A Justifiable Case of Cold FEET: Fundsmith Emerging Equities

The launch of Terry Smith’s Fundsmith Emerging Equities Trust (FEET) in June 2014 attracted a huge amount of interest, but the shares are now trading just below the issue price of 1,000 pence. Despite the disappointing start, Smith has recently said that he expects it to outperform his highly successful Fundsmith Equity fund over the long term.

Smith uses the same strategy in FEET as he does in his other fund, but is only allowed to invest in businesses that have the majority of their operations or revenues in the developing economies. About a fifth of the portfolio is in quoted subsidiaries of companies held in Fundsmith Equity.

He will only buy good quality businesses that can sustain a high return on operating capital employed (ROCE). The companies also need to have advantages that are difficult to replicate, must not require significant leverage to generate returns, have a high degree of certainty of growth from the reinvestment of their cash flows at high rates of return, be resilient to change, and be attractively valued.

FEET’s portfolio has a ROCE of 53% versus just 6% for its MSCI Emerging Markets and Frontier Markets benchmark. It has an equally attractive gross margin of 45% and operating margin of 18% compared to 23% and 12% for the index. The leverage – ratio of debt to equity – is only 42%, whereas in the benchmark it is 102%.

These exacting requirements favour some areas at the expense of others. This explains why at the end of April the £191m portfolio was invested in 46 stocks with Consumer Staples accounting for a massive 78% of the exposure and Consumer Discretionary a further 10%. The underlying companies provide non-durable consumer necessities or small ticket luxuries like sweets and cosmetics.

The largest allocation is to India, which accounts for 30.1% of the fund. Smith justifies this by saying that the country “is the biggest repository of the high quality companies that I like outside the developed world.” He is much more cautious about China and expects further turmoil to come before his holdings can deliver the sort of investment performance that they are capable of.

Smith is a long-term investor and anticipates a low level of buying and selling, although 2015 was unusual with portfolio turnover of 67%. This was mainly because only about a half of the fund was invested at the start of the year and it is now pretty much fully invested. There have also been further changes in recent weeks with Smith pruning out some of his weaker performers.

It has been a disappointing start for investors with the fund losing money since launch and lagging slightly behind its MSCI Emerging Markets and Frontier Markets benchmark. Part of this was down to the slow initial deployment of capital and Smith’s relative lack of experience in these markets, although he has now brought in a number of analysts to help support him.

Smith’s investment strategy has worked superbly in his Fundsmith Equity fund, but it remains to be seen whether it will succeed in these more challenging markets. The massive overweighting in favour of the consumer is a significant risk, especially as the fund’s portfolio is trading on a 12 month trailing PE ratio of 35.7 times earnings. This is getting on for 3 times more than the benchmark, although the higher rating is partly due to the better growth rate. The shares are also trading on a small premium to NAV, whereas its peers are typically on about a 10% discount. You can understand why investors might be getting cold FEET.