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Welcome to the deep dive. Today we're uh really embarking on a fascinating journey. We're going into the mind of a legendary investor, Terry Smith. That's right. We're going to unpack his well, his famous buy once, cry once philosophy. Exactly. It's a strategy that guided his fundsmith to frankly extraordinary returns.
We're talking over 500% since 2010. Yeah. I mean, that effectively turns an initial investment into a sixagger in what, just over a decade. Pretty remarkable. It really is. It's kind of like the difference between buying a really high quality car, one that just lasts for years with minimal fuss, right, versus say a cheaper one that's always breaking down.
And while that initial cost for quality might sting a bit, you know, the long-term payoff and just the lack of headaches, it's undeniable. And that same principle holds true maybe surprisingly for stock market investments, too. It absolutely does. So, that's what we're digging into today. Terry Smith's uh meticulous methods, how he acquires these top tier companies without, you know, overpaying.
We've basically distilled his insights from his book, Investing for Growth, how to make money by only buying the best companies in the world. We've pulled out five core takeaways. Okay. So, what can listeners expect? We'll cover how to spot the real winners. Yep. And what truly signals a company's value.
Also, crucially, when to strike for a bargain and how to see past any uh Financial trickery. Exactly. Spotting the window dressing. And finally, maybe the most important thing, why patience is just your most powerful tool. Great. Where do we start? Well, we're kicking things off with a lesson from a well, an unexpected place.
The world of horse racing. Horse racing. Okay. I'm intrigued. Yeah. About half a century ago, there was this professional gambler, Alex Bird. He figured out how to make a fortune by exploiting an optical illusion. An illusion? What was it? He noticed that in really close races, the horse furthest from the crowd looked faster.
It just appeared that way. Ah, perspective. Exactly. So Bird learned to bet basically with certainty after he knew the real outcome just by closing one eye to get rid of the illusion. Wow, that's clever. So how does Terry Smith connect that to stocks? Well, Smith advocates a similar approach. He says, "Wait until you know who the winners are, then you pick them up after the market." The book makers in this analogy.
Precisely. after the market sets the odds or the price. The trick for us as investors is recognizing these winners. And this is key, being really mindful of the price you pay, right? Because you can't just compare any two winners directly, can you? Like an IT company like Apple versus say Monster Beverages.
No, exactly. They can both be huge winners in their respective fields, but you've got to compare apples with apples, so to speak. So, okay, most of us don't have Warren Buffett's phone number to ask competitors who they fear most his silver bullet test. How does the average investor spot these champions?
Yeah, without that direct line, you look for the signs. You look for companies that consistently show high gross and operating profit margins. A strong return on assets is another one, and evidence that they're actually increasing their market share. These sound like the characteristics of those uh deep moes people talk about.
That's exactly what they are. These powerful competitive advantages protect the business, allowing it to sustain profitability over time. But don't companies like that usually trade at a premium? They sound expensive. Often, yes, they often command a premium. But what's fascinating and what we'll get into is that there are times when even these really exceptional companies can be found at a discount.
Okay, that's the hook. Okay, so assuming we can identify a potential winner, let's talk about value, specifically dividends. This trips people up, right? It really does. Think about those little TV screens you sometimes see in the back seats of cars. Yeah, kind of a gimmick sometimes. Sometimes nice, maybe, but not the main reason you buy the car.
For a lot of fast growing companies, dividends can be a bit like those screens, not the core value proposition. A really common critique you hear against these high growth companies is that they pay little or no dividends. And some investors just jump to the conclusion that the company is well worthless if it doesn't pay out cash today.
Right? But that seems short-sighted. Give us an example. Okay. Take Berkshire Hathaway back in 1980. Imagine if Warren Buffett had decided to pay out say 50% of the profits as dividends every year for the next 42 years. Okay. Shareholders get cash. Sounds good. Well, maybe not. those long-term shareholders would actually have missed out on an incredible amount of value compared to what actually happened.
Really, why why would not getting cash be better? Two main reasons really. First, Berkshire consistently generated more than a dollar of value for every single dollar it kept and reinvested in the business. Ah, so the money was working harder inside the company. Much harder. When a company can do that, those retained earnings compound internally, growing the whole business faster.
