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want to know a story about investor who turned his life around thanks to the stock market this British guy was a top performing banking Analyst at UBS when he published his book accounting for growth he uncovered misleading accounting practices of big companies that got himself in trouble his employer at the time has fired him from position of head of research as he just described practices of some of UBS clients it happened in 1992 but shows exactly what type of a man Terry Smith is he is not afraid to express his opinion and get in an argument he commented the matter with quite chilling words but he is not the one to start fights but he finishes them once when he was talking about why he doesn't like activist investors he didn't hesitate to fire shots at famous in activist investor Bill Ackman and he called him shockingly bad but how Terry Smith has built his fortune and fame of a great investor he doesn't come from a wealthy family quite on the contrary when he was young he lived in a house with no toilet inside and he definitely did not receive any City's capital for his Ventures he climbed the corporate ladder in various organizations but his true success comes from entrepreneurial Ventures he started his investment Fund in 2010 fansmith Equity Fund and achieved some stunning results since Inception he managed to compound his investors wealth at 15.6 percent while MSC work index has achieved annual return of 11.3 percent if you think that those four percentage points are not that big of a deal just look at cumulative results 527 percent managed by fan Smith versus 288.5 percent of MSC word index almost double the amount of money his performance looks even more stunning when we go back to the annual letter from 2021 when annual return since Inception was 18.6 percent how did he achieve that his strategy is actually simple but definitely not easy strategy behind fan Smith's success relies on three steps Step One is buy good companies find me Fran Smith is very selective with the stocks they invest into there it defines a good company as one which receives High Returns on Capital employed for long periods of time in relation to their cost of capital he gave this simple analogy that companies are just like us if you borrow your money at three percent and earn 20 return you will become welfare on the other hand you will become poorer if you receive lower returns to your interests although there are different formulas for calculating costs of capital such as for example wacc which stands for weighted average cost of capital Smith prefers companies that earn such outstanding returns that you do not have to wonder about exact cost of capital because it is sure that Roc is way higher it reminds me of Ben Graham analogy about fair value of stock if you see an obese man you don't have to know the exact number of pounds he weighs to know his obese similarly if you are a cashier and an old man with gray hair approaches you to buy a bottle of liquor you don't need to know his exact age to determine that he is old enough to buy alcohol but aeroc isn't the only indicator that Terry Smith and his team looks into because of regression toward the mean if any specific industry achieves High Returns on Capital employed it will attract more and more competition which in the end will lower the returns so we need so-called mold competitive advantage that will defend the company from the competition there are different types of modes such as Brands control of distribution patents installed base of equipment or software that are Troublesome to replace he also looks for businesses that have reinvestment possibilities Step 2 is don't overpay this step brings a lot of controversy as a number of people complain that fan Smith buys overpriced equities especially when you judge them on the price to earnings basis but earnings per share is not the first metric that this British champion of quality looks at he argues that earnings can be manipulated in a various way and well he wrote a book about topic so instead he focuses on free cash flow free cash flow is money left for the company after their operating and capital expenses this can't be manipulated as this is literally reconciled to the cash process by the company the point of investment is to receive more money in the future not to see your paper earning scroll so he has a point so instead of focusing on earnings yield he looks at free cash flow yield if you know companies free cash flow per share you can simply divide the price of stock by FCF per share and you will receive a percentage yield he Compares this number with what a bond yield should be and tries to get better yields than on bonds he also takes inflation into account so he can grow wealth of his clients in real not just nominal terms he Compares FCF yield of his fund and FCF yield of a broader stock market such as SNP 500.
he finished the year 2022 with FCF yield of 3.2 percent when SNP 500 was at 3.4 percent so the difference is really marginal compared to broader market and fun Smith may appear more expensive but considering how good are the companies he owns so not really that expensive and in my opinion he does a good job the last step is do nothing funsmith is a long-term investing fund purpose of buying a stock is not to make a quick Buck on volatility but to benefit from long-term growth of companies he's invested in so when he chooses company right he'd rather stay invested and doesn't leave his position if physics remains unchanged there are actually a few reasons for that first of all is that by this approach he can minimize costs of investors by less provisions on purchases and sales second of all he doesn't have to maintain huge number of analysts constantly valuing companies and giving the purchases or sell recommendations you do your research right and you just observe the fundamentals this doesn't mean that he never sells there are a number of companies he has sold such as Adobe which he sold pretty much after one quarter it wasn't bought with some short-term physics it's just fundamentals can massively change in today's world in relatively short period of time Adobe Inc has acquired a company named figma for stunning amount of 20 billion dollars which for Terry Smith was a sign of bad Capital allocation when it comes to one of the best decisions of Terry we can trace back to his purchase of Microsoft which has risen to be one of his top Holdings and also it was hintan it was his 10 bagger stock he didn't really expect a 10 bugger in 12 years while investing in already one of the biggest companies out there but how did he catch that I think from financial analysis point of view it seemed like a screaming by return on tangible Equity of Microsoft at the end of first quarter of 2010 was over 60 percent depth to equity ratio was at eight percent so there was almost no debt with no leverage at all this company was able to Learn to Earn 30 net margin remember that Warren Buffett has said that net margin of over 20 percent suggests strong competitive advantage 30 is simply wonderful gross margin standard at 80 percent which basically means that you produce something for 20 cents and sell it for a dollar wonderful when it comes to more qualitative aspects consider how strong Microsoft software's position is Windows had almost 90 percent share of operating system Market this seat nowadays at 28 percent but please consider how much this Market has grown with white adoption of smartphones Android has almost no share in this market and now is the biggest player also consider how crucial to basic operations of almost every business Microsoft tools were Excel is like one of the most important tools for accountants and finance departments around the world maybe some companies use sap some of the other use Oracle but almost everyone working on Windows will be using Excel world's finances are fueled by Microsoft Excel hundreds of thousands of Consultants will prepare their presentations in PowerPoint millions of students will write their master physics in Microsoft Word and so on also Microsoft was focusing on licensing those products so the revenue was recurring and more predictable but windows and their productivity software was not everything first segment which was also profitable was servers and tools in order not to dive too deep into it other cloud is part of this rapidly developing segment the fourth segment was entertainment where Revenue was also sticky if you want to play online on your Xbox you need Xbox Live gold which is a subscription model also if you're already on Xbox you buy games for Xbox and you are less likely to suddenly switch to PlayStation and start buying new games although nowadays you can buy subscription access to games and the greatest of all is that he bought it at 10pe most decisions might look easy in retrospect but keep in mind that this took place in 2010 one year after big financial crisis Microsoft didn't look that great compared to apple where PC market was becoming less important and apple dominated in smartphones and tablets foreign factor for his investing strategy is not only what to invest to but what not to invest in he was a top banking analyst but he refuses to invest in banking stocks that is quite tall you won't see any Commodities stocks or cyclic ads where you basically wait for an event to happen you can see his top position starting from Microsoft but second one from USA stocks is quite interesting Philip Morris is a number one tobacco company in the world they possess numerous strong Brands such as Marlboro a lamp Chesterfield icos devices and hits heated tobacco products this is more of a defensive consumer company Striker on the other hand is a company in medical technology so is idex however the second one is focused on pet Diagnostics I have noticed that Terry also likes luxury companies Estee Lauder lvmh L'Oreal Terry appreciates a strong brand when he sees one so that's all for today I hope you you found value in this video and I hope you have learned something from truly great growth investor Terry Smith thank you
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