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Hello. Thanks very much for joining us. I'm pleased to be joined by Terry Smith from the Fundsmith Equity Fund. Terry, brilliant to see you. Hope you're well. Yes, thank you. Nice to see you, too. Excellent. Well, let's talk about performance. Fundsmith Equity is now on track for its fifth year of underperformance.
Now, I know you haven't lost money for investors every single year. But it does feel like you are still lagging the market. Is there a single reason why that's happened, or is it just a multitude of things? It's a series of different reasons. Okay. Um if you look back I mean I don't kind of count 2021 because it was we were up 22.1.
The market was 20 by Yeah, of course it's underperformed. So, when you're up 22% who cares? Does anyone care? I don't, anyway. Um so, we're really starting in 2022. And then uh was when interest rates went up from zero, basically, to 5% or roundabout. And that was a big headwind for things of the sort that we own.
We own good companies. Fairly sure about that. Good companies, on average, are more highly valued than the market. And so, you end up discounting more of the cash flows or earnings in the in the valuation. You get a higher rating. Uh that's what happens with companies like that. So, when rates go up, you're like a long-dated bond holder versus a short-dated bond holder.
So, when rates go up, our type of companies suffer in share price terms. And companies which we wouldn't own, which are very cyclical or not very good, actually relatively benefit quite well. So, that was kind of 22 23. Then in 2023, just as we were about to breathe a sigh of relief from well, rates have gone up and stabilized at the higher level.
And it's really the movement in rates that affects, it's not the level. Um suddenly, the phrase was coined and not for no reason, the Magnificent Seven. We had seven companies uh that were basically producing a very substantial part of the market returns. Um I mean, if you go and and look at it at the moment, the top 10 companies produced 2/3 of the market return last year.
Uh and so, those companies, Apple and Amazon and Alphabet and Meta and Microsoft and Tesla and so on, really went And we own some of them, but we don't own all of them. I mean, there are there are some of them we would never own. I mean, Tesla, for example, is never going to fit through what we do, ever.
Um so, that was that. And then in 2024, we might say, well, we've had a year of that now. Maybe we can get back to something like normality. Uh Jensen Huang at Nvidia got up and started expounding about AI and how that was going to be the new industrial revolution, as it were. And um and how his chips were going to power it.
And we went off to the races in terms of the AI boom, hype, you choose. And so, you know, we had interest rates, the Magnificent Seven, the AI boom stroke hype. And then, behind all of that, we had this uh tailwind for all of this, which is the switch to passive funds or index funds. You know, the uh you know, we've now got over 50% of assets are in index funds.
And that is we're really bad with labels in our industry. We don't help ourselves with how we label things. They're not passive funds. They're passive in the sense there's no fund manager like me making decisions. They're just on the index. But the money's actually invested in the index on the basis of the size of the companies, their market value.
So, when money goes into the index fund, it goes into the companies in the index in proportion to their size. And it boosts the momentum of those large companies. So, if you get fed up with me after this interview and decide you want to sell my fund, which is absolutely fine, and you put it in the index, Nvidia will definitely benefit in share price terms cuz I'm going to need Nvidia.
And the index has got Nvidia cuz it's the largest company. So, you have this massive tailwind, which is persisting from uh from the switch into to index funds. So, it was a whole series of factors. Do you not look at this situation where everyone is talking about AI and thinking, well, you know, I should I should be having some of that because I can see that there's a tailwind.
Do you Or do you you stick to your principles and say, I'm only going to look at companies because of they tick the right boxes for valuation, long-term corporate strategy, and sort of perhaps clarity of earnings? Yeah, look, the short answer is we stick to our principles. We're not going to go and buy things because it's going up.
And I think probably the vast majority of people who own stocks that are in the AI boom own them because they're going up, not because they actually know what the future is with regard to AI. I don't think we know what the future is with regard to it. And uh it's not true to say we haven't got it in the ear.
I mean, we own quite a lot of Microsoft, Meta, and Alphabet. And all of them are involved in this. The difference between them and say something like Nvidia is, if, you know, this afternoon somebody announces that actually the AI thing is complete spoof and uh and the whole thing stops, I'm fairly confident that Nvidia will go down sort of 80% or more.
All right? Whereas our Microsoft and our Meta and our Alphabet have all got other businesses. They've got their social media, advertising, search, operating systems, code, GitHub, LinkedIn, Surface. All of those things will I'm sure they'll have a very bad hair day. I'm just confident of that. But I'm equally confident their other businesses will will persist and be okay.
Well, I was thinking obviously because you have you have some tech, but you also have some sort of more defensive style companies. In your Let's Let's say if we do get a market pullback, do you think that you'd fare much better relative to the market? I'd be surprised if we didn't. Yeah, I mean, and don't don't just think about market pullback.
Um I mean, I'm I'm not predicting anything here, but how about an economic downturn? We haven't had an economic downturn for 17 years. It's quite a long time, isn't it? I guess you know, the interest rate trend at the moment makes it not very likely, but there's plenty of warning signs out there in terms of what's happening in credit, particularly private credit.
