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Terry Smith's fund has paid 37 times earnings for in and a share price of around $125 in 2017 it is now at $574 so it's almost a 5x in 5 years for him and he got paid almost $16 per share in dividends during that time into its's annual dividend is now at $360 so his yield on cost is at 2.8% fun Smith has also paid 36 times earnings and a share price of around $66 for idex in 2015 idex is now at $482 so it has been a 7x for fun Smith in 8 years these are just two examples that Terry Smith has provided in an answer but before we go any further let's listen to Terry's answer in its entirety and here comes the next question at the end of 2010 the fundsmith portfolio had a free cash flow yield of 7% and at the end of 2020 this had fallen to 2.8% would Terry have reasonably expected an 18% annual return over the last 10 years with a starting free cash flow yield of 7% and given that the companies in the portfolio are now more richly valued would he expect returns of the fund to be lower over the next 10 years actually my expectations haven't changed very much uh F enough I mean what we've delivered has changed a bit and no doubt will change a bit more over time I I think but um somewhere back in the annals of all this maybe back at our very early um uh sholders meeting but somewhere back there I said somebody asked me what I thought we could deliver in terms of returns and of course you know subject to all the usual caveats about we're not promising anything and everything else I said well about 12% really I think is what we could get based on the the cash flow you we got and the growth we've got if you had the two together you get a rough guess at it about 12 and funny enough if I sit here today and I say well the free cash flow yield is sort of about three let's not get overly precise and the the growth rate sort of about eight that kind of gets me to about 11 which is about now you know so what got us to 18 well a few other things went better than we we expected I suppose is the answer uh you know and perhaps Jules I know has made up a slide on this can elaborate on what we mean by that that you know where do we get from your expectation of 12 to 18 Terry well some things that we bought on a free cash flow you would have whatever we bought them on three one of the great problems in in talking about that is when you say what it's on a three Cas Li of 3% which it is now that of course isn't a matter of debate that's just a precise mathematical number it's the last 12 months cash flow divided by the price but the great whilst it's got great Precision it's in the rear view mirror of the car um what we get is out of the wind screen of the car that's where we're heading it's the future that we're actually buying into we're not buying the past returns we're buying the future returns these companies would deliver and of course the problem we're trying to drive we're looking through the winds screen is it's always a bit foggy um but um it's a lot safer than trying to drive looking at the rearview mirror so looking at the the historic free cash flow yield and looking at the growth rate didn't get me to the right answer 10 years ago and I suspect it won't get me to the right answer this time and and if I'm wrong and I and if I'm wrong in a positive way we deliver more again it will be because of things of the sort that they'll get Julian to to go on comment on Jules uh we have three companies here and uh they are in order of the dates uh so um we bought um Inuit in May of 2017 uh and I've used pees here for Simplicity uh and we bought them on a 37 times multiple of their trailing earnings when we bought them um and today if we look at the the earnings for the last 12 months they're on that turned out to be on a kind of threee forward PE of 18 then if we go a bit further back to the summer of 2015 um and by the way these entry prices that we didn't buy our whole stake at this price this was just the actual first the first chairs we bought we bought idex uh on a a multiple of a trailing multiple of 36 times um and the the the business has done extremely well so that was kind of like a 5e forward PE of 10 times and then Visa which we bought all the way back in March of 2012 uh and at the time looked like a pretty multiple of 23 times trailing earnings um and uh fast forward eight years or nine years that's now six times and so you know my my my absolute favorite Warren Buffett quote is the one at the top which is that time is the friend of the good business so if you if you make a mistake in terms of your entry price but you have bought a good business time is is your friend and we'll bail you out and and that looks to be the case and then we've also got another slide the next one um which is entitled how growth became value and value didn't as in value didn't become uh growth and or sorry value didn't become value and and so here are five pretty classic uh value stocks I think You' you'd admit Deutsche Bank X on G IBM and shell uh and I've taken the same entry price the same entry date rather for all of them which was the beginning of 2015 and you looked like you were buying these things on multiples of you know somewhere between 10 and the High Teens um and if you fast forward 5 years you were paying 322 times 2020 earnings for Deutsche Bank minus 18 times for Exxon 42 2610 whereas uh beneath these are a handful of Fairly classic grow stocks and you could see the multiples at entry for um I mean Amazon was loss making Adobe was over a 100 times Facebook 71 times Netflix 554 times and 5 years on it turns out you were paying you know in in the single digit PE so so that I think is to Terry's point he often makes about low PE does not mean cheap and vice versa uh it's basically the uh the value stocks the earnings fell faster than the share price is what happened whereas on the the uh you know the the high relatively high quality growth stocks the reverse occurred uh although they looked pretty Punchy in terms of valuation the earnings grew an awful lot faster than the price grew quite clearly um when you get these things right that's how it works he said touching wood um I mean and um the last slide on this is one that I particularly like it's called justifi pees which hopefully you can see on the screen now this is uh looking back to uh 1973 and looking at a bunch of companies here and saying what PE could would you have paid and got as it says at the top of the slide a 7% compound annual growth rate in the share price so you could have bought these at a earnings multiple back L not the actual one they were trading on I know it goes back and computes what you could have paid for them and and got 7% growth in the share price over the intervening period And the reason they chooses 7% is because the Maci World index the index that most fund managers don't beat uh delivered 6.2% per atom so if You' paid this PE for any one of these shares you'd have beaten the index by 3/4 of a point not a bad result I think most F managers would say and when you look at it in 1973 you could have paid 281 times earnings for L'Oreal and beaten the index wow now I'm fairly sure you wouldn't have done that I'm absolutely certain I wouldn't have done it but you should have done it and and that's the problem with getting into this highly Valu must be expensive lowly valued must be cheap Mantra that people seem to have slipped into if you go down the list Brown foran which we own also the the American distiller of Jack D could have paid 174 times Colgate 126 times PepsiCo 100 times I mean these are Big Numbers aren't they that you could have paid and beaten the index it just puts it in perspective that you know we won't get the right answer out of looking at where we are by a spot valuation now just going oh it looks a bit expensive we actually have to think about the quality of the business and what it might produce for us in the years ahead before we can come to the right answer I called add on more examples than provided in the video but I think they have done a fantastic job there so I don't want to just bore you with more examples of companies however this doesn't mean that you can't make money buying value stocks that actually look cheap there are people with Decades of experience in the oil industry for example and they can understand the cycles and balance sheets of those companies so much better than I can if you can find the companies that are in your circle of competence and are looking very cheap I believe that is the time to load up the shares the key lies in understanding that that Quality Companies grow their earnings at a faster Pace this rapid growth propels their stock prices higher compensating for the seemingly steep initial valuation on the flip side many value stocks might have low PE for a reason they could be facing stagnation or even a decline buying cheap isn't always a ticket to long-term success there are also cases like turkey where even the highest quality of companies in the country are trading at low to mid single digit earnings due to macro concerns most of the foreign investors have run away from from the country in the last years regardless of the valuation and as monish Pai puts it the baby got thrown away with the bath water if you want to know more about those companies subscribe to my channel and check out my videos where I try to cover some of those companies that I believe I can understand in conclusion paying iron multiples for Quality Companies is an investment in the future it is about recognizing that the best returns often come from those businesses that consistently outpace the competition as you unar on your investment Journey remember the words of Terry Smith buy good companies don't overpay do nothing quality matters and in the world of investing it might just be the secret to long-term wealth remember quality investing requires patience it is not about quick gains but about reaping the rewards of a Val created portfolio over time let me know what you think in the comments and if you like this video hit the like button and subscribe for more in the future take care bye
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