Fundsmith Equity Fund

Owner’s Manual
Contents

Introduction 2
Why is an Owner’s Manual necessary?

Section 1 6
The investment management industry

Section 2 10
How we invest at Fundsmith
We aim to buy and hold
We aim to invest in high quality businesses
We seek to invest in businesses whose assets are
intangible and difficult to replicate
We never engage in “Greater Fool Theory”
We avoid companies that need leverage
The businesses we seek must have growth potential
We seek to invest in resilient businesses
We only invest when we believe the valuation is attractive
We do not attempt market timing
We’re not fixated on benchmarks – other than long term
We’re global investors
We don’t seek diversification
Currency hedging, or the lack of it
Management versus numbers
Our investments are liquid and our fund is open-ended

Section 3 24
The fund manager

Section 4 26
What do we charge you?

Disclaimer: Fundsmith does not offer investment advice or make

any recommendations regarding the suitability of its product
and no information contained within this document should be
construed as advice.
Should you feel you need advice please contact a financial adviser.
Past performance is not necessarily a guide to future performance.
The value of investments and the income from them may fall as
well as rise and be affected by changes in exchange rates, and you
may not get back the amount of your original investment.

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Introduction Fundsmith Owner’s Manual

Why is an Owner’s We aim to run the best fund ever.

By best fund, we mean the one with
Manual necessary? the highest return over the long term,
adjusted for risk.
Most fund managers will send you a glossy
brochure. At Fundsmith we want you to
have an Owner’s Manual. Why? Because
your understanding of what we are trying
to achieve and how we will approach it
is a critical element in enabling us to
attain our goal.

What is our goal?

Captain Cook, the navigator and explorer who discovered
Australia, once said that he didn’t want to go further than any
man had gone before, he wanted to go as far as a man could
go. Such ambition led him to discover a new continent. We hope
to run the best fund there has ever been, and certainly aim to
provide the best fund you have ever owned.

This is an ambitious goal and we need to clarify what we

mean by best and where you come in. By best fund, we mean
the one with the highest return over a long period of time,
adjusted for risk.

You may think it’s odd that by best we don’t necessarily mean the
fund with the highest return, certainly not over any short period of
time or irrespective of how the returns are achieved. Investment
is subject to a lot of fads and cycles. A good example was the
Dotcom mania when Technology, Media and Telecommunications
stocks rose to valuations which could not be supported by any
rational analysis. If you weren’t invested in technology stocks in
that period (and we wouldn’t have been) then you would have
underperformed the market. We would be happy to have done
so, as we would never own a share in a company which we did
not think was both good and at worst fairly valued. We would
not own something because it is fashionable and might go up.
Because eventually it goes down. Usually by a lot.

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Introduction Fundsmith Owner’s Manual

There are also funds which deliver high returns but which are The greatest threat you face to your
running what we would regard as unacceptable risks. They
may be following fads, like the Dotcoms, and hoping to sell out investment performance is from you.
and realise the gains before the bubble bursts; or using leverage
or borrowed money to enhance returns, which is OK until things
go wrong and the leverage magnifies the losses, or worse.

Your understanding is important because whilst you own our

In general, investors are also too active or they buy funds run
fund there may be investment fads which other fund managers
by managers who are too active. Active is one of those bits of
are following but we won’t. We need you to understand this, since
investment jargon which has more than one meaning and is
we wish to concentrate all our efforts on making the fund work
often misunderstood as a result. Fundsmith does not intend to
for you, and don’t want to deal with endless queries about why
run a passive or index fund, far from it. But investment activity
we are not following a particular investment fad. Just as vitally,
in the form of buying and selling shares has a frictional cost
we don’t want you to withdraw your money from our fund in
in terms of the commissions and the difference between the
order to follow the investment fad of the moment. Leaving aside
bid-offer spread which dealers charge. The more we can
the obvious facts that we earn fees on your funds and that in
minimise these costs, the better.
and outflows can be disruptive to our investment strategy, there
is also the fact that not being in our fund continuously for the As Warren Buffett, probably the greatest contemporary investor
long haul is likely to significantly reduce your returns. once said: “Long ago, Sir Isaac Newton gave us three laws of
motion, which were the work of genius. But Sir Isaac’s talents
John McEnroe once said that he was such a good tennis player
didn’t extend to investing: he lost a bundle in the South Sea
that the only person who could defeat him was himself; i.e. that
Bubble, explaining later, ‘I can calculate the movement of
he could only be beaten by his own temperament. The greatest
the stars, but not the madness of men.’ If he had not been
threat you face to your investment performance is from you.
traumatized by this loss, Sir Isaac might well have gone on to
Most investors make some classic mistakes which prevent them discover the Fourth Law of Motion: For investors as a whole,
from capturing the best investment performance they could returns decrease as motion increases.”
obtain. They buy at the top and sell at the bottom of markets
This low level of activity requires the deceptively simple task of
or share price cycles, motivated by greed and fear. It takes
buying the right shares in the first place and holding onto them
considerable emotional discipline to buy when others are fearful
for a long time, both of which are easier said than done.
and sell when others are greedy. Not that we intend to indulge in
market timing, but just doing nothing takes iron discipline when Investors also buy the wrong type of funds. Perhaps the best
faced with the fears and temptations of the markets. way to illustrate this is to tell you how we will run the Fundsmith
Equity Fund and how this contrasts with the way most of the fund
management industry operates.

