I’ve never been a big fan of the comparison between Terry Smith and Warren Buffett. In my view, the differences between them far outweigh the similarities.
There is, however, no arguing with the fact that the Fundsmith Equity Fund has outperformed the MSCI World Index since its inception. And it’s especially focused on two stocks right now.
Approaches in common
Both Terry Smith and Warren Buffett focus on investing in quality companies at attractive prices and for long periods of time. But – as far as I can see – that’s roughly where the similarities end.
Buffett often buys businesses outright and makes a return from the cash they generate. Smith, on the other hand, typically buys shares on the stock market and profits from price increases.
More importantly, Smith gets compensated from the fees that Fundsmith generates. Buffett, on the other hand, receives nothing for the buying and selling of Berkshire Hathaway shares.
There is, however, another difference that I think is important. And it concerns Fundsmith’s two largest holdings – Meta Platforms (NASDAQ:META) and Microsoft (NASDAQ:MSFT).
Capital intensity
Fundsmith actively looks for businesses with relatively low capital requirements. There’s a good reason for this – more asset-heavy companies tend to find their costs go up more with inflation.
This is another difference between Smith and Buffett (Berkshire’s energy and rail units are capital intensive). And Fundsmith has underperformed as utilities and industrials have done well.
Importantly, neither Meta nor Microsoft have had particularly high capital requirements in the past. Social media platforms and software don’t need much in the way of tangible assets compared to some industries.
That, however, might be changing. As the companies look to shift towards artificial intelligence (AI) and cloud computing, they’re running into some big capital expenditures.
AI infrastructure
Both Meta ($72bn) and Microsoft ($80bn) have announced big investments in data centres this year. In both cases, that’s around 50% of their existing current property, plant, and equipment.
These may well lead to higher revenues and profits and they might even be key to the companies maintaining their competitive positions. But they clearly represent large capital requirements.
This is something investors will need to pay attention to. And the way to do this is by keeping an eye on metrics like returns on capital employed (ROCE) – which Fundsmith does pay attention to.
If ROCE levels start falling with either firm, it could be a sign the returns on their data centre outlays are disappointing. But if they stay where they are – or even climb – this is a positive sign.
Fundsmith
At the moment, both Meta (9.4%) and Microsoft (7.36%) account for a significant amount of the Fundsmith Global Equity portfolio. But how long this continues, remains to be seen.
As mentioned, both companies are investing significant amounts into data centres, which affects their status as businesses with low capital requirements. And this is something investors need to take note of.
AI infrastructure could be the next growth opportunity. But the risk is that it involves a lot of cash that could otherwise be returned to shareholders and returns aren’t guaranteed.
Both have been terrific investments in the past and I think they’re still worth considering today. Whether they remain part of the Fundsmith portfolio, though, remains to be seen.