What's happening in terms of employment. Um so, it's not like it's obviously okay at the moment, is it? And um if there were an economic downturn, then yeah, I'm pretty sure that Procter & Gamble and Church & Dwight and all of those things will fare an awful lot better than than the highly valued high-tech.
Uh cuz one of the things about tech is if you look back in history, it wasn't very cyclical. I mean, there was a secular growth trend in terms of people's use of technology and and therefore its share prices. It's now such a large part of spend, both both by companies and I can't see how it can fail to be cyclical now.
I mean, there is a lot of talk around red flags in the in the in the market, whether that's an AI bubble, could it burst? But also, there's other things, you know, people worrying about the US banking uh regional banking sector. And just you know, the the it keep the the worry list is getting longer and longer.
What Are you feeling slightly concerned as investor? Cuz obviously, you've seen uh good good times and bad times. Yeah. Yeah. Um not especially, no. For a for a couple of reasons. One is we own quite a lot of defensive stuff, so we'll be relatively okay. The second thing is uh in terms of predicting downturns, it's not not what we do for a living.
But if I were trying to look at it at the moment, I would say probably the most positive thing I can think of is that people are worried. Uh it it typically you don't get the downturn when everybody's saying, oh, I'm really worried about what's happening in terms of employment. I'm really worried, you know.
I'm worried about this K-shape recovery and people at the bottom not having much consumer power. And I don't know. It it usually happens when we're all sitting here being fat and happy and cheerful and I'm thinking nothing can possibly go wrong and it hits you in the back of the head. So, actually, I think that you know, as they say, you know, a bull market climbs a wall of worry.
At the moment, there is a wall of worry, which probably means that the the bad events are not just about to strike. So, obviously, you know, markets are keep hitting new record highs. It does so you've got this one group of people worried. You've got this other group of people saying, actually, this is brilliant.
We're happy to keep buying. It's It It feels very unusual. But again, through through your career, have you seen this before? Yeah, I And when you say markets are making new highs, they are, but of course, it's a very narrow base. It's It's really AI that's making new highs. The rest of it is not making anything particularly.
Um and there's that side. Yeah, look, I would say at some point we're going to have Of course, people will say, "Are we going to have a market crash?" Yeah. I just don't know when. Are we going to have an economic downturn? For sure. I don't know when with that, either. The thing that's probably most positive moment is that a lot of people are worried.
We typically don't get the downturn when there's plenty of of public hand-wringing about things that are going wrong at the moment. Uh we usually get it when there's only blue skies in sight and everything seems to be going well. You You mentioned earlier about uh when interest rates went up, it perhaps was a bit of a headwind for some of the companies in your sort of portfolio.
When interest rates are trending down now, actually, you know, if if if we do get um lower rates or even, you know, we get an economic pullback, you know, I'm just wondering, do you do you think that your your portfolio should should work in high interest rate or low interest rate environment, or it it will only work in a lower interest rate environment?
I I think the portfolio uh strategy works in high rate environments. Um there's nothing wrong with it in in relation to that. Uh and if you look back in history, it certainly has. And really, one of the things is what's the return on capital the companies are making versus the interest rate. And the fact is this interest rate is kind of the the benchmark for what you've got to make.
If you've got companies making a 30% return on capital, if interest rates are five, well, they're making 25% over it. Whereas if they're at 10, you're making 20% over it. And if interest rates are zero, you're making 30% over it. You're still making a lot over it. The people who really suffer fundamentally are the people who haven't got very high returns.
If you if you're making 5% returns, 5% rate is quite problematic, really, isn't it? So, it works in in all of those environments. The thing that handicaps it relative to other things is the the direction of change. So, we had the 22 23 rise in interest rates, which given our our companies are more highly rated, hurt them more than the very lowly rated value cyclical companies.
They will probably benefit disproportionately as rates come down. So, what what you know, when you set up Fundsmith Equity Fund, one of the key things was about um taking a long-term view and and not overtrading, being patient. Obviously, with the underperformance of the funds in recent years, ultimately, why why should an investor stick with Fundsmith now?
Um because I think that the the strategy that we've got will produce superior long-term performance. If you own uh a bunch of companies that are producing 30% return on capital, a are converting 100% of their profits into cash, and have got a source of growth for the future that is quite predictable that enable them to keep investing at 30% returns, you will get a very good result.
But, you will need patience to do so. There's a great Charlie Munger quote that I always give to people where he says, "If you own a company that makes a 6% return on capital over time, you will gravitate towards a 6% return, no matter how cheaply you buy the shares. If you own a company that makes it, I don't know where we pick these numbers is an 18% return, you'll get you'll gravitate towards an 18% return if you own it for a long time, even if you overpay for it or seemingly high price.
That's what we're trying to do. We're trying to hold on to things that fundamentally make great returns, so that over time our return will start to gravitate towards the company's return. But, it requires a lot of patience to do that. Now, we've definitely got that patience, and clearly some of our investors have got that patience, but not all of them.
Well, Terry, thank you ever so much for joining us. It's been brilliant to talk to you. Okay.
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