Terry Smith: The Key Traits of Great Capital Allocators

In this interview with Investors’ Chronicle, Terry Smith discusses the qualities he seeks in company management, focusing on strong capital allocation, transparency, and integrity. He values leaders who can thoughtfully allocate capital to generate consistent returns, reinvesting at high rates for compounding growth, regardless of stock market fluctuations.

Smith also prioritizes honesty in management, disliking companies that heavily adjust earnings to inflate performance. He cites Jean-Paul Agon, former CEO of L’Oréal, as an ideal example of accountability, noting Agon’s refusal to exclude underperforming results from Brazil, underscoring Smith’s preference for straightforward, responsible leadership.

Here’s an excerpt from the interview:

Smith: Yeah, a couple of things. A couple of three things. We’re looking for good capital allocators. If you invest with us, you’ve allocated some of your capital to us. We then take your capital and give it to these companies.

What happens is, every year, they’ve got this set of results showing how much cash they’ve generated, how much profit, and they’ve got a series of choices they can make.

They can invest in the business. They can go out and buy things for the business, basically services or physical things. They can acquire other companies, pay a dividend, do a share buyback, or pay down debt. These are all choices, and of course, usually they do some combination of the above.

What we’re looking for is people who are good at that and can describe how they make these choices and get good results from doing it. If they’re able to get a 30% return on capital and reinvest a significant portion of their earnings at that 30% return, then our investment will compound in value significantly.

And whatever the stock market does—because the stock market is just a bunch of people selling shares to each other—the underlying value of our company will compound in value. Over time, the share price will beat the fundamentals, not the other way around.

That’s what we look for. We’re also looking for a degree of honesty. And by honesty, I don’t just mean literally not stealing—although that’s important—but also straightforwardness.

We hate companies that do 32 pages of adjustments in their earnings release to show that a 1% growth in revenues has really turned into 20% earnings growth just by excluding the bad stuff.

For example, one of the managers we really liked was Jean-Paul Agon, the former CEO of L’Oréal. On one occasion, he was asked what the results would be like if you took out the poor results in Brazil, as the company was struggling there. He responded, “Why would we do that? We own it. We own the poor results. Next question, please.” That level of accountability is exactly what we admire in a manager.

You can listen to the entire interview here: