Terry Smith: Good Companies Don’t Become Bad Companies

In his latest presentation with MeDirect Malta, Terry Smith illustrates why good companies don’t become bad companies. Here’s an excerpt from the presentation:

This slide (below) shows quite a long period of time back to 1966 and it shows the return on capital for companies, the ones in the red line started the period at 20% and as you can see it goes up and down but there are those companies at 20%, same companies obviously through the whole thing.

And then there’s the green ones which started at 10% and you can see it goes up and down and it gets to the end of the period at somewhere around half what it started, and the red ones have fallen perhaps to about 15%.

I think what this illustrates is that profitability in terms of returns or companies is persistent. They by and large… good companies don’t become bad companies and vice versa.

There aren’t sea changes in the nature of their business over time and so we don’t see very many of the companies that contribute to the red average end up being green and vice versa, which as it says can only really be explained by barriers to entry.

The companies with the good returns find a means of fending off competition through what Warren Buffett characterizes as the moat, their brands, their patents, their install base of equipment, their control of distribution etc etc.

And it does present a problem if you want to pursue the rotation, because no amount of low valuation and no amount of rotation is going to turn bad businesses into good businesses.

The energy companies and the banks and all the companies that we shun are not going to be transformed by a good month or a good year into good businesses, and over the long term it’s the returns that the business delivers which will drive the strategy.

You can watch the entire presentation here: