Smithson Investment Trust PLC: Common Name, Unique Ability (OTCMKTS:STINF)

Introduction

The Smithson Investment Trust PLC (OTCPK:STINF) is one of the few funds that the Fundsmith group manages. This group is particularly well known in the UK for its opinionated founder Mr. Terry Smith, and for the Fundsmith Equity Fund, which has generated market beating returns since inception in 2011 via applying a long-term, buy-and-hold investment philosophy focusing on high quality, global, large and mega cap stocks.

The Fundsmith group has recently been in the press due to announcing a voluntary liquidation of its Emerging Equities Trust, with Terry Smith stating that it had “fallen below our expectations”. We find it admirable that a fund house, especially one with such few funds, closes a product if it continuously underperforms. Clearly the focus is on returns rather than using the brand to build assets under management.

Smithson remains one of the few vehicles being advised by Fundsmith besides the giant (>20 billion GBP) Fundsmith Equity Fund. The funds are managed applying similar investment principles, made explicit in the Smithson’s owner’s manual. Whilst Fundsmith has been more resilient than the market indices in general during 2022, Smithson has declined considerably more. Its focus on small/mid cap stocks with higher growth rates has meant they have been more aggressively hit by the market discounting higher future interest rates due to an expectation of higher inflation rates.

Nevertheless, the Smithson portfolio also consists of high quality businesses that can generate and sustain a high return on operating capital employed, made possible by focusing on businesses whose advantages are difficult to replicate. Furthermore, they focus on businesses with a high degree of stability, which are resilient to change, and do not require significant leverage to generate attractive returns. These criteria that Fundsmith have followed religiously for over a decade in their core fund, they have transferred to the Smithson fund. Hence, whilst the smaller companies in Smithson depend on a higher degree in future growth assumptions, which will make them more volatile, especially under current market conditions – we should carefully remember what is under the bonnet are very high quality businesses. If they are now available discounting lower growth assumptions, all the better.

The Fundsmith Group

I discovered the Fundsmith group several years ago, and was automatically enamoured of their simple, yet effective investment strategy. Their three step description was:-

• Buy good companies

• Don’t overpay

• Do nothing

The Fundsmith equity fund has explained their investment approach in a few more words, but still very succinctly, on material available on their website in the following manner:-

The Company will invest in equities on a global basis. The Company’s approach is to be a long-term investor in its chosen stocks. It will not adopt short-term trading strategies. The Company has stringent investment criteria which Fundsmith LLP and Fundsmith Investment Services Limited as investment manager adheres to in selecting securities for the Company’s investment portfolio. These criteria aim to ensure that the Company invests in:

• high quality businesses that can sustain a high return on operating capital employed;
• businesses whose advantages are difficult to replicate;
• businesses which do not require significant leverage to generate returns;
• businesses with a high degree of certainty of growth from reinvestment of their cash flows at high rates of return;
• businesses that are resilient to change, particularly technological innovation;
• businesses whose valuation is considered by the Company to be attractive.

The Company will not invest in derivatives and will not hedge any currency exposure arising from within the operations of an investee business nor from the holding of an investment denominated in a currency other than sterling.

As a result of this focus they have primarily invested in three sectors since inception: consumer staples, healthcare and technology. They have stated they generally do not invest in banks, material or energy companies, as they do not meet their criteria. The latter sector clearly working against them during 2022, but since inception none of these industries/sectors have outperformed the fund. The funds annualised return on the T class accumulation shares has been 15.5% from inception to October 2022. A most satisfactory return indeed.

Yet, I must admit that since discovering this potent team of experts in the summer of 2018, I have not invested in any of their funds (until a week ago), and have yet to invest in the Fundsmith Equity Fund. My stumbling block has been valuation. I simply couldn’t invest in a portfolio of stocks (even of their quality) with a free cash flow [FCF] yield of 4% or less. Whilst higher than 10 year USD government bond yields, which at that time were around 3% (note the Fundsmith Equity fund is available with a USD, EUR and GBP share class), I personally cannot invest until the FCF yield is at least 5% on an absolute basis (which is just above the average USD interest rate since 1798, which is the introduction of America’s first bank). If I can get an opportunity to buy the Fundsmith equity fund with a yield of approximately 5%, I’ll happily buy it and not look at the price again for another 10 years.