4 5
Section 1 Fundsmith Owner’s Manual

The investment The greatest risk to most fund

managers’ careers is not losing
management industry money for you or underperforming
the index. It is in doing something
We offer you a single FSA authorised different to their peers.
fund which will bring to retail investors
a method of investment which they
have not been able to access before.
Fundsmith is a new asset management
company established to provide an
alternative because we believe that most
existing equity investment funds are not
delivering what they should.

This is obviously true in the sense that the performance of

the average equity fund over the past decade has been dire.
The average IMA Global Growth fund delivered a total return
of just 0.7% in the ten years to 31st of July, 2010. But matters
are worse than even these statistics suggest. The same funds
have underperformed the index by 5.3 percentage points.

This is hardly surprising as the average equity fund manager

owns far too many stocks and in effect tracks the index.
So what you are buying is in fact an index fund less the
manager’s fees and costs of dealing, which is also expensive.
This structure makes underperformance against the index
inevitable. Why do fund managers do this? Because for them
the greatest risk is not underperforming the index with your
money, it is stepping out of line with their peers. Especially if
they fail. Warren Buffett also said, ‘Failing conventionally is
the route to go; as a group lemmings may have a rotten image,
but no individual lemming has ever received bad press.’ But
it is not clear that doing something different to the crowd is
career enhancing even if you are right. The gatekeepers of the
investment world – the consultants who advise institutional
investors and the advisers who advise many private investors
– are not generally supporters of divergent thinking or action.
This is ironic, because the only way to succeed in investment
is to break out from the crowd.

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Section 1 Fundsmith Owner’s Manual

We want to diverge from the management groups is to raise a new fund for every possible
investment technique and for every new fad and to hope that at
benchmarks. Positively, of course. least some of them succeed in a random process and that you
We don’t believe in tracking error. In don’t notice the ones which don’t.

fact, we regard it as a waste of time. At Fundsmith we will only have one equity fund, because in
active management we think that’s all you will ever need.

You may also notice that the name of our fund is simple: the
Fundsmith Equity Fund. It doesn’t say it’s a Growth Fund or an
Income Fund. Our marketing advisers were very keen for us to
Nor is this problem limited to the UK. A recent study by
get the word Income or Dividend into the title because apparently
academics at Yale School of Management, using the Active
income funds outsell growth funds. We haven’t followed that
Share methodology, showed that mutual funds in the US with
advice because we regard the distinction between income
a low Active Share (“index huggers” or “closet indexers”) had
and growth as artificial. Good businesses of the sort we seek
about 30% of all assets in 2003, compared to almost zero in the
to invest in produce cash flow returns on their capital invested
1980s, and that low Active Share funds have poor benchmark
which are better than the average, and they can sustain those
adjusted returns and do even worse after expenses.
returns, and even replicate them on newly invested capital.
At Fundsmith we are never going to discuss tracking error. When they find opportunities to invest at these superior rates
Tracking error is the measure of how closely a portfolio tracks of return we want them to do so rather than pay our fund a
the index against which it is benchmarked. In fact, we embrace dividend. However, most of the companies of the sort we seek
tracking error. We want to diverge from the benchmarks. In will pay a dividend as they generate cash flows which compare
a positive way, of course. So we don’t want our owners to be favourably with their profits, and opportunities to invest at
confused into believing that tracking error is a problem or even superior returns are limited even for good companies. Whether
a legitimate subject for thought or discussion or to waste any you choose to receive that income or seek to compound it is
time on it. simply a matter of whether or not you tick the “Reinvestment”
box on the fund application. The idea that there is one set of
Most fund managers own too many stocks. Apart from making investible companies which are “growth” companies and which
their performance track the indices, which you can achieve much do not pay dividends and a different set that pay most of their
more cheaply with an index fund, this also makes it difficult for earnings out and so are “income” stocks is simply a marketing
them to invest in the companies they own with conviction. How man’s invention, not an investment reality.
much can you know about the 80th company in your portfolio?
Anyway, enough of what’s wrong with the fund management
Most fund management groups also manage a proliferation industry. How will we run the Fundsmith Equity Fund?
of funds. There are over 2,400 UK domiciled mutual funds
which can invest in UK companies and only some 2,700
companies listed on the London Stock Exchange. This presents
a fairly obvious problem. Most fund management groups have a
myriad of funds covering growth and income, large companies
and small companies, international and domestic equities,
The name of our fund is simple:
emerging markets funds, long only funds and long/short funds, the Fundsmith Equity Fund. It doesn’t
funds covering particular sectors, and that’s just in equities. We
could be forgiven for thinking that the strategy of many fund
say it’s a Growth or an Income Fund.
We regard this distinction as artificial.