Second, dividends get taxed right away. Reduces the amount you actually get to reinvest yourself. Exactly. It dampens the compounding effect for the shareholder. It's a bit like how high fees in actively managed funds can eat away at your returns over time. So, it's often much better for the company to just keep the earnings and reinvest them productively, provided they can reinvest them productively.
Yes, exceptional management knows when that's the right call. So you definitely shouldn't dismiss a great company just because it doesn't pay a dividend. Sometimes it's actually a positive signal. Okay, that makes sense. So you've identified a winner. You understand the dividend situation. Yeah. But when do you actually pull the trigger?
When do you buy? That's the critical question, isn't it? You might see Tesla with amazing growth or Microsoft with its huge moat or Apple and LVMH with their pricing power. But just looking at quality isn't enough. Absolutely not. That's what Howard Marx calls first level thinking. Just looking at the quality.
Explain that a bit more. First level thinking. It's basically a simplistic view, right? Judging an investment only on how good the company seems without seriously considering the price tag, the valuation. So a good company isn't always a good investment. Exactly. Markx famously said, "There's no such thing as a good or bad idea regardless of price.
A company could be growing at a perfectly healthy 20%. But if its stock is already priced as if it's going to grow at 30%, well, your returns could still be pretty crappy. So, you need both quality and a reasonable price. You do. And the good news is for the patient and prepared investor, opportunities always come up to buy these quality companies at a discount.
Even the darlings we mentioned, Apple, Microsoft, LVMH, they've all had significant drops from their peaks at times. So, it is possible to be that investor who snaps up a gem when it's say 40% off its high. It absolutely is. What causes those drops? If the company is still great, why does the price fall so much sometimes?
What creates these undeserved discounts? Well, often these opportunities pop up because of, you know, common market themes or reactions. One big one is quarterly results, uh, the short-term focus. Exactly. A company might be trading at a high multiple, let's say a PE of 40. Then it reports a quarter that's just okay, maybe 20% growth instead of the 35% analysts were hoping for.
And a stock tank. It can tumble. Yeah. Even though, as Terry Smith likes to say, a year is just a lap around the sun. A single quarter is even less significant in the long run, right? But a minor miss like that can drastically shift short-term sentiment. So, if you can keep that long-term view when everyone else is getting myopic, that's when you find great companies at fair prices.
Makes sense. What's another trigger for these opportunities? General market panics are another big one. Like the COVID crash in early 2020. Yeah. When it felt like everything was being sold off indiscriminately. Pretty much the herd of sheep, as some call it, just sells everything. It's actually a key reason why so many fund managers struggle to beat simple index funds like the S&P 500.
They get caught up in that emotion. Can you give an example from that time? Sure. Think about Microsoft. During the COVID crash, its stock took about a 25% hit. Wow. But logically, you wouldn't think a global pandemic would fundamentally hurt Microsoft's business. Maybe even the opposite. Exactly. It required quite some imagination to think their core operations would be negatively affected long term.
So, if you're fishing for these quality companies, the ones that usually trade at above average multiples, it's often really smart to just wait, wait until the next big market storm to cast your rod, so to speak. Okay, so patience pays off in finding the entry point, but then how do you really know if it's a bargain?
How do you avoid buying something that just looks good, like a dodgy used car with a new paint job? That's a great analogy, the paint job. Many investors rely heavily on the PE ratio, the price toearnings ratio, to gauge if a stock is cheap or expensive. It's probably the most common valuation metric people know it is.
But just like that used car might look fine on the surface but be a wreck underneath the E and PE the earnings can be surprisingly easy to manipulate. How so? How can earnings be manipulated? Oh, in various ways. A clever CFO can pull different levers. For example, earnings per share might look like it's growing nicely, but maybe the company is constantly issuing new shares, diluting existing investors.
So, the overall profit pie gets bigger, but so does the number of slices, the number of people splitting it. Your actual share might not be growing much at all. Okay, so dilution is one way. What else? Depreciation can be played with understated or overstated. Costs can sometimes be capitalized onto the balance sheet when they really should be expensed immediately against profits.
Little accounting choices can significantly change the reported earnings figure. So, the PE ratio might look attractive, but it's based on a potentially misleading number. How does an investor cut through that? How do you avoid spending hours analyzing a company only to find out it's built on shaky foundations?
