Fundsmith

aroominyork

Prism said:

aroominyork said:

Prism said:

One aspect of quality only investing, whether that is via an active fund like Fundsmith or a passive quality fund, is that they have over the last 30 years or so outperformed. That is under a specific set of conditions of falling interest rates and I would not assume that this outperformance would continue if interest rates continue to rise - I would expect the opposite. Anyone getting into Fundsmith expecting significant outperformance in the coming is likely to be disappointed unless we have another crash and then hopefully Fundsmith once again will provide some resilience. 

But... Fundsmith invests in companies with low levels of debt so surely they are not significantly affected by raising interest rates? Compare their model of 'established winners' to other types of growth companies - either small caps with future potential reliant on short/medium term debt, or large companies with high turnover, investing in being world leaders but not currently generating high profits - Baillie Gifford comes to mind.

The companies themselves are likely not affected and can also probably increase their prices to match inflation. However the share prices of those companies will be affected. People are less willing to pay higher share prices for future growth when they believe they can get much quicker returns from cheaper stocks. If people only want to buy Microsoft on a PE of 20 not 30 then that's a 33% drop baked in. Money floods out of growth equities into value stocks, commodities and eventually new higher yield bonds regardless of the actual performance of the underlying companies.

Why do higher interest rates trigger this switch from growth to value, if growth companies' fundamentals remain sound?

ChesterDog

Partly because inflation erodes the values of the expected future cash flows of the companies.

Prism

aroominyork said:

Prism said:

aroominyork said:

Prism said:

One aspect of quality only investing, whether that is via an active fund like Fundsmith or a passive quality fund, is that they have over the last 30 years or so outperformed. That is under a specific set of conditions of falling interest rates and I would not assume that this outperformance would continue if interest rates continue to rise - I would expect the opposite. Anyone getting into Fundsmith expecting significant outperformance in the coming is likely to be disappointed unless we have another crash and then hopefully Fundsmith once again will provide some resilience. 

But... Fundsmith invests in companies with low levels of debt so surely they are not significantly affected by raising interest rates? Compare their model of 'established winners' to other types of growth companies - either small caps with future potential reliant on short/medium term debt, or large companies with high turnover, investing in being world leaders but not currently generating high profits - Baillie Gifford comes to mind.

The companies themselves are likely not affected and can also probably increase their prices to match inflation. However the share prices of those companies will be affected. People are less willing to pay higher share prices for future growth when they believe they can get much quicker returns from cheaper stocks. If people only want to buy Microsoft on a PE of 20 not 30 then that's a 33% drop baked in. Money floods out of growth equities into value stocks, commodities and eventually new higher yield bonds regardless of the actual performance of the underlying companies.

Why do higher interest rates trigger this switch from growth to value, if growth companies' fundamentals remain sound?

Its related to the discounted cash flow (DCF) element of valuation which takes into consideration the difference between cash gained now and that gained in the future and then comparing against just earning interest in the bank. Most of the ratings agencies use it and lower their valuations of growth companies when interest rates rise. 

NoviceInvestor1

Prism said:

Every fund in a portfolio should require a justification beyond 'I think it will provide higher returns'. In the case of Fundsmith, I use it as an alternative to a developed world fund like Fidelity Index World. I do this for a few reasons but mainly to avoid the riskier, more cyclical parts of the market like banks, miners, car makers and the like. The end effect of this is generally a lower volatility compared to other large cap equity funds and typically a lower drawdown when there is a crash. The last time this was tested was 2020 and it worked very well then. In general I try to reduce risk and volatility across most aspects of my portfolio, not just large cap global equities.

Not wanting to be argumentative at all, but how about in the market correction in 2022 - does that not count? Fundsmith fell far more than a developed world index......

Anything with an overweight to tech and the USA looked like it held up well in 2020, those same overweights have been detrimental in the next market correction. No two corrections/crashes are the same.

Fundsmith has underperformed a quality index for 3 years out of the last 4, what do you think will be the catalyst for the fund turning around and going back to generating alpha like it used to half a decade ago? 

Thrugelmir

NoviceInvestor1 said:

Prism said:

Every fund in a portfolio should require a justification beyond 'I think it will provide higher returns'. In the case of Fundsmith, I use it as an alternative to a developed world fund like Fidelity Index World. I do this for a few reasons but mainly to avoid the riskier, more cyclical parts of the market like banks, miners, car makers and the like. The end effect of this is generally a lower volatility compared to other large cap equity funds and typically a lower drawdown when there is a crash. The last time this was tested was 2020 and it worked very well then. In general I try to reduce risk and volatility across most aspects of my portfolio, not just large cap global equities.