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Section 2 Fundsmith Owner’s Manual

How we invest We aim to be long-term, buy and

hold investors. We seek to own only
at Fundsmith stocks that will compound in value
over the years.
We aim to buy and hold
We aim to be long-term, buy-and-hold investors. We seek to
own only stocks that will compound in value over the years.
Accordingly, we have to be very careful about the stocks we
pick. We believe, as does Warren Buffet, that we do not have
a good investment idea every day, or indeed, not even every
year. Consequently, we should treat our investment career like
one of those tickets you get for a tram which is spent once
it’s been punched 20 times, as that’s the number of great
investment ideas we’re likely to be able to find at a price we can
justify investing in them. This also minimizes the frictional cost
of trading.

We aim to invest in high quality businesses

This may sound blindingly obvious, but you might be surprised
how many investors either don’t do this or do not have a good
definition of a high quality business.

In our view, a high quality business is one which can sustain a

high return on operating capital employed. In cash. It’s funny
how investors who are not at all confused about this concept
when they are seeking the bank deposit with the highest rate of
interest (necessarily balanced by risk, as depositors in Icelandic
banks discovered) or even the return on a fund such as ours, lose
their marbles when it comes to evaluating companies. They start
talking about growth in earnings per share and other gibberish.
Earnings per share is not the same as cash, but more importantly
it takes no account of the capital employed to generate those
earnings or the return which is earned on it. If all you want from
your investments is earnings per share growth, we can provide as
much as you need providing you supply us with unlimited capital
and turn a blind eye to the returns we are able to generate.
Frankly I wouldn’t recommend it as a way of investing, although
that’s precisely the way many investors do invest, especially in
acquisitive companies.

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Section 2 Fundsmith Owner’s Manual

Note that we are not just looking for a high rate of return, we least innumerate) competitors when credit is freely available.
are seeking a sustainably high rate of return. An important To be fair, during equity market “bubbles”, some competition
contributor to this is repeat business, usually from consumers. can be funded by equity which seems to require no foreseeable
A company that sells many small items each day is better able return, but Dotcom style phenomena are mercifully rare, and like
to earn more consistent returns over the years than a company every cloud they have a silver lining; the Dotcom boom led to
whose business is cyclical, like a steel manufacturer, or “lumpy”, depressed valuations for the “old economy” stocks of precisely
like a property developer. the sort we seek.

This approach rules out most businesses that do not sell direct The kinds of intangible assets we seek are brand names,
to consumers or which make goods which are not consumed dominant market share, patents, licenses, distribution networks,
at short and regular intervals. Capital goods companies sell installed bases and client relationships. Some combination of
to businesses; business buyers are able to defer purchases of such intangibles defines a company’s franchise.
such products when the business cycle turns down. Moreover,
business buyers employ staff whose sole raison d’être is to drive Since stock markets typically value companies on the not
down the cost of purchase and lengthen their payment terms. unreasonable assumption that their returns will regress to the
Even when a company sells to consumers, it is unlikely to fit mean, businesses whose returns do not do this can become
our criteria if its products have a life which can be extended. undervalued. Therein lies our opportunity as investors.
When consumers hit hard times, they can defer replacing
We never engage in “Greater Fool Theory”
their cars, houses and appliances, but not food and toiletries.
We really want to own all of the companies in our fund. We do
However, not all companies which sell capital goods or which sell
not own them knowing that they are not good businesses or are
to businesses are outside our investible universe. A business
over-valued, in the hope that someone more gullible will come
service company may have a source of consistent repeat
along and pay an even higher price for them. We wisely assume
business, and some capital goods companies earn much of
that there is no greater fool than us.
their revenue, and sometimes more than all their profits, from
the provision of servicing and spare parts to their installed base We avoid companies that need leverage
of equipment. These can satisfy our criteria. We only invest in companies that earn a high return on their
We seek to invest in businesses whose assets are capital on an unleveraged basis. The companies may well have
intangible and difficult to replicate leverage, but they don’t require borrowed money to function.
For example, financial companies (such as banks, investment
It may seem counter-intuitive to seek businesses which do not
banks, credit card lenders, or leasing companies) typically
rely upon tangible assets, but bear with us. The businesses we
earn a low unleveraged return on their capital. They then
seek to invest in do something very unusual: they break the
have to lever up that capital several times over with money
rule of mean reversion that states returns must revert to the
from lenders and depositors in order to earn what they deem
average as new capital is attracted to business activities earning
to be an acceptable return on their shareholders’ equity. Even
super-normal returns.
worse, some sectors such as real estate, can only earn an
They can do this because their most important assets are not adequate return on equity by employing leverage. This means
physical assets, which can be replicated by anyone with access that not only are their unlevered equity returns inadequate,
to capital, but intangible assets, which can be very difficult to but periodically the supply of credit is withdrawn, often with
replicate, no matter how much capital a competitor is willing disastrous consequences given the illiquidity of their asset
to spend. Moreover, it’s hard for companies to replicate these base. In assessing leverage, we include off-balance sheet
intangible assets using borrowed funds, as banks tend to favour finance in the form of operating leases, which are common
the (often illusory) comfort of tangible collateral. This means that in some sectors, such as retailing.
the business does not suffer from economically irrational (or at

