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Why following Terry Smith’s 3 rules could help make you a million

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Terry Smith gets a lot of attention from private investors, and rightly so. His Fundsmith Equity Fund has been one of the top performers for a number of years now, achieving a return of just under 270% since inception in 2010, according to a recent presentation from the main man. It’s likely played a role in some becoming millionaires.

That’s not to say you necessarily need to invest with Fundsmith to make a mint. Those confident enough to pick stocks off their own backs can still learn a lot from Smith’s self-described “very simple” strategy.

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1. Only invest in good companies

Your immediate response might be: “But how do you find such businesses?” Smith has a number of suggestions.

First, you should be looking for those firms that make great returns on the money management invests to help them grow. This is known as Return on Capital Employed (ROCE).

In Smith’s view, we should be looking for companies achieving a consistently high number on this metric. The average in his fund last year was 29% — almost double the ROCE of the FTSE 100.

Smith also likes companies with intangibles such as brands (because they are hard to replicate), those with growth potential, and those that show a willingness to invest in further developing their products. He avoids businesses with lots of debt.  

Such is Smith’s commitment to investing in the best companies, his portfolio contains only 25-30 stocks at any one time. That sort of concentration carries risk but the rewards will be far greater if they perform well. And, so far, they have. 

2. Try not to overpay

The fact that Smith considers the price of a company to be less important than quality is telling. Like Warren Buffett, he avoids buying sub-standard businesses, even if they’re trading on bargain valuations.

Note, however, that this doesn’t mean he will buy at any price. Firms trading on obscene valuations are unlikely to get a look in. That said, Smith has gone on record stating it’s still very possible to buy a stock trading on over 30 times earnings and still beat the market, so long as those returns on capital stay high for a long time. 

Also worthy of mention is Smith’s admission that investment involves an element of guesswork. We can’t know the future for sure, so any calculations we make when attempting to value a business should always take this into account. 

3. Do nothing

This is arguably the hardest part of Smith’s strategy. Of course, doing something, anything is also rooted in our genetic make-up. Once upon a time, our survival was dependent on running away and asking questions later.

That’s why we’re susceptible to jumping in and out of stocks on the slightest whim, or during a stock market wobble, only to regret selling later on. I’ve done it. You’ll probably do it too at some point, especially as share-dealing is so easy these days. 

Like the Fool UK team, Smith is against market timing for the reason it’s very hard, if not impossible to do. Moreover, it interferes with the magic of compounding. That’s why he remains fully-invested at all times and watches his companies like a hawk.

Be under no illusion that you should be willing to do the same if you want to match his performance.

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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.