Manager Research

We recently concluded our review of the Fundsmith Equity Fund and the BCI Fundsmith Equity Feeder Fund and downgraded the funds to a Tier 3 rating.

A Tier 3 rating reflects our view that there are one or more material concerns with the investment proposition and that we believe stronger alternatives are available for investors. Our rating view is inherently forward-looking and is formed through an assessment of the business, the investment team, the investment process, evidence of past investment decisions, and value for money.

Fundsmith is a well-established global equity manager with a clearly articulated investment philosophy centred on owning a concentrated portfolio of high-quality businesses that exhibit:

• High return on capital

• High barriers to entry

• Low levels of debt
• High reinvestment rates
• Resilience to disruption
• Attractive valuations

Their tagline captures this well: “Buy good companies, don’t overpay, do nothing”.

Our research process focuses on testing if they are likely to execute on this goal over time, delivering value to investors. Having concluded our most recent assessment, we see several material issues which cause us to reduce our confidence in future outcomes. Positively rated equity funds require a strong foundation to deliver over extended horizons, and we don’t believe these are in place for Fundsmith at this point.

We initially rated the Fundsmith Equity Fund Tier 1 in 2019, reflecting high conviction in the manager’s investment capability and strong outcomes delivered during a period characterised by supportive market conditions, positive earnings growth, and a sustained rerating of high-quality businesses.

In 2020, we downgraded the fund to Tier 2 as we became more cautious around elements of the business structure and culture, while remaining comfortable that the core investment approach remained robust. Since then, a more challenging market environment has provided a clearer test of the strategy.

The fund benefited from significant tailwinds from launch in 2010 until 2019, as portfolio companies experienced both earnings growth and valuation rerating off a low base post the GFC. This early rerating to the premium valuations these companies command drove early outperformance, and strong business inflows followed.

Subsequently there have been a number of company-level disappointments which have led to a significant period of underperformance. This period has also coincided with a notable increase in portfolio turnover, which has become more pronounced in recent years.

While the philosophy is often characterised as “low-turnover”, our analysis suggests that the strategy has been more active than commonly assumed, having held approximately 45–50 stocks through time, with around 20–25 positions sold (after accounting for corporate actions). Our concern is not with activity per se, but rather with the timing, rationale, and effectiveness of sell decisions.

In reviewing the stocks that have detracted most from performance, particularly those that have subsequently been sold, we observe that many of the losing positions were sold after a negative corporate event, with Fundsmith ascribing the blame to the company management, rather than their own ability to avoid buying companies that can fall into such traps. This is central to their success. When paying a premium for a high-quality company, and there is a problem, it is difficult to recover losses. Fundsmith has made more errors in this context than would reasonably be expected.

For a concentrated global equity strategy, where investors pay a premium for earnings quality and the margin for error is low, these outcomes materially undermine confidence in the effectiveness of the investment process. Investment decision making remains highly centralised, with portfolio responsibility concentrated among a narrow group of individuals. Analysts appear largely removed from final portfolio decisions, and previous efforts to broaden portfolio management responsibility have delivered mixed results.In our view, this centralisation increases dependency risk and has contributed to delayed sell decisions and slower adaptation as investment theses weaken.

Fundsmith remains closely associated with its founder, Terry Smith, whose role in both the business and portfolio decision making remains significant. While founder-alignment has historically been viewed as a strength, we do not believe succession risk has been adequately addressed, despite long-standing intentions to transition ownership and responsibility more broadly within the firm.

The partnership structure and concentration of ownership add complexity, and control remains heavily skewed toward a small number of individuals. Although steps have been taken to introduce new partners, these have not materially reduced dependency risk within the flagship strategy, where decision-making remains highly concentrated and where the majority of assets are managed.

In our view, this concentration of ownership and decision-making reduces the likelihood that the portfolio-management and sell-discipline shortcomings identified above are challenged or addressed in a timely manner, increasing the risk that these behaviours persist.

Conclusion

The Fundsmith Equity Fund is guided by a clearly articulated investment philosophy, but this has not translated into consistently successful investment outcomes. Evidence points to persistent limitations in portfolio management, most notably in the timing and discipline of sell decisions.

This reflects a disconnect between fundamental research and the timing of portfolio actions, particularly sell and sizing decisions. Given the concentrated nature of the strategy, where investors pay a premium for earnings quality and the margin for error is low, these behaviours have had a disproportionate negative impact on outcomes. This is also compounded by the level of concentration in decision-making. We see limited evidence that this is changing in a way that would materially improve future returns. We therefore believe stronger alternatives are available and have downgraded the fund to a Tier 3 rating.