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.

Houses are expensive. House builders are cheap.

Much has been written on both sides of the Atlantic over the past year of the frenetic rise in house prices. Barely a day goes by without a house price index being released showing record breaking inflation. Since these stories are clearly popular (and unpopular...) with readers you can always be sure that each data release is met with a plethora of news coverage.

Zoopla, one of the major online property listing sites in the UK, reported average home price appreciation of 7.1% in 2021. Liverpool and Manchester topped the list of best performing cities, reporting average growth of 10.7% and 8.5% respectively.

Mortgage lender Halifax reported house price inflation of 9.8% for the UK as a whole, bringing the average price of a home to a record high of £276,000.

These numbers are nothing as compared to the USA where the average price of a home went up by 18% in 2021 according to CoreLogic's Home Price Index, the most in at least 45 years.

Based on personal experience, these numbers are comparable to certain sub-markets in North West England.

With house price growth at these inflated levels, you might expect the share prices of the UK's top house builders to be on a similar trajectory. But a quick glance at their share prices and valuations shows anything but:

Company	1 Year Share Price Performance	P/E Ratio	Dividend Yield	Share Price vs. pre COVID Peak
Persimmon	- 6.1%	10.3 x	9.2%	- 22.3%
Taylor Wimpey	- 1.4%	11.4 x	5.3%	- 32.5%
Barratt	- 2.7%	10.5 x	4.4%	- 22.5%
Bellway	+ 4.7%	9.4 x	3.9%	-30.5%

Clearly UK house builders' share prices have not risen in line with house prices in the last two years.

When you compare their share price performance to their largest US contemporaries, things look even worse:

Company	1 Year Share Price Performance	P/E Ratio	Dividend Yield	Share Price vs. pre COVID Peak
DR Horton	+ 13.0%	7.7 x	0.9%	+ 42.1%
Lennar	+ 12.6%	6.7 x	1.1%	+ 34.9%
Pulte	+ 5.4%	8.0 x	1.1%	+ 10.3%
NVR	+ 14.9%	16.7 x	-	+ 27.9%

Whilst the four largest US home builders' share prices are all well above their pre COVID peaks (ranging from +10.3% to +42.1%), the figures for the UK house builders are still very much below. Persimmon as the best pandemic performer of the four remains c. -22% below its previous peak in February 2020.

The reasons for this are multiple and varied (though in my opinion far from all being correct) including:

• Concerns around build cost inflation

• Stretched affordability for home buyers

• Changes to government backed equity loans through Help to Buy and the wider legislative environment

• The possibility/likelihood of rising mortgage rates

• Perceptions around the strength (or lack of) for the UK economy as a whole

• Memories of previous boom-bust cycles for the housing market including the disastrous 2007-09 period when many of the major house builders found themselves in extremely precarious financial health

In light of this last point, it is worth considering three key differences between today's market environment and 2007-09:

1. The UK government is the largest owner of housing equity in the country, by far.

Through the Help to Buy equity loan scheme. The total value of equity loans issued by the government since 2013 is £20.9 billion. Some of this will have been repaid since then, but a majority is likely to remain outstanding meaning that Her Majesty's Treasury is de facto the largest investor in UK houses by an order of magnitude. The UK government has a few £billion reasons not to see the housing market go into reverse.

2. Institutional investment.

In a zero interest rate world, institutional investors are starved of yield and are starting to look for it in a very big way in the UK's housing stock. Increasingly this attention is focusing on single family homes - the bread and butter of the volume house builders.

Investment in UK build-to-rent reached a record £4.1bn in 2021, up 14% on 2020 which was itself a record. With new and bigger entrants to this market seemingly announcing themselves on a weekly basis, 2022 looks set to break the record again.

Entrants to this market in the past year include Goldman Sachs, KKR, Ares, John Lewis, Lloyds Banking Group and Blackstone to name but a few. There is quite literally a wall of institutional capital targeting housing product across the length and breadth of the country. Liquidity matters. Fund flows matter. Don't hold your breath for a housing market collapse anytime soon.

3. Balance sheets.

In the run up to the financial crisis, many of the house builders were over indebted, seeking to juice their returns in a market awash with cheap credit. They paid a dear price when the bottom fell out in 2007-09 with many small and medium sized builders going under and many of the larger ones forced to raise substantial new equity just when their shares were at rock bottom prices.

This is no longer the case. Even though yields on corporate bonds remain near record lows, the volume house builders have learnt their lesson. Take Persimmon again, which has zero net debt and £1.23bn of cash on its balance sheet.

Just so we are clear on the level of pessimism surrounding these companies - Persimmon, which has been a cash printing machine for most of the last 10 years with nearly £1bn in EBITDA and an operating margin of c. 30%, currently offers a 9.2% dividend yield in the strongest housing market in recent history.

Yields on residential investment property in the institutional space are in the 3.0 - 4.5% range and trending lower. Sterling remains pretty weak vs. the dollar in the post Brexit landscape. How long before the private equity mega-funds turn their sights on buying the house builders instead of the houses?

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.