Competition is good but invest in firms with a monopoly for profit
Think of the stock market like a giant bottle of ketchup: it drips out its bounty in unpredictable globs. That image – vivid, concrete and blunt – comes from Terry Smith and the managers behind his new Smithson investment trust, which started trading yesterday.
With his hugely successful Global Equity fund, Mr Smith’s straightforward style has produced a reliable stream of index-beating returns from the fickle ketchup bottle of the market. The fund is up 309pc since its launch in 2010. Now, to judge from the record-breaking enthusiasm at launch, investors believe Smithson can follow suit.
The global mid-cap trust had a launch target of £250m. Investors piled in, and the target was soon raised to £600m. In the end, Smithson raised a record £822.5m, beating the £800m for Neil Woodford’s Patient Capital in 2015.
Disillusion soon followed for Mr Woodford’s investment trust, which focused on the high-risk, high-potential world of disruptive technology.
But Smithson has a very different, much less glamorous target: simply a high probability of an acceptable profit. Mr Smith’s investing approach can be counter-intuitive (see page 5 for more) but it also has the benefit of simplicity: buy good companies; don’t overpay; then do nothing. In the case of Smithson, Mr Smith will supervise portfolio managers Simon Barnard and Will Morgan, and their approach hews close to the Global Equity model.
The key difference is Smithson’s focus on medium-sized firms, with an average size of £7bn. Such targets are too small to suit the behemoth of the Global Equity fund. Interestingly, they are, on the other hand, much larger than the firms covered by some of Smithson’s nearest competitors. The firms owned by Edinburgh Worldwide Investment Trust, for example, have an average market cap of just £2.5bn, less than half as much.
The larger size of the firms in Smithson’s sights fits with the managers’ desire not to try to predict the next big thing, but to select “companies that have already won”. The companies that Smithson is seeking have not only a proven record of financial success, but have established dominance in their market thanks to a durable advantage, such as intellectual property. This advantage should give them the potential of steady growth for years to come.
This approach has similarities to the championing of monopolies by Peter Thiel, a co-founder of PayPal. Thiel proposed in his 2015 book Zero to One that companies should strive to become effective monopolies in their sector, as Google has in search. Competitive markets are efficient ways to improve products for consumers, but they also push down profits for warring businesses. By contrast, an earned monopoly, such as one based on unique patents, can reward investors long-term.
And Smithson’s managers are happy to reject fast-growing firms in sectors where a winner has yet to emerge, such as technology. As they put it, “rapid change and fierce competition has meant that these innovations have rarely created long-term profits for shareholders”.
One problem with the wild enthusiasm for Smithson at launch is that it creates its own competitive pressures, and is likely to keep the trust’s price trading at a premium to the net value of its assets. A premium can be worth paying, but it increases the risk of overpaying, especially for a new and unproven venture.
One alternative would be to invest directly in firms that match the Smithson thesis. Its managers have identified 83 potential investments, of which they will only hold 25-40. Potential holdings in the trust’s brochure include New Zealand appliance manufacturer Fisher & Paykel; Danish bioscience firm Chr Hansen; British engineers Spirax Sarco; and Texan travel technology specialist Sabre.
Owning such firms directly risks not being diversified enough to cope with any unexpected flops. But the real challenge might be the discipline required to buy the shares and then do nothing for years, as Fundsmith recommends. As with ketchup, it’s tempting to shake the bottle as soon as you get frustrated, but if the Smithson team are right, the best things come to those who wait.
Chr Hansen’s dairy culture business could be a good bet for long-term growth, but make sure to stay diversified