Fundsmith has underperformed a quality index for 3 years out of the last 4, what do you think will be the catalyst for the fund turning around and going back to generating alpha like it used to half a decade ago? 

When individual stock selection again becomes key. We've experienced an era of freely printed money lifting all boats. Finally over. A new era has begun. 

aroominyork

Prism said:

aroominyork said:

Prism said:

aroominyork said:

Prism said:

One aspect of quality only investing, whether that is via an active fund like Fundsmith or a passive quality fund, is that they have over the last 30 years or so outperformed. That is under a specific set of conditions of falling interest rates and I would not assume that this outperformance would continue if interest rates continue to rise - I would expect the opposite. Anyone getting into Fundsmith expecting significant outperformance in the coming is likely to be disappointed unless we have another crash and then hopefully Fundsmith once again will provide some resilience. 

But... Fundsmith invests in companies with low levels of debt so surely they are not significantly affected by raising interest rates? Compare their model of 'established winners' to other types of growth companies - either small caps with future potential reliant on short/medium term debt, or large companies with high turnover, investing in being world leaders but not currently generating high profits - Baillie Gifford comes to mind.

The companies themselves are likely not affected and can also probably increase their prices to match inflation. However the share prices of those companies will be affected. People are less willing to pay higher share prices for future growth when they believe they can get much quicker returns from cheaper stocks. If people only want to buy Microsoft on a PE of 20 not 30 then that's a 33% drop baked in. Money floods out of growth equities into value stocks, commodities and eventually new higher yield bonds regardless of the actual performance of the underlying companies.

Why do higher interest rates trigger this switch from growth to value, if growth companies' fundamentals remain sound?

Its related to the discounted cash flow (DCF) element of valuation which takes into consideration the difference between cash gained now and that gained in the future and then comparing against just earning interest in the bank. Most of the ratings agencies use it and lower their valuations of growth companies when interest rates rise. 

Three points. First, surely discounted cash flow affects companies with poor pricing power more negatively than quality companies with wider moats, which is more typical of funds like Fundsmith. Second, a move to value would primarily be towards companies whose business models are generating good profits today but which are underpriced, rather than not temporarily unloved companies which a fund manager thinks will recover. And third, if ‘cash in the bank’ is a factor, that would affect all companies equally (growth and value) and lead to all boats falling on the same tide. (This is a useful discussion – thanks.)

Thrugelmir said:

NoviceInvestor1 said:

Prism said:

Every fund in a portfolio should require a justification beyond 'I think it will provide higher returns'. In the case of Fundsmith, I use it as an alternative to a developed world fund like Fidelity Index World. I do this for a few reasons but mainly to avoid the riskier, more cyclical parts of the market like banks, miners, car makers and the like. The end effect of this is generally a lower volatility compared to other large cap equity funds and typically a lower drawdown when there is a crash. The last time this was tested was 2020 and it worked very well then. In general I try to reduce risk and volatility across most aspects of my portfolio, not just large cap global equities.

Fundsmith has underperformed a quality index for 3 years out of the last 4, what do you think will be the catalyst for the fund turning around and going back to generating alpha like it used to half a decade ago? 

When individual stock selection again becomes key. We've experienced an era of freely printed money lifting all boats. Finally over. A new era has begun. 

... which would surely favour sustainable quality companies.

Prism

NoviceInvestor1 said:

Prism said:

Every fund in a portfolio should require a justification beyond 'I think it will provide higher returns'. In the case of Fundsmith, I use it as an alternative to a developed world fund like Fidelity Index World. I do this for a few reasons but mainly to avoid the riskier, more cyclical parts of the market like banks, miners, car makers and the like. The end effect of this is generally a lower volatility compared to other large cap equity funds and typically a lower drawdown when there is a crash. The last time this was tested was 2020 and it worked very well then. In general I try to reduce risk and volatility across most aspects of my portfolio, not just large cap global equities.

Not wanting to be argumentative at all, but how about in the market correction in 2022 - does that not count? Fundsmith fell far more than a developed world index......

Anything with an overweight to tech and the USA looked like it held up well in 2020, those same overweights have been detrimental in the next market correction. No two corrections/crashes are the same.

Fundsmith has underperformed a quality index for 3 years out of the last 4, what do you think will be the catalyst for the fund turning around and going back to generating alpha like it used to half a decade ago? 

