Notes from the past week below including Templeton on determining bargains, Buffett's "surest way of making money", Core capital allocation questions shareholders must ask, and more:
Terry Smith of Fundsmith - Quality First, Price Second
As we've mentioned in previous newsletters, we love learning from investors with fundamental value approaches that are different from our own. We've heard of Terry Smith and Fundsmith but never heard from him directly until a few days ago. He's an articulate investor and we've included notes from some of his talks below:
8:45 What makes a "good" company?
Here, Smith outlines his definition of a good company; the first two points are:
1) High returns on capital employed in cash; and
2) Growth driven from reinvestment of cash flows at high rates of return
Buffett has emphasized high returns on equity as the best financial indicator of quality, and this is mirrored in 1).
Two points we've noted from experience: a) Almost everybody in the stock market seems to be searching for such quality; and b) When you do find high returns on equity, 2) is usually lacking - especially if you insist on cheap valuations.
But Smith's success is undeniable earning 15%+returns over a decade managing almost £20bn.
Also worth noting the remaining qualitative points he looks for - we admire the way he excludes large swathes of industry (energy, banks, etc.), and sticks to his knitting.
42:00 Cheapness Isn't Important (!)
Smith's secondary emphasis on price is fascinating. Over long periods of time, the mathematics is clear. You're going to do a lot better emphasizing highly profitable companies over price if the business can sustain such reinvestment for long periods of time and you can hold on to it.
Caveat: Our holding periods are short-term (two to four years), which is usually sufficient time for stocks to approximate intrinsic value if we've purchased them at bargain prices. P/E re-ratings are remunerative.
Nevertheless, it's fascinating to see good long-term performance with less emphasis on valuation - though Smith did underperform -17.8% vs -11.3% (MSCI World Index) in the first half of 2022. An investor placing less emphasis on valuation should probably expect underperformance in down markets.
Breakeven P/E Ratio
Smith undertook a study that hits at the nub of what we wanted to know: What's the breakeven p/e multiple to match the market performance when buying 'quality' stocks - because logically, there is always a price limit for a sensible investment purchase (and many 'growth' investors fail to address this):
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