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Section 2 Fundsmith Owner’s Manual

We are more interested in and people’s lives. They have created value for some investors,
but a lot of capital gets destroyed for others, just as the internet
companies which have physical has destroyed the value of many traditional media industries.
growth in the merchandise or We are at one with Warren Buffett who suggests that the most
sensible course of action for an investor who witnessed the
service sold than simple pricing Wright brothers’ inaugural controlled powered flight at Kittyhawk
power, although that’s nice too. in 1903 would have been to shoot them down. Anyone who
doubts the wisdom of this should take a look at the financial
performance of airlines over time.

Big, exciting new developments, even those that change the

world, are not necessarily good long-term investments. We do
The businesses we seek must have growth potential not have the skills or the appetite to spot a new innovation
It is not enough for companies to earn a high unlevered rate of and ride the wave of initial enthusiasm for the short term with
return. Our definition of growth is that they must also be able the (often unspoken) aim of selling out before the truth about
to reinvest at least a portion of their excess cash flow back into its potential to destroy value is apparent. As investors, we only
the business to grow, while generating a high return on the cash seek to benefit from product development in long established
thus reinvested. Over time, this should compound shareholders’ products and industries.
wealth by generating more than a pound of stock-market value
for each pound reinvested. We only invest when we believe the valuation is attractive
Again this one may seem obvious but we have seen many
In our view, growth cannot be thought about sensibly in isolation investors who invest in quality companies, yet still underperform
from returns. Rapid growth may be good news or it may be bad because they consistently overpay for those investments.
news. It depends on how much capital you have to invest to We estimate the free cash flow of every company after tax
generate that growth. The “earnings” of a bank savings account and interest, but before dividends and other distributions,
will grow faster, the more money you deposit into the account. and after adding back any discretionary capital expenditure
But it is unlikely to be a good investment strategy to put most which is not needed to maintain the business. Otherwise we
of your assets into such an account, and you certainly shouldn’t would penalize companies which invest in order to grow.
rejoice at the fact that if you double your capital invested you
will get twice as much interest. That is not growth. The source
of growth is also a factor to consider. Growth in profits from
increasing prices can simply build an umbrella beneath which
competitors can flourish. We are more interested in companies
which have physical growth in the merchandise or service sold Bonds do not grow or compound in
than simple pricing power, although that’s nice too. value. Our goal is to buy securities
We seek to invest in resilient businesses that can do both, and provide yields
An important contributor to resilience is a resistance to product
that are similar or better than bonds,
obsolescence. This means that we do not invest in industries
which are subject to rapid technological innovation. Innovation at a cheaper price.
is often sought by investors but does not always produce lasting
value for them. Developments such as canals, railroads, aviation,
microchips and the internet have transformed industries

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Section 2 Fundsmith Owner’s Manual

