Simon Barnard: Smithson should have theoretically underperformed in 2021

‘Very small degree of outperformance’ satisfies Fundsmith manager as Treasury yields rise


Smithson Investment Trust fund manager Simon Barnard (pictured) has said the £2.9bn strategy theoretically should not have outperformed in a year where 10-year Treasury yields increased 66%.

In 2021, Smithson’s share price increased 18.1% and its net asset value was up 18.9% compared to 17.8% in the MSCI World Small and Mid Cap Index. The investment trust never traded at a discount during 2021, with an average premium of 2.2%. New shares were issued at an average premium of 2.7% and raised £534m.

In his annual letter to shareholders, Barnard said he remained satisfied with the “very small degree of outperformance” given the market backdrop.

During the year, US 10-year Treasury yields increased from 0.91% to 1.51%, prompting discussions of a market rotation out of high growth companies, which Smithson holds, into lower-rated value companies.

“What enabled the portfolio to keep up with the index then?” Barnard said in the letter. “The answer is that on this occasion there were a number of companies that performed well for individual reasons. It is also the case that sometimes financial theory proves to be just that, a theory, which doesn’t actually play out perfectly in the financial markets, driven as they are by millions of fallible, emotional people.”

One of the portfolio’s highest-rated stocks, Wingstop, was one of its best performers in 2021, returning more than 30%, Barnard noted.

“This also serves to remind us that ‘highly rated’ does not automatically equate to ‘expensive’ – it always depends on what you are getting for the price. Having said all this, we still consider ourselves fortunate to have outperformed in this environment, but if this trend of increasing interest rate expectations persists, we may not continue to be so.”

Moderate inflation doesn’t concern Smithson

Barnard said he wasn’t concerned about moderate inflation – the factor that is driving central banks to raise interest rates and push up bond yields.

This is because Smithson’s holdings have high gross margins, meaning low raw material costs, and also low capital requirements, allowing them to generate high returns on this capital.

Additionally, many of the portfolio’s companies are in a strong position to raise prices.

“This is not necessarily something we want them to do unilaterally; as a market leader raising prices can often create an ‘umbrella’ under which competitors can flourish by charging slightly lower prices while still maintaining a good margin,” he said. “But if inflation is creating a cost issue for the whole industry, it is comforting to know that our companies have the market power to increase prices should it become necessary.”

Why Smithson doesn’t want to invest in value stocks

Barnard rejected any suggestion the managers should adapt to the market rotation by buying into value stocks.

“Whilst other managers may be able to run a value strategy, we believe it is inherently more difficult, as you cannot hold value companies for the long term if all you are doing is owning a poor quality company at a low price, which you hope will re-rate in the future,” he said.

“If this does happen (there is no guarantee), you then have to sell the company to find another such investment, and so on.  This means that unlike our strategy, time is not your friend, because the longer you are holding the company and waiting for it to re‐rate, the lower your annualised returns become, and if you’re particularly unlucky, the worse the company becomes.”

Sales and purchases during 2021

During the year, the investment trust sold two companies and added two new positions.

UK biotechnology company Abcam was dropped at a “high valuation” due to uncertainty stemming from a change in strategy. “While we do not disagree with the strategy to enter new markets, it brings elevated risk given the large amount of spending required to conduct R&D and acquire companies in these new areas, and the uncertain paybacks on those investments,” Barnard said.

Chr. Hansen, a Danish biosciences company, was sold for similar reasons.

US companies Rollins and Wingstop were introduced into the portfolio.

Barnard touted family-controlled pest company Rollins for its strong margins and returns on capital. “Unlike in the UK, houses and businesses in many parts of the world require frequent attendance by pest control professionals to keep them comfortable, and in some cases, habitable. This leads to highly repeatable revenue, as many customers pay for the services on a monthly subscription basis.”

In contrast, Wingstop is a fast-growing franchised chicken wing restaurant and delivery business founded in 1994. Within three years, franchisees are able to generate returns of 70% on their investment in new restaurants, Barnard said. “This has created an enormous pipeline of new units waiting to be built, which should underpin double digit growth for the company for years to come.”

See also: Fundsmith Smid trust gets first taste of underperformance