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Is Fundsmith’s Terry Smith as good as he’s cracked up to be?

Terry Smith is considered to be one of the best investors in the UK. Smith founded his asset management firm Fundsmith in 2010. The firm’s flagship offering, the Fundsmith Equity fund has since gone on to achieve one of the best performance records of any equity fund in the UK. It has accumulated billions of dollars in assets along the way.

Over the past five years, Fundsmith Equity has produced a total return for investors of 162%, compared to its sector return of just 66%.

But is Smith a good stock picker or has he just got lucky? That’s the question I’m going to try to answer today.

Experienced manager

Smith entered the fund management industry after a long career in the City. He was formerly the chief executive of broker Tullett Prebon where he turned the little known business into a trading powerhouse, reportedly creating £2bn of shareholder value along the way.

Smith isn’t a traditional fund manager by any means. He believes fund managers should try to keep costs as low as possible, trading only a couple of times a year. He’s also not afraid to speak his mind. He won’t invest in any businesses he does not understand or like to be associated with, such as banks and weapons businesses (although tobacco giant Philip Morris International is a top 10 holding).

Instead, Smith concentrates his efforts on finding high-quality companies that have a durable competitive advantage and wide profit margins, following a similar strategy to the Oracle of Omaha Warren Buffett.

A unique approach

Fundsmith’s returns show that this approach is working. His concentrated bets on American tech companies such as PayPal, Microsoft and Intuit have yielded fantastic performances over the past five years.

That being said, Smith’s significant exposure to the US tech sector does, in my opinion, leave him highly exposed to the sector’s frothy valuations. Take the fund’s largest holding PayPal, for example. Shares in this company are currently dealing at a forward P/E of 33. Meanwhile, shares in business software provider Intuit are dealing at a forward earnings multiple of 35.

These premium valuations leave the stocks open to substantial declines if growth slows or market sentiment changes. I think that’s the most significant risk Fundsmith’s investors currently face. The portfolio is stuffed full of high-quality stocks, which have seen booming demand over the past 10 years. As a result, many now trade at quite demanding valuations. Fundsmith’s returns have benefited from this theme, but it is unlikely to last forever.

Conclusion

While I am concerned about the premium valuation of some of the stocks in the portfolio, overall I wouldn’t bet against Smith and his team.

Over the past nine years, they have proven that they know how to pick high-quality companies and avoid losses. As long as they to stick to this successful strategy, I think it is highly unlikely investors will have to deal with losses.

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Rupert Hargreaves owns no share mentioned. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. The Motley Fool UK owns shares of and has recommended Intuit, Microsoft, and PayPal Holdings. The Motley Fool UK has the following options: short October 2019 $97 calls on PayPal Holdings and long January 2021 $85 calls on Microsoft. 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.