Star UK fund manager Terry Smith criticised some of the management decisions at investee companies Meta, Apple and Unilever as his Fundsmith Equity fund lost money in a rare underperformance last year, which he attributed to the world exiting the long period of “easy money”.
While also railing against a lack of shareholder engagement and transparency at some investee companies and against companies removing share-based compensation from their non-GAAP metrics, the fund manager said the looming recession in many global economies “holds few fears for us” as the portfolio of companies “should demonstrate a relatively resilient fundamental performance in such circumstances”.
He noted that four of the £25bn fund’s five worst performers in 2022 were in what might be termed the tech sector: Meta Platforms Inc (NASDAQ:FB) (which detracted 3.3% from the fund’s performance), PayPal (2.5%), Microsoft Corporation (NASDAQ:MSFT) (1.8%) and Amazon.com Inc (NASDAQ:AMZN) (1.5%), with pet specialist IDEXX Laboratories (NASDAQ:IDXX) the exception (detracting 1.7%).
Share price falls for some of these names “have become more pronounced because of events surrounding the business”, including Meta’s regulatory jostling and metaverse investments and Paypal’s “disregard” for customer engagement and cost control, as well as the general market sell-off.
“This is hardly surprising given the attention devoted to pursuing some clearly over-priced acquisitions. That is what happens when management start to conclude that investments do not need to earn an adequate return.”
As for IDEXX or Microsoft, he said “we are not aware of any major fundamental problems with either” and that the fund’s exposure to technology “is a lot more subtle and nuanced, as well as smaller and more widely spread than the headlines sometimes suggest”.
He acknowledged that there may be further headwinds for the tech sector and shares could head lower, though the silver lining might be that “this pressure on revenue growth may cause some of the tech companies we invest in to stop behaving as though money is free and halt some of the less promising projects outside their core business” – mentioning Apple’s lossmaking “other bets” investments, Amazon’s food delivery and Indian technical education businesses (recently withdrawn), Meta’s obsession with the metaverse.
While companies in the portfolio are more lowly rated than they were a year ago, now rated roughly in line with the market, Smith said this “does not make them cheap”.
He said there “is no guarantee that they will not become more lowly” but insisted his team’s focus for the fund is on the company’s fundamental performance, “as it should be, because in the long term that will determine the outcome for us as investors”.
Engagement and activists
Smith also lamented the lack of investor engagement at companies such as Unilever PLC (LSE:ULVR) and Paypal, where the fund has been a major shareholder from its inception and 2015, respectively, and has had its opinion ignored, yet activist investors have been invited to join the board of both companies (Nelson Peltz and Elliott Management respectively) shortly after buying their stakes.
“I am not envious. I do not want a seat on the board of Unilever, PayPal or any other listed company,” he wrote in his annual letter to investors.
“What I am complaining about is the bipolar response some companies have to long-standing shareholders versus newly arrived ‘activists’… One reason is that we try to be long-term shareholders and when we hold shares in what we consider to be a good business, which we think is underperforming its potential, we like to see if we can help to correct that.”
The unit trust fell by 13.8% in 2022, compared with a fall of 7.8% for the MSCI World Index with dividends reinvested and a 1.2% gain for the FTSE 100.
After detailing the long rise and growth of ‘easy money’ since the 1990s, when low interest rates were used “as a palliative in periods of market volatility”, through the quantitative easing (QE) post the global financial crisis that was twinned with low/zero/negative interest rates, Smith said, “attempts to suppress volatility will only exacerbate it in the long term”.
The end of the pandemic meeting the Russian invasion of Ukraine has seen Murphy’s Law – ‘what can go wrong will go wrong’ combined with Sod’s corollary of ‘Murphy was an optimist’ – and the effect on prices of energy and various other commodities has seen inflation surge, with the consequence of a “rapid and painful end to easy money”.
This has led to the collapse of “unwise investments” such as the cryptocurrency ‘exchange’ FTX and the meltdown of shares in “those tech companies with no profits, cash flows or even revenues”.
Accounting for shares
In his diatribe against the removal or not of share-based payments, the author of the best-selling book 'Accounting for Growth' noted that Intuit Inc. (NASDAQ:INTU) appears to sit at a valuation premium of 14% over Microsoft (28.4 times versus 25.0 times) but “Intuit shares are actually trading at a premium of 73% if share-based compensation is treated in the same manner between the two companies”.
“Many investors and analysts, including us, look to cash flow metrics more than accrual profits. Unfortunately, share-based compensation may cause distortions in cash flow metrics as well, even when they follow GAAP. Under GAAP, share-based compensation is added back in the cash flow from operating activities, which in turn is used in the computation of free cash flow,” he wrote.
Smith said he agreed with those that argue for share-based compensation being reclassified from the operating activities section to the financing activities section of a cash flow statement for analytical purposes.
Applying this concept to Intuit, he said it would imply that the company is not trading at a trailing twelve-month free cash flow yield of 3.5% as it seems, as removing US$1.5bn of share-based compensation leaves free cash flow yield down at 2.2%.
“I suspect the most pernicious effect of adjusting profits to exclude the cost of share-based compensation occurs when the management start to believe their own shtick and mis-allocate capital based upon it,” he seethed.