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:
Buy good companies
Don't overpay
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).
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:
Buy good real estate (think high quality assets in supply constrained growth markets)
Don't overpay (ensure that unlevered yield on cost is always greater than your cost of debt capital, resulting in positive leverage)
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.
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