In January, I built a simple stock screen based on the criteria described in the Fundsmith owner’s manual. While Terry Smith is certainly not a purely systematic investor, he does have some clearly defined requirements that I was able to use.
For me, one particularly interesting aspect of Smith’s style is his approach to valuation. He looks for relative value rather than absolute cheapness.
In other words, the returns on offer have to be better than lower-risk alternatives (my bold):
“Our aim is to invest only when free cash flow per share as a percentage of a company’s share price (the free cash flow yield) is high relative to long-term interest rates and when compared with the free cash flow yields of other investment candidates both within and outside our portfolio.
Our goal is to buy securities that we believe will grow and compound in value, which bonds cannot, at yields that are similar to or better than what we would pay for a bond.”
During a decade of ultra-low interest rates, this led to Fundsmith purchasing shares that looked expensive on many measures, but which still performed well and offered relative value.
However, interest rates and inflation are now higher than they’ve been at any time since the Fundsmith Equity Fund was launched.
I think high-quality companies that generate high returns should still outperform over long periods – a topic Megan covered recently here and here.
But with 5% risk-free returns now available, the guidelines I’ve quoted above suggest to me that Fundsmith may need to start looking for stocks with lower valuations.
Revisiting my screen
The UK bank rate was 3.5% when I published my original article, so I specified a maximum price/free cash flow ratio of 30 (equivalent to a 3.3% FCF yield)
The bank rate is now 5% in the UK and slightly higher in the US, at the time of writing. Based on Smith’s guidelines above, I should be looking for stocks with a free cash flow yield of at least 5% – equivalent to a P/FCF of 20.
However, free cash flow can vary more than earnings from year to year. Stockopedia’s data provider may also not calculate free cash flow in exactly the same way that Fundsmith does.
To allow some flexibility, I’ve left the…