Our aim is to invest only when free cash flow per share as a A subset of our inability and unwillingness to try to make
percentage of a company’s share price (the free cash flow yield) market timing calls is that we will not invest in sectors which
is high relative to long-term interest rates and with the free are highly cyclical. It is possible to deliver performance from
cash flow yields of other investment candidates both within such investments, but it requires a good sense of timing for the
and outside our portfolio. economic cycle and how the market cycle relates to it. It also
requires strong nerves, because such investments are often
Our goal is to buy securities that we believe will grow and counter-intuitive, as exemplified in the investment adage “Only
compound in value, which bonds cannot, at yields that are buy cyclicals when they look expensive”. This is because when
similar to or better than what we would pay for a bond. they have little or no earnings, they are at or close to the bottom
of the cycle. The converse applies; to sell them when they look
We do not attempt market timing
cheap, as they are then at peak earnings.
We do not attempt to manage the percentage invested in equities
in our portfolio to reflect any view of market levels, timing or We are not sure we have either the skill set or the constitution
developments. Getting market timing right is a skill we do not for such investing. In any event, investing in cyclical businesses
claim to possess. Looking at their results, neither do many other has one big disadvantage even if you get this worrisome timing
fund managers, but that does not seem to stop them trying. process roughly right; they are mostly poor quality businesses
Studies clearly show that most successful fund managers avoid which struggle to make adequate returns on their capital. There
market timing decisions. Apart from an inability to do it well are are few barriers to entry into their business sectors. If you want to
the potential consequences of even trying it. This is illustrated become a major airline investor, I am sure you will be welcomed
by the fact that if, for example, you had invested in a UK index with open arms. But whilst you wait to see whether you have got
fund from 1980-2009 you should have achieved a return of your timing right, the underlying value of your investment is more
some 700% on your investment. However, if you missed the best likely to erode than compound, and of course occasionally they
20 days of stock market performance during that period, that do not survive a cycle at all.
return would have been reduced to just 240%. We do not claim
to be able to time buy and sell decisions so as to capture 20 We’re not fixated on benchmarks
days out of some 7,000 working days. In addition, our fund is Over a sufficient period of time, you will no doubt want to
not meant to provide an asset allocation tool. We assume that if assess our performance against a range of benchmarks – the
you own our fund you have already taken the decision to invest performance of cash, bonds, equities and other funds, and we
that part of your portfolio in equities, managed in the manner will assist you in that process by providing comparisons.
we describe.
However, we do not think it is helpful to make comparisons
with movements in other asset prices or indices over the short
term, as we are not trying to provide short term performance.
Be warned: in our view, even a year is a short period to measure
things by. Moreover, a year does not have its foundations in
Big, exciting new developments, the business or investment cycle. It is, in fact, the time it takes
the earth to go around the sun and is therefore of more use in
even those that change the world,
studying astronomy than investment.
are not necessarily good long-term
investments.

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Section 2 Fundsmith Owner’s Manual

A year is the time it takes for UK equities strikes us as bizarre. Why should the best growth
companies in the world be listed in a stock market based in a
the earth to revolve around the country which only ranks fifth in the world by size of its economy
sun. It has no foundation in and is located on a smallish island off the coast of Europe?
Another advantage of investing with a global perspective is the
the investment cycle. ability to contrast and compare growth rates and valuations of
companies from all geographies.

Some of the companies we seek to invest in derive a significant

portion of their revenues from developing markets. This can
enable us to obtain some of the benefits of developing markets
For this reason, you should only invest in our fund if it is with
exposure, mostly growth, whilst benefiting from the governance
money that you will not need for a long period of time, and you
structure of a large, international company; mostly but not
are capable of remaining relatively sanguine about mark to
always listed in one of the world’s major stock markets.
market adjustments. Falls in market prices may make the market
value of our portfolio go down, but we will only be concerned if We don’t seek diversification
we believe that the intrinsic value of our portfolio of companies
We do seek portfolio diversification, but the strictness of our
has declined, and we will tell you so. Conversely, we will not be
investment criteria will inevitably leave us with a concentrated
rejoicing if or when we get a short term performance boost from a
portfolio of 20-30 companies. We do not fear the concentration
take-over. The problem is that we will need to find a replacement
risk which this brings for two reasons. One is that research has
investment which can deliver high and sustainable returns on
shown that you can achieve close to optimal diversity with 20
capital in cash and grow its business to deploy at least some of
stocks. But this may not be true in our case, as our investment
the cash that it generates at those sorts of returns. As you may
criteria typically lead to a concentration in certain sectors. We
gather, such investments are few and far between.
then fall back on our other reason for not fearing concentration
We’re global investors risk. As Mr Buffett said: ‘Wide diversification is only required
when investors do not understand what they are doing.’
We are a bit suspicious of the term “Global”. When someone
presents a card which states that they are the “Head of Global As a result, we take no notice of sector, industry or of country
Sales”, it is tempting to ask them how many globes they have weightings. In any event, the country of domicile of a company’s
sold. It usually just means Head of Sales, but some organisations headquarters or listing is a very imperfect guide to where a
proliferate Heads and Managing Directors quicker than rabbits company derives its revenues, profits and cash flows, which are
breed, so it’s probably just a grandiose way of attempting to subjects of real interest to us.
make a distinction.

