Lessons from Terry Smith's book 'Investing for Growth'

I recently finished reading Terry Smith's book, Investing for Growth. Smith founded his fund management business in 2010 and his flagship 'Fundsmith Equity Fund' has produced an annualised return of 18.6% since inception (vs. 12.9% for the MSCI World Index).

He is a best selling author (Investing for Growth and Accounting for Growth) as well as a frequent media commentator and columnist on topical financial matters. Smith's annual letters, with their simple explanations of somewhat complex financial topics, combined with his investment track record have earned him comparisons to a certain Oracle in Omaha, Nebraksa.

Smith has an enviable track record and a very clear, three step investment strategy:

1. Buy good companies

2. Don't overpay

3. Do nothing

Pretty simple, pretty straightforward.

Coupled with this are some very clear financial metrics he looks for in the businesses in which he invests. These include:

• High returns on invested capital (ROCE) - i.e. a strong ability to generate a high rate of return on each incremental dollar invested in the business

• Strong margins (both gross margin and operating margin)

• A high level of cash conversion (the ability to promptly turn most business profits into cash)

• A high interest cover ratio - i.e. a limited amount of leverage

Businesses producing such metrics are unlikely to be cheap and therefore Smith is rarely discouraged by what may appear to be a high entry multiple in terms of the price paid for a business relative to its current earnings.

Take a look at the following chart from his 2021 annual letter. It shows the P/E multiples one could have paid for various companies back in 1973 and still have achieved a 7% compounded annual return for the next 46 years to 2019 (beating the 6.2% offered by the MSCI World Index).

Source: Fundsmith 2021 Annual Letter

An investor could have paid a P/E of 281x for L'Oreal, 230x for Lindt or 115x for Heineken in 1973 and still beaten the MSCI World Index for the next 46 years.

An investment with a high multiple relative to its current level of earnings does not necessarily make it expensive. Conversely, an investment with a low multiple on its current level of earnings is not necessarily cheap.

Whilst reading the book, I thought about how Smith might approach the current real estate investment landscape and the universe of investable assets. I doubt he'd be buying troubled shopping centres on 12%+ yields.

Instead, I imagine he'd be looking for high quality assets at a fair price. Areas of interest might include urban multi-family, suburban single family homes, warehousing & logistics, data centres & medical office - all located in solid growth markets.

These asset types are certainly among the more expensive in the current environment. Smith's approach suggests that he wouldn't be worried about the seemingly high multiples and low yields on offer if quality cashflows were available in supply constrained markets with tremendous opportunities for future rent growth.

Smith's three step investment strategy for the real estate universe could perhaps be summarised thus:

1. Buy good real estate (think high quality assets in supply constrained growth markets)

2. Don't overpay (ensure that unlevered yield on cost is always greater than your cost of debt capital, resulting in positive leverage)

3. Do nothing (hold for the long-term and let compounding do the rest)

At Hoffman & Hoffman our approach is not dissimilar: we are focused on acquiring and operating high quality income producing assets, primarily residential in supply constrained sub-markets of high growth cities such as Manchester. We invest long term capital and our ideal holding period is forever.

The best time to sell might be never (especially if you pay taxes)

In early 2000, SoftBank founder and CEO Masayoshi Son invested $20m into a little known Chinese ecommerce company otherwise known as Alibaba. Even after this year's sell-off in Alibaba's stock, that initial stake is worth in excess of $100bn.

Less well known is the story of Shirley Lin at Goldman Sachs. Goldman actually invested in Alibaba a year before SoftBank and at a much lower valuation. Having been offered 50% of the company for $5m, Goldman ultimately decided to invest $3m and sold it five years later for $22m and a seven-fold return. Not bad. But earlier this year those shares would have been worth nearly $200bn before dilutions - far in excess of Goldman's entire market cap which currently sits at $127bn.

This is an extreme example demonstrating the power of extraordinary, nonlinear returns from a tiny minority of investments. But it also serves to highlight the folly of selling a great investment too early. "You can't go broke taking a profit" is an oft-repeated aphorism in the investment world. Taken literally, those words might be true, but they're unlikely to make you very rich either.

For the tax paying investor considering the sale of a successful investment, there are further penalties to consider for exiting too soon.

Consider the following example:

Two investors each start with $100 and invest it for 30 years.

Investor A invests $100 and earns 10% a year on her investment. Investor A is happy with her choice, sits tight for 30 years and does not sell at any stage.

Investor B invests the same $100 in year 1 but in the belief that good investments don't last forever, he sells and reinvests his money every two years into something new. As it so happens, Investor B ends up with a 10% return on all of his investments. However, his switching comes with a cost and he has to pay capital gains tax at 20% every time he sells and reinvests his money.

At the end of 30 years Investor B is left with $1,064 from his initial $100 investment. This seems pretty good until you realise that Investor A has amassed $1,745. The difference is a whopping 64%. Crucially, even if both were to sell their entire investment at the end of 30 years and pay all the taxes due, Investor B would have $1,027 whilst Investor A would have $1,416 - nearly 38% more.

In the institutional investment world where fees and promotes are largely dictated by pre-tax IRRs there can be something of a divergence between the interests of the sponsor / general partner and the best interests of the limited partners / investors . A sponsor may be incentivised to sell a particular asset "early" in order to crystallise their own performance related fee. This results in the limited partner interrupting the compounding of their investment capital with a taxable event as well as missing out on any future gain in the value of the asset.

One caveat to this is that many (or even most) of the limited partners in the world's biggest mega funds are tax exempt entities (think pension funds, endowments etc.).

But for the non tax-exempt limited partner where taxes need to be paid upon the realisation of investment gains, it is usually better to hold for much longer time periods. Indeed, in the corners of the real estate market which are not subject to wild changes in fortune based on technological progress, the best hold period may in fact be forever. After all, London's Grosvenor Estate encompassing Mayfair & Belgravia has been owned by the same family since 1677. It would have been quite some mistake if Sir Thomas Grosvenor had sold up in 1690.

Our firm is currently just a little smaller and a little less storied than Grosvenor but between Masayoshi Son, Goldman Sachs, Alibaba and Sir Thomas we won't be selling any of our investments anytime soon.

The stratospheric cost of home renovations in London

If you want good value, don't look for it inside the M25.

I recently undertook a renovation project for a two bedroom property in West London which is owned by an investor with whom I've done multiple deals up in Manchester.

London is more expensive than any other UK city on just about every metric including hourly labour for building contractors. (I once made the fleeting mistake of thinking that the "day rates" for various trades published on the website of a well known London property maintenance company were somewhat reasonable, before realising that they were in fact quoting hourly).

So whilst I expected the cost of building work to come in significantly higher as compared to similar projects we have done in the North and elsewhere - I hadn't realised by quite how much.

I have completed multiple kitchen & bathroom remodels on properties in the North and East for c. £6k all-in including units, fittings and labour. I had five contractors quote for the job in London against the very same schedule of works. The labour alone was quoted from £13k all the way up to £23k. What a bargain. With yields on investment property in central London languishing around half of what you can get in Manchester and elsewhere, any return on capital employed will quickly be eaten up by the cost of maintenance and renovations.

Perhaps it's a result of the extreme imbalance between current demand and supply for such services - driven by the coronavirus pandemic and the consequent and much publicised boom in home renovation projects. Or perhaps it's just a reflection of what contractors can get away with in a neighbourhood where the average home price is approaching £2 million.

To summarise: if you want to make money investing in rental property, go North. If you want to make money fitting bathrooms and kitchens, buy a house in Slough and work exclusively for property owners in Kensington and Chelsea.