Invest in the businesses investing in themselves
Feted stock picker Terry Smith has a secret formula for finding the best companies, finds Sam Brodbeck
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.
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.”
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.
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.”
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