other. Maybe Hellmann’s would be growing as fast or even faster without its "purpose".
To further illustrate the point, this year we are moving on to soap. When I last checked it was for washing. However, apparently that is not the purpose of Lux, the Unilever brand, which apparently is all about "inspiring women to rise above everyday sexist judgements and express their beauty and femininity unapologetically." I am not making this up; you can read it here: https://www.unilever.com/brands/personal-care/lux/. I will leave you to draw your own conclusions about the utility of this.
On Share-Based Compensation
I suspect the most pernicious effect of adjusting profits to exclude the cost of share-based compensation occurs when the management start to believe their own shtick and mis-allocate capital based upon it. Too often management fail to mention expected returns on capital deployed when they make acquisitions and instead rely on statements about earnings dilution or accretion. We have just been living through an era where interest rates were close to zero. Statements about earnings dilution or accretion from an acquisition versus the alternative of interest income forgone on the cash do not reflect anything useful. In a period of such low rates the only acquisitions which could be dilutive are those where the money was literally shredded. Amazingly there are some of those too.
