Terry Smith: How To Select Companies That Will Perform Well In The Future

Johnny HopkinsTerry SmithLeave a Comment

In Terry Smith’s book – Investing for Growth, he discusses how he selects companies that will perform well in the future. Here’s an excerpt from the book:

Even if they were not handicapped by blinkers in predicting the outcome of events, those who wish to rely upon forecasts would still labour under the problem that markets are second-order systems.

In order for a forecast to be useful it not only has to be accurate (and that includes the timing) but you also need to know what the market expects in order to have a chance to predict how it will react to events and benefit from it. But where was the recession which we were told would follow a vote for Brexit, or the market crash which would follow a Trump victory?

To return to J. K Galbraith: ‘We have two classes of forecasters. Those who don’t know — and those who don’t know they don ‘t know.’ We are in the former camp, and so long as many other investors rely upon people in the latter camp this gives us an advantage.

The irony of this is that as Ian E. Wilson, the former chairman of General Electric, said, ‘No amount of sophistication is going to allay the fact that all your knowledge is about the past and all your decisions are about the future.’ Given that we acknowledge that the future is unknowable — we regard the phrase “foreseeable future” as an oxymoron — how do we manage to select companies to invest in which will perform well in future and better than our benchmarks?

The short answer is carefully. Very few companies make it through our filtering system as potential investments and even fewer make it into our portfolio.

The longer answer is that, whilst we seek companies which have superior financial performance, that should be an outcome of their operations — not their primary objective. We are seeking companies that offer a superior product and/or service to customers which enables them to generate these impressive financial returns and prevent competition from eroding them.

I can’t think of a company which was mainly focused on driving financial results, and especially those that have obsessed about quarterly earnings in comparison with “the Street’s” expectations, which has blossomed into a great company and investment. It is ironic to quote a former chairman of GE, given the fate of General Electric after the Jack Welch era of suspiciously consistent quarterly earnings “beats” is itself a moral tale about this.

We try not to let share prices inform us about businesses but rather do this the other way around.

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