Notwithstanding the hyperbole with which the term is often

used, our fund seeks to be a global investor. Fund management
groups have tended to proliferate national or regional
investment funds that are an anachronism. Investors based in We take no notice of sector, industry
developed economies, such as the UK, who are overweight in
their local market as a consequence of buying these funds may or country weightings. The country
find themselves underweight in companies with high growth or domicile of a company is a very
prospects more typically found in developing markets, and may
exclude from their portfolios suitable investments listed outside imperfect guide to where it derives
the UK. The idea of having an investment fund restricted to its revenues, profits and cashflows.

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Section 2 Fundsmith Owner’s Manual

Currency hedging, or the lack of it Many companies can be excluded

Our policy is not to hedge our currency exposure. There are
several reasons for this. One is that we do not purport to be from consideration simply from a
any good at currency trading. It has a cost which is often rather description of what they do or the
more than it appears when you are being sold the hedge.
In addition, you cannot know what any individual company’s sector they occupy, and the most
currency exposure is without knowing what hedging, if any, it impressive management team in
has conducted in its own treasury operations. Experience would
suggest that not even the treasurer is sure of that on occasions. the world will not induce us to
In any event, you cannot permanently hedge a portfolio or a invest in them.
company against movements in any commodity with a price
which fluctuates. Many of the companies we seek to invest in
generate revenues in the same currencies as they incur most of
their costs. Therefore, their exposure to currency fluctuations is
largely a matter of translation of their profits.
Management versus numbers
It is also a fact that if a fund is denominated in a soft currency, We are rather more comfortable analysing numbers than
its performance will look better than it will if it is in a hard we are trying to gain insights into companies by meeting the
currency. Again, we don’t intend to do anything to mask or alter management. We intend to find companies which are potential
that by hedging, as we don’t think it has any bearing on the investments by a screening process looking at the results
real performance the fund delivers and we don’t know which they produce to find the sort of high return, cash generative,
currencies will depreciate and which will appreciate. However, if consistently performing businesses we seek. In fact, most
you think you do, you can always hedge your position. companies can be excluded from consideration simply from a
description of what they do or the sector they occupy, as most
are cyclical, require leverage to get adequate returns, sell to
other businesses, make capital goods or durable items, or some
combination of these factors.

Our policy is not to hedge our That is not to say that we won’t seek to meet management.
It is important to assess whether management provides honest
currency exposure. We do not
stewardship, acting in the interests of the owners and telling
pretend to be any good at it. it how it is rather than PR spin to try to enhance investors’
perceptions. This does not mean we seek management with
a narrow focus on what has become labelled “shareholder
value”. Too often a reliance upon the simplistic targets required
by shareholder activists, such as growth in earnings per share
and returning capital to make the balance sheet “efficient”,
(sometimes so efficient that it busts the company) has been
to the long term detriment of shareholders. We would prefer
management to invest adequately to maintain a company’s
brands and franchise value and grow it, albeit with good returns,
and be honest about the impact of this on earnings and capital
requirements. Companies which under-invest in their franchise
in order to meet short term targets are not good candidates for
compounding wealth.

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Section 2 Fundsmith Owner’s Manual

However, we are aware of the limitations of our insights into

human nature and we therefore expect management words to
be borne out by figures in the report and accounts.

We are also believers in the adage that you should only buy
shares in businesses which could be run by an idiot because
sooner or later, they all are.

Also, we are a minority investor in large quoted companies

rather than a private equity investor with a controlling stake in
a company who can seek to control management. We can and
will engage with management in an effort to ensure that their
decisions are in the long term interests of the company and
in particular in relation to capital allocation and management
remuneration which we regard as vital. But ultimately, our main
sanction in the event that management is behaving badly or
illogically is to not own the shares.

Our investments are liquid and our fund is open-ended

The companies we invest in are likely to have large market
capitalisations without major blocks being held by controlling
shareholders. Therefore their shares are easily tradeable. In
addition, our fund is an OEIC, i.e. an open-ended fund. Other fund
managers may tend to have lock up periods during which you
have to give notice and wait to redeem your investment or they
manage a closed-ended fund which means that the performance
of your investment is dependent upon the relationship between
the share price of the fund and the underlying net asset value
of the investments. The liquidity in the shares of the fund itself,
or the lack of it, can become an issue for investors seeking to
redeem their investment. Investors suffer no such handicap with
the Fundsmith Equity Fund.

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Section 3 Fundsmith Owner’s Manual

The fund manager Fundsmith will always be

Terry Smith’s main vehicle
for his own investments.

The fund will be managed by Terry Smith,

based in London, assisted by Julian • The cash flow returns on the original investments in Tullett
Robins, as Head of Research, based in Liberty and Prebon in 2003-4 including dividends and other
payments to shareholders represent an Internal Rate of
the USA. Return (IRR) of 25% p.a. for the period 2003-2010.

