I’m sure that Terry Smith and the Fundsmith Equity Fund are well known amongst readers. Ironically I haven’t covered that fund here yet, but it’s not hard to see why it is so popular because Smith takes a very simple approach to investing: buy firms that post stable, high quality earnings and hold them. Perhaps less popular is Fundsmith’s emerging and frontier markets (“EM”) offering – the Fundsmith Emerging Equities Trust (FEET). Clearly this one is quite a bit smaller, with the market-cap of the trust only standing at around £355m versus £20b in net assets for Fundsmith Equity.
Anyway, two reasons led me to take a look at FEET right now. Firstly, EM and Asia seem to offer up decent value at the moment, though FEET is definitely not a value play. For that, I have covered Schroder Asian Income a couple of times already, plus the China value fund Fidelity China Focus. The former stays within developed Asian markets, while the latter pretty much speaks for itself. The second reason is, well, the Fundsmith connection. It stands to reason that FEET might have a lot in common with the Fundsmith Equity Fund.
On that note, let’s start with Fundsmith Equity and its approach to investing. As most readers know, the thing that underpins its portfolio is earnings quality. What staple holdings like PepsiCo, Microsoft and L’Oréal all have in common is that they generate very high returns on capital employed (“ROCE”). That allows them to return a big slice of their profit to investors via things like dividends and buybacks. Or put another way, they need to retain relatively little in order to grow. I know I repeat that point a lot on this site, but that’s because it really does boost the investment case for these types of names.
A Similar Approach
Unsurprisingly FEET takes much the same approach. And just like with Fundsmith Equity, the focus on quality skews the portfolio towards defensive names versus its benchmark. A quick look at the latest factsheet puts consumer staples at over half of assets. Healthcare takes up another 15%, way ahead of the benchmark. Banks are avoided entirely from what I can see, again in keeping with Smith’s wider approach to long-term investing.
Most of the trust’s investments are not household names in the UK for obvious reasons, though multinational subsidiaries like Nestlé India, British American Tobacco Bangladesh and Hindustan Unilever speak for themselves. Note that India accounts for nearly 50% of the fund’s exposure, while many Chinese firms, like otherwise-high-quality alcohol company Kweichow Moutai, are generally not favoured for various reasons such as corporate governance. Still, a number of Chinese firms do score a pass on those housekeeping screens, such as soy sauce maker Foshan Haitian.
Back to the quality angle for a moment. The manager breaks out a lot of statistics on this in the 2020 annual report which quantifies everything above. As you’d expect, the weighted average ROCE here is way, way in excess of the benchmark. While the market posts a ROCE in the 10% region, FEET’s clocks in at around 40%. Unsurprisingly average profit margins and cash conversion also exceed the market average by some distance.
Expensive At First Glance
There are two ways you can read that heading. In terms of the fund’s fees, the ongoing charge here stands at circa 125bps. I know that is a lot more than many want to pay, for which two counter points spring to mind. One, this is about as active a strategy as you can find. Overlap with the benchmark index is less than 10%. Two, and this goes without saying, but the trust accesses markets that really are way beyond the scope of most retail investors. So while a buy-and-hold strategy can often be cheaply replicated by retail investors, in this case it can’t. In that sense, being only 25bps more expensive than Fundsmith Equity looks okay. The annual fee has also come down from 1.7% a few years ago.
The trust has underperformed, with NAV compounding at a circa 5.2% annual clip in GBP terms since inception in 2014. Its EM benchmark has recored a circa 9% CAGR over the same period. Large divergence is not surprising given the tiny overlap between the two, and flows into passive ETFs have had an impact on the trust’s relative performance. Currency fluctuations have also had a large impact on sterling reported results, with the firm obviously very much exposed to the Indian rupee. In any case, the underperformance since inception is clearly disappointing for investors. Note also that FEET typically traded at a premium to NAV in the years after launching. That has since fallen away, with the current 1,335p share price representing a circa 6% discount to NAV.
The second way you could read that heading is, of course, in terms of valuation. FEET’s basket of stocks does not look cheap on conventional metrics such as the PE ratio and so on. Management had the ‘owner earnings’ yield (steady state free cash flow) at 2.5% at the end of 2020. Likewise, the portfolio dividend yield stood at just 1.4% at the end of 2020. All else being equal, higher quality firms deserve a premium for the reasons set out in the previous section. FEET’s investments also enjoy very good prospects. Still, I’m not thrilled by the current valuation, and regret not covering the trust when it traded in the 1,000p area last year. That worked out to a 3%-plus FCF yield at the time, which was clearly much more attractive. Anyway, I will continue to keep on eye on this one going forward.
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