Fidelity - Three steps to heaven

Three Steps to Heaven was a posthumous No. 1 hit by Eddie Cochran for which Showaddywaddy did a cover version. At Fundsmith it’s the foundation of our investment process for the Fundsmith Equity Fund:

 

1. Invest in good companies

2. Don’t overpay

3. Do nothing

 

1. A good company is one which creates value for its shareholders by making a high return on capital-significantly above its cost of capital-across the business and economic cycle.

 

What is return on capital? It is usually measured by the Operating Profit of the business, divided by the capital employed, expressed as a percentage.

 

What is the cost of capital? The cost of debt is relatively easy-you can find a reference to the cost of bonds in the accounts and if there is bank debt you can just use the interest charge divided by the average of opening and closing debt as the percentage cost. Cost of equity is trickier to ascertain and is usually taken as a so-called risk free rate, such as the yield on government bonds in the same currency that the company operates in, plus a risk premium to compensate for the additional risks inherent in equity investment. This slightly complex formula probably explains at least in part why so few investors seem to try to work this out.

 

Why is this important? Companies are just like us in some respects. If you borrowed money at 10% per annum and invested it at a 20% per annum return you would become richer. But if you invested at 5% per annum you would become poorer. Similarly, a company which makes return above its cost of capital become more valuable-it creates value for its shareholders- and vice versa.

 

But don’t all companies create value for their shareholders? Sadly not, there are some industries which are prone to make returns below their cost of capital much or all of the time, such as the airline industry which has probably not created value for shareholders throughout most of its existence.

 

But surely if a whole industry just keeps destroying value, why would anyone invest in it? Fund managers invest in companies which do not make adequate returns and so destroy value because they hope they will change-that a change of management, an upturn in the business cycle, a takeover or industry consolidation will alter this fundamentally poor characteristic. Whilst fund managers wait for their investments in bad companies to come good they steadily erode value by the equivalent of borrowing money from you the shareholder and investing it at an inadequate rate of return.

 

When you own shares in a good company you can be sure that its value will rise over time.

 

2. Don’t overpay. The secret of investment may be to buy low and sell high, but if you are buying shares in good companies, it doesn’t matter if you forget the second bit. If you are going to own a portfolio of good companies with high returns which compound in value over time you can’t play “Greater fool theory” in which you knowingly overpay for the shares hoping that a greater fool will buy them off you at an even more egregious valuation, as you intend to hold onto them. Which leads to;

 

3. Do nothing. In many ways the most difficult part of the strategy. Fund managers often seem to act as though they are paid by investors for activity when in fact they are paid for their results. And those results are generally enhanced by masterly inactivity as dealing activity costs money in terms of commissions, bid-offer spreads, and Stamp Duty on UK shares.

 

In December 2014, Fidelity's Tom Stevenson spoke to Terry about his investment process and the financial characteristics of the companies he holds – watch the video interview here.

 

An English language prospectus for the Fundsmith Equity Fund is available on request and via the Fundsmith website and investors should consult this document before purchasing shares in the fund. Past performance is not necessarily a guide to future performance. The value of investments and the income from them may fall as well as rise and be affected by changes in exchange rates, and you may not get back the amount of your original investment. Fundsmith LLP does not offer investment advice or make any recommendations regarding the suitability of its product. This financial promotion is intended for UK residents only and is communicated by Fundsmith LLP which is authorised and regulated by the Financial Conduct Authority.