Interview notes with Terry Smith

follow me to earn money!

1. Q: Your goal is to be the best stock fund. How do you select stocks?

A: To be clear, the best stock fund refers to risk-adjusted performance. Hot stocks may perform better in the short term, just like some hot stocks during the epidemic, but they may eventually return to calm.

2. Q: So how do you select stocks to achieve this goal?

A: We have many criteria. First, we look for companies with high returns on investment (ROIC or ROIE). The companies in our portfolio have an average return on investment of about 30%, that is, for every dollar or pound invested in these companies, they will generate 30 cents in profit, which is about 70~80% higher than the market average.

3. Q: What about other criteria?

A: We also consider the company's growth potential, otherwise there will be no compound interest effect. If a company simply returns all the money it earns to shareholders, then the shareholders are equivalent to taking a high-yield bond, and high-yield bonds will not have a compound interest effect. Companies generate compound interest because they reinvest part of their profits in businesses with high investment returns. Growth potential and high investment returns are both indispensable.

(Note: Dividend reinvestment is different from company retained earnings reinvestment. Dividend reinvestment is reinvestment based on the company's stock price, while the company's own retained earnings reinvestment is reinvestment based on the company's book value. Generally speaking, the company's book value is much smaller than the company's stock price, so the return on the company's retained earnings reinvestment is much higher than dividend reinvestment)

4. Q: Is there anything else?

A: A certain degree of predictability. We like companies that make money from daily, repeatable, and predictable businesses. The so-called unpredictable companies, such as film companies, this movie made a lot of money, but what about the next one? We like daily chemicals, pet food, medical devices, or operating systems like Microsoft, which are predictable consumer products.

5. Q: Can you give the last criterion for selecting stocks?

A: The last but not least is the management's ability to allocate capital. When a company has a lot of cash, many managements will do stupid things, such as investing in a lot of value-destroying things, so we will look for those rational, responsible and honest managements.

6.Q: With so many restrictions, you may have discarded many companies from the beginning.

A: In fact, for us, most companies are not investable.

7.Q: So there are many sectors that are not in your portfolio, such as mining, oil,...

A: There are also transportation stocks, banking stocks, insurance stocks, real estate stocks, etc. Yes, we do not have these sectors in our portfolio. There was once a survey to investigate the difference between the return on investment (ROIE return on captital employed) and the cost of capital, which is the most important financial indicator. The survey shows that consumer goods, IT, medical care, business services, etc., these sectors make more money than the cost of capital, and they are creating value. And those mining, banks, investment banks..., they make less money than the cost, which is a disaster.

Yes, these sectors can make a lot of money when the economic cycle is good, but good companies are good companies, bad companies are bad companies, and they are hard to change their nature (A Leopard Cannot Change Its Spots).

8.Q: So you have a series of criteria for selecting companies, so how do you ensure that you don’t pay too high a price?

A: Valuation is not as important as the quality of the company. For example, L'Oreal's initial valuation PE was as high as 281. Humans are not good at grasping the difference between different compounding interests, such as a 10% return and a 12% return. This difference is generally not easy to grasp, so it is more important to own a good company than a cheap company.

9. Q: Can you explain it in detail?

A: Buffett once said: It is far better to buy a good company at a suitable price than to buy an ordinary company at a favorable price. If you buy an ordinary company at a favorable price, when the stock price returns to normal, your investment will be over, and you will have to find a new investment. If it is an excellent company, you don't have to do anything, just hold it.

10. Q: But you still can't ignore the company's valuation, right?

A: We will not ignore valuation. We generally look at the ratio of a company's free cash flow to its market value, that is, the free cash flow yield. Then we estimate a medium-term growth rate. Because we generally invest in predictable companies, we can give a relatively reliable growth rate estimate. With the free cash flow yield and growth rate, we can roughly have the expected return on investment. For example, if a company's free cash flow rate is 4% and its growth rate is 10%, then the expected return is about 14%, or if the company's free cash flow rate is 1% and its growth rate is 13%, then the expected return is also about 14%.

11. Q: So what about Novo Nordisk in comparison? Its growth is quite fast, but it also looks quite expensive.

A: Compared with whom? Novo Nordisk's PE is 45 times, but Lilai's PE is 75 times. There is still a need for more consideration. 45 times PE looks quite expensive, but considering the growth rate of nearly 30%, it is not expensive, because this static PE will soon drop to 20 times in two years, which is almost the same as the market average.

12. Q: Can Novo Nordisk maintain this growth?

A: Its Ozempic weight loss drug is patent protected. Other drugs must be approved by the FDA and undergo clinical trials before they can be sold. And this Ozempic also shows a lot of other potential (cardiovascular, heart disease............). We invest in Novo Nordisk not only because of this drug, but also because of their R&D capabilities that are ahead of their competitors. Of course, we may be wrong.

13.Q: In addition, what about the other 7 giants in the US stock market? You invested in Google, Meta, and Microsoft. Why did you invest in them?

A: We also invested in some Apple. Let's start with Tesla. Tesla does not meet any of the criteria I just mentioned. It is a car company. The best car companies can hardly bring enough returns to shareholders. This is a bad business. Ford's return on investment is only 3%, which is lower than the yield of government bonds.

14.Q: What about other giants?

A: Google's PE is 25 times, which is closer to the market average. Google and Meta are the online advertising duopoly. Unless something can interfere with it, this is a pretty good business. People talk about a lot of possible disruptors, but they are not seen yet.

15.Q: What about Meta?

A: Meta is a little cheaper. Meta now has 2 billion daily active users and is still growing. People complain that Meta's growth is too slow, but it already has 2 billion daily active users. How can you expect it to grow?

16.Q: What about Microsoft?

A: Microsoft is the leader in commercial office software and one of the cloud computing oligarchs. I think Nadella has proven that he is an excellent CEO. Of course, Microsoft is also the most expensive, with a PE of 35 times.

17. Q: But Microsoft still attracts you?

A: It depends on who you compare it with. Nvidia's PE is as high as 75 times, and Adobe has 39 times. Adobe will make money from AI, but it doesn't have a large language model yet, right? He also has to pay platform companies like Microsoft. ......

18. Q: Some people say that no matter who wins in AI, Nvidia, as a company selling shovels, will be able to reap the benefits in the end?

A: I don't think the exponential growth in demand for Nvidia's GPUs can continue. Nvidia is indeed doing a good job, but if the company that buys shovels doesn't make a lot of money in the end, then the company that sells shovels won't be able to sell a lot of shovels in the end. There is also competition. Nvidia has undergone two transformations, and each time Nvidia's stock price fell sharply.

19. Q: You also invested in Philip Morris, a tobacco company. Is this company still growing?

A: The company's sales have grown by 10% in the past few years. Traditional tobacco has stopped growing, but they have iQOS and Zyn........

20. Q: Have you not invested in Swiss companies?

A: We are looking at some Swiss companies, but we have not invested yet, such as Schindler, which performs worse than its peers Otis and Kone. For example, Nestle, their free cash flow growth is not good, we will continue to track.

21. Q: Your shareholding has changed very little. Which stock did you buy last time?

A: We bought two stocks, one of which we are still buying, so we cannot disclose the name. The other is Fortinet. The market for network security is huge. This company has been growing at a rate of 20% in the past. The epidemic has led to a 40% increase in home office work. Now it has to return to normal, but its underlying business has not changed.

22. Q: Are there any good companies that have not met your valuation requirements?

A: Hermès, it does not have many luxury brands like LVMH, but its brand position is very good.

23.Q: In your shareholder letter, you said that the stocks that are most criticized are often the ones that bring the best returns?