The Smithson Investment Trust PLC

Smithson has explained their investment approach succinctly on material available on their website in the following manner:-

The Company’s investment policy is to invest in shares issued by small and mid-sized listed or traded companies globally with a market capitalisation (at the time of initial investment) of between £500 million to £15 billion. The Company’s approach is to be a long-term investor in its chosen stocks. It will not adopt short-term trading strategies. Accordingly, it will pursue its investment policy by investing in approximately 25 to 40 companies.

The Investment Manager focuses on investing in those companies it believes can compound in value over many years. It seeks to achieve this by selecting companies that have an established track record of success, such as having already established a dominant market share in their niche product or service or having brands or patents which others would find difficult, if not impossible, to replicate. The Investment Manager believes such SMID sized companies tend to out-perform large companies and that there is also an investment opportunity to take advantage of greater discrepancies between the share price and valuation of SMID sized companies, in part due to lighter research coverage and less information being available on them. SMID sized companies tend to have higher expected returns but also higher expected risk, defined as price volatility (a measure of how much its price moves over time), when compared to larger companies. However, adding a small and mid cap portfolio to a large cap portfolio can raise expected returns without increasing risk, due to the different risk and return characteristics that SMID sized companies provide.

The Investment Manager seeks to invest in SMID sized companies that exhibit strong profitability that is sustainable over time and generate substantial cash flow that can be reinvested back into the business. Its strategy is not to overpay when buying the shares of such companies and then do as little dealing as possible in order to minimise the expenses of the Company, allowing the investee companies’ returns to compound for Shareholders with minimum interference.

The Investment Manager looks to avoid companies that are heavily leveraged or forced to rely upon debt in order to provide an adequate return, as well as sectors and industries that innovate very quickly and are rapidly changing. It instead focuses on companies that have exhibited an ability to continue outperforming competitors and will look for companies that rely heavily on intangible assets in industries such as information technology, health care and consumer goods. The Company’s investments will be long-term and the Investment Manager will not be forced to act when market prices are unattractive.

This approach worked very well for the trust until 2022 came along. Then the fund peaked at around 20 GBP, and dropped to around 12 GBP, where it currently stands. I initiated a small position just below 12 GBP. The fund under conventional valuation methods remains expensive (which is why I initiated a small position, but I lost my Fundsmith virginity). Its free cash flow yield I estimate around 3.5% (it was reported to be 2.0% at the end of 2021, and Smithson was trading around 20 GBP at that time. We also note in the 12 months to the last reported quarter for their portfolio companies, weighted average neutral free cash flow per share growth for Smithson was 21%. We assume as a portfolio cash flow will continue to grow low to mid double digits over the next five years). Should the FCF yield surpass 4% and approach 4.5%, I would happily increase my position. Though of course at that moment I would then compare the Smithson yield to that available on the Fundsmith equity fund.

Reviewing the Smithson annual letter will indicate to the reader very clearly the quality of the portfolio. Smithson calculate a portfolio look-through to determine what are the fundamental metrics of the portfolio overall. We can see it has a return on invested capital of 33% (41% including Rightmove), a gross margin of 67%, an operating profit margin of 24%, a cash conversion of 112%, and an interest cover of 35x. Truly the metrics of a high quality business.

Conclusion

The Fundsmith group offer investment vehicles that provide exposure to some of the best businesses in the world. In recent years I have found it difficult to invest in them due to the low free cash flow yields available. However, as the market declines the yields are improving, and investors should keep an eye on how these funds develop. If Smithson is available at yields greater than 4%, or the Fundsmith equity fund at yields greater than 5%, they will become serious investment candidates for me. The group has shown over the years to execute exactly as they say they would, generating excellent results, and have a talented team of analysts and managers that behave in a manner aligned with their investors. Perhaps whilst the group is not as well known outside of the UK, they should be a fund house on your radar.