In­vest in the busi­nesses in­vest­ing in them­selves

Feted stock picker Terry Smith has a se­cret for­mula for find­ing the best com­pa­nies, finds Sam Brod­beck

The Daily Telegraph - Your Money - - MONEY -

Since the dawn of in­vest­ing, pro­fes­sional and am­a­teur stock­pick­ers alike have ar­gued over the most ap­pro­pri­ate way to fil­ter out the best com­pa­nies from the rest. Pro­fes­sor Robert Shiller de­vel­oped the so-called “Cape” score as a way to find stocks and mar­kets cheap com­pared to his­tor­i­cal av­er­ages.

And the world’s most ad­mired in­vestor, Warren Buf­fett, uses his fa­mous “eco­nomic moat” the­ory to iden­tify com­pa­nies with strong com­pet­i­tive ad­van­tage and pric­ing power.

Terry Smith, among Bri­tain’s most suc­cess­ful fund man­agers of the past few years, re­vealed one of his favourite met­rics for find­ing stocks in a re­cent ar­ti­cle. Mr Smith hit out at ex­perts who preach about the im­por­tance of the div­i­dends paid out by com­pa­nies to the to­tal re­turns of an in­vest­ment.

Writ­ing in the Fi­nan­cial Times, he said there was “some­thing so al­lur­ing about div­i­dend in­come that it of­ten seems to lead in­vestors to aban­don com­mon sense”. In­vestors are look­ing at the wrong data, he added. Rather than the in­come paid to share­hold­ers, the key num­ber is the “re­tained profit” of a com­pany. This is the profit left over after pay­ing all costs, in­clud­ing taxes and div­i­dends. Of­ten, this money is rein­vested in the busi­ness it­self, and might pay for new equip­ment or re­search.

“This is a fea­ture of eq­ui­ties which no other as­set class pos­sesses. A portion of the re­turns that com­pa­nies gen­er­ate are re­tained and au­to­mat­i­cally rein­vested on your be­half,” he said.

“This cre­ates more value than you can ever cap­ture by rein­vest­ing div­i­dends.”

Warren Buf­fett’s own com­pany, Berk­shire Hath­away, es­chews div­i­dends, and has pro­duced an an­nual com­pounded re­turn of 19pc since 1977, Mr Smith noted.

Tele­graph Money asked AJ Bell, the bro­ker, to rank the com­pa­nies in the FTSE 100 in­dex of lead­ing Bri­tish stocks with the high­est re­tained prof­its.

In or­der to strip out firms which may rank highly be­cause of prof­its built up decades ago, the anal­y­sis only in­cludes com­pa­nies that have in­creased their re­tained profit fig­ure ev­ery year for at least the past five.

AJ Bell’s Laura Suter said: “Re­tained prof­its is a use­ful mea­sure to as­sess the fi­nan­cial health of a com­pany, as it’s ef­fec­tively the pile of money the com­pany has to hand to rein­vest in the busi­ness and grow it.

“How­ever, you need to look at com­pa­nies that are able to grow their re­tained earn­ings over time, rather than just burn­ing through the ex­ist­ing cash pile. You can’t take this fig­ure in iso­la­tion, and to meet the Terry Smith test of whether it works as an in­vest­ment, you have to drill down and look at the other cri­te­ria he judges a com­pany against.

“You would need to look at the debt lev­els, the com­pet­i­tive ad­van­tage it has, how re­silient it is to change and – cru­cially – its val­u­a­tion.”

Ms Suter has looked at a few stocks that made the list in more de­tail, pick­ing out two com­pa­nies that fit Mr Smith’s broader in­vest­ment phi­los­o­phy, and two that score highly, but would not fit with his over­all strat­egy.

Halma

Mar­ket value: £5bn Sec­tor: Man­u­fac­tur­ing Yield: 1.1pc Halma sells equip­ment which is nec­es­sary to com­ply with health, safety and en­vi­ron­men­tal rules. It is a clas­sic de­fen­sive stock, ex­pected to per­form well ir­re­spec­tive of the state of the wider econ­omy. Turnover and prof­its have risen each year for the past 14 years. Ms Suter said: “Terry Smith clearly has his eye on Halma as it has been flagged in mar­ket­ing ma­te­rial as one of the stocks that may go into his new in­vest­ment trust, Smith­son.”

Reckitt Benckiser

Mar­ket value: £46bn Sec­tor: House­hold goods Yield: 2.5pc Reckitt Benckiser owns many of the world’s best-known con­sumer brands, in­clud­ing Durex con­doms, Nuro­fen headache pills and Det­tol, the dis­in­fec­tant. Mr Smith al­ready holds the com­pany in his flag­ship Fund­smith Eq­uity fund.

easyJet

Mar­ket value: £4.6bn Sec­tor: Travel and leisure Yield: 3.6pc De­spite hold­ing nearly £2bn re­tained profit, low-cost air­line easyJet has lit­tle chance of ap­pear­ing in a fund man­aged by Mr Smith, not least be­cause he has pre­vi­ously ruled out ever buy­ing shares in an air­line. Ms Suter said: “The sec­tor is highly com­pet­i­tive and even though easyJet has a strong brand and large cus­tomer base, you could ar­gue the busi­ness has lim­ited pric­ing power.”

Bar­ratt De­vel­op­ments

Mar­ket value: £5bn Sec­tor: House build­ing Yield: 5.1pc While pay­ing chunky div­i­dends in the good times, house­builders gen­er­ally fail Mr Smith’s lit­mus test, said Ms Suter.

“The in­dus­try has very low bar­ri­ers to en­try, it is ex­posed to con­sid­er­able po­lit­i­cal risk and mar­gins can be squeezed quite eas­ily if labour and raw ma­te­rial costs go up,” she said.

Low- cost car­rier easyJet has built up bil­lions in re­tained profit, but Terry Smith has ruled out ever hold­ing air­lines in his port­fo­lios

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