One of the investors we watch very closely here at TAM is Terry Smith, CEO at Fundsmith. We’ve recently been reading through the Fundsmith ‘Owners Manual’ which is very similar to the Berkshire Owners Manual. One of the sections in the manual covers Smith’s fourteen filters for purchasing a great investment. Here’s an excerpt from the manual:

1. We aim to buy and hold
We aim to be long-term, buy-and-hold investors. We seek to own only stocks that will compound in value over the years.

2. We aim to invest in high quality businesses
This may sound blindingly obvious, but you might be surprised how many investors either don’t do this or do not have a good definition of a high quality business.

3. We seek to invest in businesses whose assets are intangible and difficult to replicate
It may seem counter-intuitive to seek businesses which do not rely upon tangible assets, but bear with us. The businesses we seek to invest in do something very unusual: they break the rule of mean reversion that states returns must revert to the average as new capital is attracted to business activities earning super-normal returns.

4. We never engage in “Greater Fool Theory”
We really want to own all of the companies in the Fundsmith Equity Fund. We do not own them knowing that they are not good businesses or are over-valued in the hope that someone more gullible will come along and pay an even higher price for them. We wisely assume that there is no greater fool than us.

5. We avoid companies that need leverage
We only invest in companies that earn a high return on their capital on an unleveraged basis. The companies may well have leverage, but they don’t require borrowed money to function.

6. The businesses we seek must have growth potential
It is not enough for companies to earn a high unlevered rate of return. Our definition of growth is that they must also be able to reinvest at least a portion of their excess cash flow back into the business to grow while generating a high return on the cash thus reinvested.

7. We seek to invest in resilient businesses
An important contributor to resilience is a resistance to product obsolescence. This means that we do not invest in industries which are subject to rapid technological innovation. Innovation is often sought by investors but does not always produce lasting value for them. Developments such as canals, railroads, aviation, microchips and the internet have transformed industries and people’s lives. They have created value for some investors, but a lot of capital gets destroyed for others, just as the internet has destroyed the value of many traditional media industries

8. We only invest when we believe the valuation is attractive
Again this one may seem obvious but we have seen many investors who invest in quality companies, yet still underperform because they consistently overpay for those investments.

9. We do not attempt market timing
We do not attempt to manage the percentage invested in equities in our portfolio to reflect any view of market levels, timing or developments. Getting market timing right is a skill we do not claim to possess. Looking at their results, neither do many other fund managers, but that does not seem to stop them trying.

10. We’re global investors
We are a bit suspicious of the term “Global”. When someone presents a card which states that they are the “Head of Global Sales”, it is tempting to ask them how many globes they have sold. It usually just means Head of Sales, but some organisations proliferate Heads and Managing Directors quicker than rabbits breed, so it’s probably just a grandiose way of attempting to make a distinction.

11. We don’t over diversify
We do seek portfolio diversification, but the strictness of our investment criteria will inevitably leave us with a concentrated portfolio of 20 – 30 companies. We do not fear the concentration risk.

12. Currency hedging, or the lack of it
Our policy is not to hedge our currency exposure.

13. Management versus numbers
We are rather more comfortable analysing numbers than we are trying to gain insights into companies by meeting the management. We intend to find companies which are potential investments by a screening process of their financial results to identify high return, cash generative, consistently performing businesses.

14. Our investments are liquid and the Fundsmith Equity Fund is open-ended
The companies we invest in have large market capitalisations without major blocks being held by controlling shareholders. Therefore their shares are easily tradeable. In addition, the Fundsmith Equity Fund is an OEIC, i.e. an open-ended fund.

You can find a copy of the Fundsmith Owners Manual here: Fundsmith Owners Manual.

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