Well, Terry Smith strongly advocates for using a more robust measure, free cash flow yield per share, FCF yield. Free cash flow. Let's break that down. What is it exactly? You find it on the cash flow statement. Essentially, you take the cash flow generated from the company's core operations and subtract the capital expenditures, the money needed to maintain and grow the business assets.
That gives you the free cash flow. Okay? Cash from operations minus capex, right? Then you divide that FCF figure by the number of shares to get FCF per share and then divide that by the current share price to get the FCF yield. And why is that better than earnings? Because it's much harder to fake cash.
This is close to what Warren Buffett calls owner's earnings. It represents the real cash the business generates after all necessary investments. The cash that's actually left over. Exactly. The cash that can genuinely be used to buy other businesses or pay you dividends or just be saved for a rainy day.
It's the true economic reality. So using FCF yield helps you answer that crucial question. Are you looking at the shiny paint job or are you looking under the hood? That's a powerful distinction. looking under the hood with FCF yield. Okay, so we've covered identifying winners, dividends, timing the purchase, and looking past earnings.
What's the final takeaway? The final point is about sticking with your strategy. Think about cars again. No single car is perfect for everything. Right. True. A Tesla might be great for city driving, but maybe not ideal for a long, rugged road trip. Exactly. But you wouldn't just throw the Tesla away because it's not suited for one specific task.
No, of course not. Well, the same applies to stock market companies and maybe even more importantly to investment strategies. Ah, so don't jump ship just because your strategy isn't the absolute best performer in every single environment. Precisely. So many investors fall into this trap of constantly switching strategies or chasing the hottest fund manager.
Performance chasing. Yeah. You you see your friend who just bought an S&P 500 index fund crushing it one year while you're carefully selected growth at a fair price. Stocks are lagging a bit and the temptation is huge to just ditch your approach and copy them. But is that really a good reason to switch?
Usually not if your underlying process is sound. Look, investors appetite for risk is always shifting. It changes based on macro factors like interest rates, inflation scares, where people think we are in the economic cycle. So the market mood swings constantly. And remember what Smith said about a year being just a lap around the sun.
It's a totally arbitrary period to judge the long-term success of an investment strategy. So, what's a more reasonable time frame? Ideally, you want to evaluate your results over a full economic cycle. You need to see how the strategy performs through both the good times, the bull markets, and the bad times, the bare markets.
Only then can you really tell if it was a winning approach. Only then can you truly get a sense of its resilience and effectiveness. Sticking to a sound process through thick and thin requires real discipline, it's much harder than it sounds. Yeah, it's incredibly difficult when the news cycle is shouting about short-term gains and losses every single day.
It is. But if you have a solid process based on principles like the one Smith uses, you have to stay true to it. Otherwise, otherwise you risk getting whipsawed. Buying high when things feel good and everyone's optimistic. Selling low when fear takes over. That classic destructive cycle. A cycle that's pretty much doomed to repeat until your portfolio is just hollowed out.
Okay, so let's recap the core principles from Terry Smith we've dived into. Right. First, focus on identifying the true leaders, the winners in their respective industries. Those are your best potential investments. Second, understand that dividends are well practical, but they're not essential for a company's success or its value to you as an investor.
Sometimes reinvesting is better. Third, recognize that opportunities will come along, even for the best companies, to buy them at fair prices. You just need patience and preparedness. Fourth, always look beyond that surface paint job of reported earnings. Dig deeper using metrics like free cash flow yield to see the real picture.
And finally, evaluate your investment strategy and its results over a full market cycle at the very least. Don't get sidetracked by short-term noise or performance chasing. Stick to your sound process. It all comes down to that discipline and long-term perspective in this world of, you know, constant market chatter and the desire for instant gratification.
What personal habits or maybe mindset shifts do you think are really necessary for someone listening to truly embody this patient buy once cry once philosophy? How can you stick to your process through thick and thin? That's the real challenge, isn't it? It takes conviction and maybe turning down the noise a bit.
Definitely something for all of us to think about. And if you're keen to explore the roots of this style of investing even further, well, a great place to look is the book Picking Growth Stocks. It was written by the person many consider the father of growth investing, Thomas Rorice Jr. himself. Really foundational stuff.
Excellent recommendation. Well, thank you for joining us on this deep dive into making money by, as Terry Smith puts it, only buying the best companies in the world.
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