I should have say economic crash which are far more concerning and might yet happen if interest rates rise too much and GDP drops consistently. What we have seen in 2022 is just a rerating of assets and barely counts as even a correction. I think MCSI World hit -10% for two days before recovering. Fundsmith has been off the pace by around 7% which seems reasonable considering the valuations of the holdings.

As I said earlier, I think it may well continue to underperform for a while. The only way it will turn it around is if the companies it holds are in fact more profitable than the index by an amount that exceeds their valuations. The Fundsmith managers believe that they are but that also requires everyone else to agree eventually. Or if there is an economic crisis, possibly brought on by inflation or debt, causing interest rates to level off or drop again.

NoviceInvestor1

Prism said:

NoviceInvestor1 said:

Prism said:

Every fund in a portfolio should require a justification beyond 'I think it will provide higher returns'. In the case of Fundsmith, I use it as an alternative to a developed world fund like Fidelity Index World. I do this for a few reasons but mainly to avoid the riskier, more cyclical parts of the market like banks, miners, car makers and the like. The end effect of this is generally a lower volatility compared to other large cap equity funds and typically a lower drawdown when there is a crash. The last time this was tested was 2020 and it worked very well then. In general I try to reduce risk and volatility across most aspects of my portfolio, not just large cap global equities.

Not wanting to be argumentative at all, but how about in the market correction in 2022 - does that not count? Fundsmith fell far more than a developed world index......

Anything with an overweight to tech and the USA looked like it held up well in 2020, those same overweights have been detrimental in the next market correction. No two corrections/crashes are the same.

Fundsmith has underperformed a quality index for 3 years out of the last 4, what do you think will be the catalyst for the fund turning around and going back to generating alpha like it used to half a decade ago? 

I should have say economic crash which are far more concerning and might yet happen if interest rates rise too much and GDP drops consistently. What we have seen in 2022 is just a rerating of assets and barely counts as even a correction. I think MCSI World hit -10% for two days before recovering. Fundsmith has been off the pace by around 7% which seems reasonable considering the valuations of the holdings.

As I said earlier, I think it may well continue to underperform for a while. The only way it will turn it around is if the companies it holds are in fact more profitable than the index by an amount that exceeds their valuations. The Fundsmith managers believe that they are but that also requires everyone else to agree eventually. Or if there is an economic crisis, possibly brought on by inflation or debt, causing interest rates to level off or drop again.

That seems fair.

I just wonder if the risks of a highly concentrated fund exposed to a tiny part of the market, with big overweights to US and tech, which used to be less volatile than MSCI World but now isn't are underplayed somewhat. Even Scottish Mortgage looked "defensive" based on 2020 performance, though we all know it's not! 

Would you have concern that the underperformance in 3 of the last 4 years are linked to either fund size and/or a reduction in active share (this has come down quite a bit)?

As a relatively recent convert to the "other side" (i.e. passive investing) I find the case of Fundsmith really interesting. It's gone from vast blockbuster outperformance to underperformance, which has coincided with the increase in size. Is it a blip, or is it the next statistic in terms of the vast majority of active funds that underperform in the long run after a good run in the short term kind of thing. 

GazzaBloom

Thrugelmir said:

NoviceInvestor1 said:

Prism said:

Every fund in a portfolio should require a justification beyond 'I think it will provide higher returns'. In the case of Fundsmith, I use it as an alternative to a developed world fund like Fidelity Index World. I do this for a few reasons but mainly to avoid the riskier, more cyclical parts of the market like banks, miners, car makers and the like. The end effect of this is generally a lower volatility compared to other large cap equity funds and typically a lower drawdown when there is a crash. The last time this was tested was 2020 and it worked very well then. In general I try to reduce risk and volatility across most aspects of my portfolio, not just large cap global equities.

Fundsmith has underperformed a quality index for 3 years out of the last 4, what do you think will be the catalyst for the fund turning around and going back to generating alpha like it used to half a decade ago? 

When individual stock selection again becomes key. We've experienced an era of freely printed money lifting all boats. Finally over. A new era has begun. 

Now, in this exciting new era, if only the majority of fund managers could reliably pick winning stocks consistently over time for their funds and beat the indexes, we'll all be laughing.

tebbins

Higher interest rates:
1. Make investors less able and willing to take unnecessary risks with growth stocks.
2. Increase the risk-free rate input into a DCF model, making expected future cash flows worth less in today's terns.
3. Cheap debt is the fuel of growth stocks, the expected cash returns to investors are often via (the promise of) buybacks, buybacks also depend on cheap debt.

Source for 3: search William Lazonick value extracting CEO, and Yardeni Research S&P500 buybacks.

That said, quality is still quality.