Terry Smith: How to Consistently Beat the Index

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In his latest interview with The Market, Terry Smith explains why Investing in high-quality companies is more important than focusing on undervalued ones. Historical data shows that even high P/E ratios, such as 281 for L’Oréal, can lead to market outperformance over time.

Warren Buffett advises that owning a great company at a fair price is better than a fair company at a great price, as great companies continue to generate returns.

By combining a company’s free cash flow yield with its medium-term growth rate, investors can estimate expected returns, aiming to exceed the market’s average long-term return of 9-10%, thus consistently beating the index.

Here’s an excerpt from the interview:

Valuation is not as important as quality. We looked back over fifty years at the P/E ratios you could have paid for certain companies and still outperformed the S&P 500. For L’Oréal, the starting P/E you could have paid was 281.

People are very bad at working out the difference between different compound rates of return. The difference between a 10% return and a 12% return isn’t something we can easily grasp. We think it’s 20%, but it’s not. Owning good companies is more important than owning undervalued companies.

There’s a great Buffett quote on it: «It is better to own a great company at a fair price than a fair company at a great price». If you own a fair company at a great price, you hope that the price will adjust to the correct valuation. But after that, that’s the end of your good investment. You have to move on and find something else, whereas a great business is a gift that can keep on giving.

We don’t ignore valuations and we have a very simple rule of thumb: We take the free cash flow that a company generates divided by its market value, which is the free cash flow yield, and then we take what we think is the medium-term growth rate.

We’re relatively good at estimating that because we invest in fairly predictable businesses. If you put the yield and the growth rate together, you get a rough measure of your expected return. Over very long periods of time, the stock market has delivered returns of around 9% to 10%.

If we get a really good company, we can get returns in excess of 10%. If we get a yield of 4% and a growth rate of 10%, we’ll get 14%, which should beat the index. It does not really matter if the yield is 1% and the growth is 13%, or if we get a yield of 4% and growth of 10%.

You can read a transcript of the interview here:

Terry Smith Interview – The Market

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