Annual Shareholder Letter from the 'British Buffett': The market has deemed NVIDIA and Microsoft as winners in AI, but history has proven that the market is always wrong.

In the value investment community, Terry Smith, a British fund manager, is well-known and hailed as the "British Buffett".

On January 9th, the 70-year-old Terry Smith released his annual shareholder letter.

In 2010, Terry Smith founded Fundsmith, the largest active equity mutual fund in the UK. Since its inception, Fundsmith has achieved an annualized return of 15.3% and reached a size of 24 billion pounds. In 2023, Fundsmith's return rate was 12.4%, which did not outperform the MSCI Global Index's return rate of nearly 17%

The shareholder letter pointed out that in terms of long-term performance, Fundsmith's performance remains outstanding among the 165 global sector funds of the Investment Association. Since 2010, the average cumulative return rate of the 165 funds is 215%, while Fundsmith's return rate has reached 550%.

Terry Smith believes that outperforming the market in 2023 is more challenging than before. The Nasdaq has risen by 43% in one year, and the "Big Seven" have contributed to most of the gains. Only one company, NVIDIA, has contributed an 11% increase. They have not invested in all of the "Big Seven" companies, and they will not take the risk of buying stocks in all seven companies in the future.

Regarding the rise of NVIDIA and Microsoft, Terry Smith warns investors to be cautious. Looking back at the past half-century, few pioneers in the technology field have become long-term leaders. From Nokia to Intel to BlackBerry, they have gradually declined.

Terry Smith reiterates his three-step investment strategy as always: buy shares in good companies, try not to overpay, and then do nothing.

The ultimate winners in the technology field are usually not pioneers

Terry Smith points out that AI is not a new concept. The market's increased interest in artificial intelligence this year is mainly due to the popularity of OpenAI's large language model, ChatGPT, and Microsoft's stock price soaring as a major shareholder of the company.

Terry Smith believes that the stock market has always assumed that it can identify the ultimate winners in the AI field, namely chip companies NVIDIA and Microsoft. However, looking back at the pioneers of technological development over the past half-century, most of them have declined: Chip company: Intel; Internet service provider: AOL; Mobile phone: Nokia; Search engine: Yahoo; Smartphone: BlackBerry; Social media: Myspace.

Where are they now? Does this history indicate that the market cannot successfully predict the winners in the field of artificial intelligence from the beginning?

In addition, Terry Smith believes that there may not be winners in either the provider of large language models or the use of large language models. The widespread adoption of artificial intelligence may lead to a situation where everyone has artificial intelligence and no one has any advantage.

Estée Lauder - the biggest drag; Meta - the biggest contribution

According to the analysis in the shareholder letter, Estée Lauder has become the biggest drag on performance, with a -1.8% impact on returns. The second biggest drag is McCormick, one of the world's largest seasoning suppliers, which has a -1.1% impact on returns.

Terry Smith said they have sold Estée Lauder due to the group's misjudgment in the economic recovery after the pandemic, resulting in "serious deficiencies" in its supply chain. The profit margin of McCormick's service business has not yet recovered to pre-pandemic levels, but there is no concern about its long-term prospects.

In 2023, the five companies that contribute the most to the fund's performance are Meta, Microsoft, Novo Nordisk, L'Oréal, and IDEXX Laboratories, the largest company in the pet healthcare industry.

Terry Smith said that Meta's impressive performance made him wonder if he should establish a fund that only invests in the most questioned stock in the annual portfolio. Meta appears for the third time on the list of top contributors, while Microsoft appears for the eighth time.

Terry Smith pointed out that when they started buying Meta's stock in 2011 at around $25, there were deafening criticisms (the end-of-2023 price was $354).

Novo Nordisk has performed well this year due to its weight-loss drug Wegovy. Terry Smith pointed out that they have held this stock for seven years, and Novo Nordisk's unconventional approach to drug research and its ownership structure have attracted them. The majority of Novo Nordisk's shares are held by the Novo Nordisk Foundation, which ensures that the company takes a long-term perspective and approach to its business strategy and decision-making:

Novo Nordisk appears for the fourth time on the list of top contributors - this is a successful investment before the word "weight loss" related to Novo Nordisk is repeatedly mentioned. Terry Smith believes that L'Oreal is a brand that has been favored for a long time, and its emphasis on the Chinese market is in stark contrast to Estee Lauder.

In addition, IDEXX has also appeared for the fifth time in the list of top five contributors.

Terry Smith's Three-step Investment Strategy

The first step is to "choose good companies". From a quantitative perspective, Terry provides investors with a clear selection criteria by creating a perspective earnings table for the portfolio stocks. There are five indicators in total: Return on Capital Employed (ROCE), Gross Margin, Operating Profit Margin, Cash Conversion Rate, and Interest Coverage Ratio.

The most important one is ROCE - ROCE = Adjusted Net Profit / (Shareholders' Equity + Long-term Liabilities).

As mentioned in the shareholder letter, a sustained high return on capital employed is a sign when looking for "good companies". Weighted average free cash flow (the cash generated by the company after paying all expenses except dividends) is an indicator of a company's future growth prospects.

Terry Smith stated that the companies they hold have had an average ROCE of over 25% in the past 8 years, reaching 32% in 2022 and 2023. Gross margins have been above 62%, operating net profit margins have been above 26%, and operating profits have been essentially free cash flow. The cash conversion rate has reached 90%, and the weighted average free cash flow has grown by 14% in 2023.

The interest coverage ratio measures whether the pre-tax profits generated by a company can cover the interest payments for the period. It can indicate whether the company still has the ability to pay interest to avoid debt risks, as well as whether it still has financing capabilities to turn things around. The interest coverage ratio of the stocks in Terry's portfolio is more than 17 times.

Terry Smith pointed out that the only indicator that continues to lag behind historical performance is the cash conversion rate, which is below the historical level of around 100%. This is due to some companies being affected by exceptional events. It is expected that these events will subside by 2024, benefiting these companies.

The second step of the strategy involves valuation. Terry Smith pointed out that at the beginning of 2023, the weighted average free cash flow (FCF) yield (free cash flow divided by market value) of the portfolio was 3.2%, which decreased to 3.0% by the end of the year. The median FCF yield of the S&P 500 index for the year was 3.7%:

Our portfolio is far superior to the average level of the S&P 500 index constituents, so it is not surprising that their average valuation is higher than that of S&P 500 index companies. This in itself does not necessarily mean that these stocks are overpriced, just as low valuation does not necessarily mean that stocks are cheap.

The third step of the strategy involves holding the stocks for the long term and not being swayed by short-term market fluctuations. Terry Smith believes that by focusing on good companies with strong fundamentals and attractive valuations, investors can achieve long-term success. If, as we expect, the cash conversion rate of the investment portfolio companies improves in 2024, we believe that this valuation difference will be eliminated.

Terry Smith pointed out that reducing the turnover rate of the portfolio is still one of their goals, which is also reflected in the strategy of "doing nothing after buying". The turnover rate of the portfolio in 2023 was 11.1%, slightly higher than the average level:

We only spent a total of 0.008% (less than one basis point) of the average value of the fund on voluntary transactions (excluding transaction costs related to subscriptions and redemptions, as these are involuntary). We sold shares of Adobe, Amazon, and Estée Lauder, and purchased shares of Procter & Gamble, Marriott, and Fortinet.