Smithson: An old head on young shoulders

When Fundsmith CEO Terry Smith invested £25m of his own money into their new Smithson Investment Trust, the focus on small and medium capitalised companies became a major talking point over the autumn. We discuss some of the issues raised by Fundsmith’s approach to the launch of the trust.

The Smithson investment trust, came about after a question from investors; which stocks have outperformed constituents of Fundsmith’s main fund? Despite the high hurdle rate of double digit annualised returns achieved in the main fund, the overriding theme was small and mid-capitalised companies. This is an area the main fund cannot access due to the size of the companies and the liquidity constraints this may present, hence Smithson was born. The trust follows the same philosophy with a focus on a disciplined approach of only picking quality companies that can weather an investment and economic cycle. This is underlined by Smithson’s investable universe that hasbeen whittled down to just 83 stocks from a total of 5,275 candidates. Terry Smith has had a big hand in defining this investable universe.

With the launch of a new Fundsmith investment trust, Terry Smith has not just been promoting the trust. The founder and chief investment officer has been discussing some of the pitfalls of traditional fund management techniques. Alongside his unnervingly simple mantra ‘buy great companies, and hold forever’, Terry Smith has written a series of articles in the Financial Times on investing myths. The Fundsmith team is known for promoting the merits of disciplined stock selection and pitfalls of overtrading, but has also used this launch as a forum to critique falsehoods championed by the industry. Two important topics raised that investors should consider in their portfolio construction are the ability to diversify their portfolio and asset allocation.

A focus on asset allocation is important to mitigate investor’s risk, but it is often misunderstood. The allocation of capital determines the volatility of returns not the returns themselves. The focus on the assets invested is just as important as the type of assets invested in. A focus on regional asset allocation must be analysed in the round. Listing on the London Stock Exchange does not mean your returns are aligned to the UK economy, in fact roughly three quarters of the UK top 100 companies revenue is sourced from outside the UK. Terry Smith would argue a greater benefit could be achieved to lower risk with the addition of a global small capitalised portfolio, enter Smithson. The MSCI World Small Cap Index has a defined universe with an average market capitalisation $1.5bn and c.4,300 constituents.

We conclude that a measure of both practices are valid considerations in the portfolio construction process. Asset allocation is a combination of the state of the investment environment and the requirements of the client. Quality analysis identifies equities that can demonstrate consistent high return characteristics which are likely to outperform in the long run. Valuation is a consideration, but momentum and other theme based investing can mean taking on undue risk if there is an understanding of the underlying investment exposure.