Fundsmith is a fund management company established in • When Tullett was acquired, its pension fund had a significant
2010 by Terry Smith and chaired by Keith Hamill. The business deficit. Terry Smith has been investment advisor to the fund
is headquartered in London with an office in Connecticut, USA, since 2003 and the deficit has been converted to a surplus
and comprises a team who have worked closely together for by a discretionary manager who has outperformed all major
many years. The Fundsmith Equity Fund will be the only equity stock and bond indices by employing a strategy very similar to
fund we will ever manage and is the main vehicle for Terry’s that which Fundsmith employs.
own investments. • Terry has a long track record in financial markets as an original
Terry Smith thinker and as a person who is prepared to bet against the
crowd. Apart from Accounting for Growth, he is credited with
Terry has been in the financial services industry for 36 years. He
being one of the few commentators who predicted the extent
was the No. 1 rated investment analyst for the Banks sector for
of the Credit Crunch.
most of the 1980s. In 1990 he became head of UK Company
Research at UBS Phillips & Drew, a position from which he was Julian Robins
dismissed in 1992 following the publication of his best selling Julian Robins is an investment analyst who has worked with
book Accounting for Growth. He joined Collins Stewart shortly Terry Smith for much of the past 25 years, including over a
afterwards, and became a director in 1996. In 2000 he became decade together at Collins Stewart. Julian started his career
Chief Executive and led the management buy-out of Collins with the stockbroking firm EB Savory Milln in 1984. From 1987
Stewart, which was floated on the London Stock Exchange five until 1999, he worked for BZW and after their takeover of BZW’s
months later. In 2003 Collins Stewart acquired Tullett Liberty equity business in 1998, CSFB. Between 1988 and 1993 he was
and followed this in 2004 with the acquisition of Prebon Group, BZW’s senior bank analyst in London. From 1993 until 1999, he
creating the world’s second largest inter-dealer broker (IDB) worked as an institutional salesman in New York. In 1999 he
which facilitates trades between banks in foreign exchange, was one of the founders of Collins Stewart’s New York office. He
bonds, interest rates, equities and energy. Collins Stewart and has a 1st class degree in Modern History from Christ Church,
Tullett Prebon were demerged in 2006. Oxford and is qualified as a Series 7 Registered Representative
• The buyout of Collins Stewart was at one eighth of a penny per and Series 24 General Securities Principal with FINRA. Julian is
share compared with an all time high of 266p per share. a partner of Fundsmith LLP.

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Section 4 Fundsmith Owner’s Manual

What do we charge you? 1% p.a. for direct investors

No performance fees
No initial fees
No redemption fees
For direct investors, we charge 1% of the No overtrading
value of the funds which we manage for
you per annum.

However, in recent years the term “hedge fund” has come to

If you come through an intermediary, then the charge is 1.5%. It
represent just a charging structure, as hedge funds have
is higher because we have to reward the intermediary. We have
developed in every area of activity and asset class, ranging
no objection to intermediaries per se, but using them does add
from equities, bonds, currencies, commodities, derivatives
to your and our costs and may cause communication issues.
and even collectibles such as art and fine wine. It is not always
These are important considerations given that we regard your
possible to short some of these assets, and even when it is
understanding of our investment style and process as vital to our
possible, it is clear from the results of many hedge funds during
success in delivering performance to you.
the Credit Crunch that they either weren’t hedging or weren’t
We do not charge a 5% initial fee as many UK mutual fund doing so effectively. This leaves hedge funds defined by the two
providers do. In our view, only having 95p in every £1 you invest at and twenty charging structure.
work in the fund is an unreasonable handicap to your investment
There are two problems with that structure. Firstly, human
performance, especially once it is allied with the usual problems
nature being what it is, it provides temptation for the hedge fund
of the fund manager incurring costs through over-trading. You
manager to make an extreme and often highly leveraged bet
can imagine what it does to your returns when the 5% upfront
with the fund. If it comes off, he or she walks away with 20%
fee and the costs of over-active dealing are applied to the sort of
of the gains. If not, it’s not their money which is lost. Using this
closet index fund which most managers offer.
methodology, many hedge fund managers have been able to
You will note that we have not set Fundsmith up as a hedge fund retire after a short period of good performance. Even if it does
charging the traditional “two and twenty” i.e. 2% of funds under not fail and lose the investors’ money, this “strategy” does not
management plus 20% of gains. Why? We have no desire to run lead to long term compounding of returns, because, by definition,
a hedge fund in the true meaning of the term; we have no desire the fund manager takes to the hills (or his yacht) after a short
to short stocks as a hedge since we regard this as superfluous period of spectacular performance.
in respect of the long term performance we aim to deliver.
The second issue is more pernicious; the two and twenty charging
In addition, we regard it as a positively dangerous distraction
structure cannot work for investors even if the hedge fund
from our main task of finding and holding exceptional company
manager is capable of generating superior returns indefinitely.
stocks. Moreover, it adds leverage to the fund which we avoid, in
This was illustrated in a study of Warren Buffett’s performance.
the same way we avoid investment in companies which require
By 2008, Buffett’s Berkshire Hathaway had created net worth
leverage to deliver adequate returns. Shorting also substantially
of some $62bn. But if instead of Buffett controlling a company
increases activity in a fund, the cost of which is detrimental
in which he was a co—investor with other shareholders
to performance. Investors often fail to realise that the more
and from which he takes no fees, he had invested the money
successful a short position is, the quicker it declines as a portion
with an outside hedge fund manager who delivered exactly the
of the portfolio and needs to be replaced by a new short position.
same performance from the same investments, 90% of the
That is the reverse of a good long idea. You can run good long
value created would have accrued to the hedge fund manager.
ideas forever, and we intend to try.
That’s why we only charge you 1% p.a. if you come to us directly.

