Lesson 7 of 7
Terry Smith and the quality compounder
Fundsmith's published test, a high return on capital earned in cash, without leverage, at a valuation that is not too high.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Fundsmith's published test for quality: a high return on operating capital employed, and that return has to arrive in cash, not sit in growing receivables or inventory.
- Three rules follow: no need for leverage to reach that return, a valuation that is not too high, and very little trading once a position is bought.
- A high return that never converts to cash is not the same as a high return, and the conversion rate is where that gap shows up.
Fundsmith's Owner's Manual states its quality test plainly: a high return on operating capital employed, earned in cash. Reported profit can rise while the cash behind it does not, and the manual treats that gap as the test that matters.
Headline return against cash return, two businesses
- Company A, return on capital employed20%
- Company A, converted to cash · 100% conversion20%
- Company B, return on capital employed20%
- Company B, converted to cash · 60% conversion12%
Four of the manual's rules
What the Owner's Manual asks for
- A high return on operating capital employed, earned in cash.
- No need for borrowed capital to reach that return.
- A valuation that looks attractive rather than stretched, with no attempt to time the market.
- Very little trading once a position is bought, since each sale and repurchase adds cost without adding to the return.
Why cash, not the reported number
A return on capital employed can rise while a business quietly grows its receivables or its inventory, tying up more cash than the income statement shows. The manual's own point is that investors who look for the bank deposit with the highest rate of interest stop asking that question of companies, and talk about earnings growth instead of the return on the capital behind it. The conversion rate, cash generated against reported profit, is this page's way of measuring whether a return actually arrives in cash.
No leverage, a fair price, and almost no trading
A return achieved without borrowed capital says the business earns it on its own economics, not on a capital structure that could be withdrawn in a downturn. The manual's valuation test is a free cash flow yield high relative to long-term interest rates, compared with bond yields and with other candidates in the portfolio. It names no fixed number, and this page does not compute one for any company.
The low-trading rule follows from holding a compounder for years rather than months. Each sale and repurchase is a frictional cost, and a business earning a genuinely high cash return needs less rotation to be worth holding.
What this approach costs
A published preference for quality earned in cash tends toward businesses the market already recognises, which is priced in. Buying rarely and holding long also means fewer chances to add a cheaper alternative once one appears, and a valuation test that only screens out the most stretched prices still leaves a wide range of prices the rule accepts.
Check yourself
In Fundsmith's test, what has to be true of a high return on operating capital employed?
- It must come from leverage
- It has to arrive in cash, not sit in growing receivables or inventory
- It must be reinvested entirely in new capital spending
Show the answer
Answer: B.
The manual's own wording is a high return on operating capital employed, in cash. A rising reported return that is not converting to cash fails the test.Company B earns a 20 percent return on capital employed but converts only 60 percent of it to cash. What is its cash return?
- 20 percent
- 12 percent
- 32 percent
Show the answer
Answer: B.
20 percent times 60 percent conversion is 12 percent. The headline return overstates what actually reaches the business in cash.Fundsmith's valuation rule requires what?
- The lowest P/E available in the market
- A valuation that is not too high, not necessarily a low one
- No valuation test at all, since quality is what matters
Show the answer
Answer: B.
The published rule is that the valuation must look attractive, not stretched. It does not require the cheapest price on offer.Sources
- Fundsmith Equity Fund Owner's Manual: high returns on operating capital in cash, no need for leverage, an attractive valuation, no market timing, very little trading.
- Smith, Investing for Growth, 2020.
What this leaves out
- Both companies in the worked example are illustrative, not any filed company's figures.
- Cash conversion computed here is a simplified return-times-conversion figure, not a full reconciliation of operating cash flow to reported profit.
- The manual's valuation test is a free cash flow yield high relative to long-term interest rates; it names no fixed number, and this page does not compute one for any company.
- Nothing here is advice about any security.