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 Fundsmith Owner’s Manual

And finally… We don’t guarantee to make you

happy to pay tax, only to try to ensure
what about tax? that the amount you are paying it on
is as large as possible.
Too much activity increases the cost of operating a fund. It also
deprives investors of an unusual advantage; an interest free
loan from the government. In the UK, gains which are realized
within a mutual fund such as the Fundsmith Equity Fund are not
taxable. However, disposals of holdings by investors in mutual tax, but the net amount retained will still be greater than if tax
funds are chargeable to Capital Gains tax. An investor who keeps had been paid on gains along the way. Therefore the investor
realizing holdings will therefore pay CGT. Once this has been should be happy. Please note we said “should be”. We don’t
subtracted, the amount which can be reinvested is significantly guarantee to make you happy to pay tax, only to try to ensure
reduced. Over time this will have a serious effect on the amount that the amount you are paying it on is as large as possible.
an investor can obtain by compounding his or her investment.
But whilst this is true of all mutual funds, if you are going to
Now you might say that an investor can escape this handicap pursue this strategy to maximise your wealth as an investor, the
by adopting the same long term, buy and hold strategy that choice of fund is critically important. Ideally, it should be a fund
Fundsmith pursues. However, it is hard to pursue perfectly which you can trust to deliver for the whole of your investing
with individual shareholdings. Sometimes it is necessary to life because changing funds will trigger the tax payment. What
buy and sell shares to reflect changes in relative valuations. might such a fund look like? Well, we would argue that it should
We are constantly evaluating our investments against each other have a clear strategy which was shown to deliver consistent
and other shares in our investible universe for this reason, and superior returns over a long period of time. We would also
and from time to time there is involuntary turnover caused by argue that it should be run by a fund manager who is unlikely
takeovers. In fact, this can happen frequently when you own to change, unlike the 65% of managers who move jobs every
shares in good businesses. For the investor who owns individual 3 years. Fundsmith is Terry Smith’s business and is now
shares, this creates taxable events, whereas it does not create the main vehicle for his own investments. He will never
a taxable event in a mutual fund like Fundsmith. Therefore, by leave to work for another fund management company. Taking
holding such a fund, an investor’s gains are compounded on all of this into account, the fund you choose might be the
what is in effect an interest free loan from the government, i.e. Fundsmith Equity Fund.
gains realised within the fund are not taxed and we can earn
returns on the tax which would have been paid until such time
as the investor withdraws from the fund. This produces the ironic
result that an investor who pursues this approach will generate a
greater absolute amount of money and of course will owe more

Disclaimer: Fundsmith does not offer investment advice or make

any recommendations regarding the suitability of its product
and no information contained within this document should be
construed as advice.
Should you feel you need advice please contact a financial adviser.
Past performance is not necessarily a guide to future performance.
The value of investments and the income from them may fall as
well as rise and be affected by changes in exchange rates, and you
may not get back the amount of your original investment.

28 29
 33 Cavendish Square
London
W1G 0PW
UK
140 Elm Street
New Canaan
CT 06840
USA
T +44 (0)330 123 1815
E [email protected]
W www.fundsmith.co.uk

©2010 Fundsmith LLP. All rights reserved. This financial promotion is communicated by
Fundsmith LLP. Fundsmith LLP is authorised and regulated by the Financial Services Authority.
It is entered on the Financial Services Authority’s register under registered number 523102.
Fundsmith LLP is a limited liability partnership registered in England and Wales with number
OC354233. Its registered office address is 52-54 Gracechurch Street, London, EC3V 0EH.