Best Stocks to Buy: Lessons from Terry Smith
The blueprint for success: What sets exceptional companies apart
Hi, Investor 👋
I’m Jimmy, and welcome to another edition of our newsletter. Today, we’re diving into the investment philosophy of Terry Smith, one of the most respected fund managers of our time.
Renowned for his “buy and hold” strategy and his focus on high-quality companies with strong fundamentals, Smith has consistently delivered outstanding returns. In this edition, we’ll unpack the core principles that define his approach, explore how they’ve stood the test of time, and highlight what we can learn from his disciplined and straightforward methodology.
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When it comes to investing, few figures have had as much influence as Terry Smith, the legendary CEO of Fundsmith. His straightforward, no-frills approach to identifying great companies has resonated with investors across the globe. In this newsletter, we explore Smith’s philosophy on what makes a truly exceptional company, breaking it down into key principles that can guide investors in making smarter, long-term decisions.
1. The DNA of a Great Business: Superior Returns on Capital
At the core of any great business is its ability to generate high returns on the capital it employs. According to Smith, this is non-negotiable. Why? Because companies that earn more on their investments than the cost of that capital create intrinsic value over time.
Imagine two businesses: one earns 25% on the money it invests, while the other earns 10%. Over the years, the first business will compound wealth for its shareholders at a much higher rate. Time is your friend. Conversely, businesses that consistently earn below their cost of capital destroy value—a warning sign for any investor. Time is your enemy.
Look for companies with a proven track record of generating high returns on operating capital. Industries like consumer goods, software, and healthcare often host such companies due to their scalable models and competitive advantages.
Main examples:
Microsoft (MSFT);
Mastercard (MA);
Johnson & Johnson (JNJ);
Coca-Cola (KO);
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2. Growth: It’s About More Than Just Scaling
It’s not enough for a company to be profitable—it also needs a clear path to growth. But not all growth is created equal. Smith points out that the best companies reinvest their profits into ventures that also deliver high returns. This creates a virtuous cycle of reinvestment and compounding.
For example:
Emerging Markets: Companies like Unilever and Nestlé have successfully expanded into developing regions where rising incomes boost demand for everyday products.
Premiumization: In developed markets, there’s a growing trend toward consumers paying more for better quality—think luxury brands or organic foods.
"It’s no use having outstanding returns if you’re limited to a very small segment, niche, or geography and can’t reinvest the money being generated to grow the business." - Terry Smith
The lesson? Look for businesses that not only grow but grow wisely, reinvesting in areas with high potential returns.
Main examples:
PayPal (PYPL);
Amazon (AMZN);
Thermo Fisher Scientific (TMO);
Caterpillar (CAT);
3. Competitive Moats: Protecting the Castle
Great companies don’t just thrive—they defend. Smith highlights the importance of "competitive moats," which are the barriers that keep competitors at bay. These can take many forms:
Brand Loyalty: Companies like Coca-Cola have built emotional connections with their customers that competitors struggle to replicate.
Supply Chain Efficiency: Firms like Amazon and Walmart leverage their vast, optimized supply chains to maintain cost advantages.
Technological Leadership: Companies like Apple and Microsoft use continuous innovation to stay ahead in fiercely competitive markets.
These moats aren’t just defensive—they also allow companies to command premium pricing and maintain higher margins. For investors, understanding a company’s moat is crucial to evaluating its sustainability.
Main examples:
Walmart (WMT);
Apple (AAPL);
Meta Platforms, Inc. (META);
Nike (NKE);
4. The Danger of Overvaluing Valuation
Investors often fall into the trap of focusing too much on whether a stock is "cheap" or "expensive." Smith argues that this mindset misses the point.
“Quality is rarely cheap,” he famously says. The real question isn’t whether the company is undervalued today but whether its quality and growth potential will justify its price in the future.
This perspective aligns with the philosophy of buying exceptional businesses at fair prices rather than mediocre ones at a discount. Over the long term, the former significantly outperforms.
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5. Navigating Growth Opportunities
Smith’s investment philosophy also involves understanding where growth will come from. He identifies four key areas where exceptional companies can thrive:
Emerging Markets
In regions like Asia, Africa, and Latin America, rising middle classes create huge opportunities for companies that understand local needs and tastes. Household staples and healthcare are particularly strong categories.
"When people in developing countries surpass a certain level of disposable income, they become consumers." - Terry Smith
Premiumization
As consumers in developed markets grow wealthier, they seek higher-quality goods. This trend is evident in sectors like food, fashion, and beverages. Premium products often carry higher margins, driving profitability.
"We may not be consuming more most of the time, but we are consuming better. We can refine what we do. So, whatever we’re talking about in terms of consumption, there’s a good chance we’ll move up the curve over time in terms of the brand of goods we consume and improve." - Terry Smith
Aging Populations
Demographic shifts, particularly in developed nations, mean greater demand for healthcare services, pharmaceuticals, and senior living solutions. Companies operating in these industries are poised for sustained growth.
Digital Transformation
The adoption of new technologies continues to reshape industries. From the shift to digital payments (benefiting companies like Visa) to the rise of e-commerce, the digital age offers endless avenues for expansion.
6. The Fundsmith Blueprint: Simplifying Investment Decisions
Terry Smith’s investing principles boil down to three core tenets:
Invest in good companies: Look for businesses with high returns on capital, strong growth potential, and durable moats.
Don’t overpay: While valuation matters, the quality of the business should take precedence.
Do nothing: Once you’ve found a great company, hold onto it. The power of compounding works best over the long term.
This simple yet powerful strategy has helped Fundsmith deliver market-beating returns year after year. For Smith, investing isn’t about chasing trends or timing the market—it’s about owning a portfolio of exceptional businesses and letting them do the work.
7. Lessons for Everyday Investors
What can the average investor take away from Smith’s philosophy? Here are a few actionable tips:
Focus on Fundamentals: Avoid the hype and dig into a company’s financials. Are they consistently profitable? How do they reinvest their earnings?
Think Long Term: Great companies need time to grow and compound their value. Patience is key.
Diversify Smartly: While quality trumps quantity, having a mix of industries and geographies in your portfolio helps manage risk.
Keep Learning: Investment is a journey. Regularly revisit your strategies and learn from investors like Smith who’ve mastered the art of long-term growth.
Conclusion: Quality Always Wins
In a world full of investment options, Terry Smith’s philosophy cuts through the noise. By focusing on high-quality companies with sustainable growth and strong competitive advantages, investors can build portfolios that withstand the test of time. It’s not about finding the next hot stock—it’s about aligning with businesses that are built to last.
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Investing for Growth
If you’re intrigued by Terry Smith’s investment philosophy, Investing for Growth offers a deeper dive into his unique approach. The book captures the essence of long-term investing, focusing on high-quality businesses, compounding returns, and avoiding unnecessary complexity. It’s not just a guide to strategy but a reflection on how to think like a disciplined investor, navigating markets with clarity and purpose.
What makes this book stand out is its emphasis on simplicity and common sense—principles often overlooked in a world of over-complicated financial theories. For anyone seeking to refine their investment mindset or understand the foundations of Smith’s success, Investing for Growth is an invaluable resource.
Ready to explore? You can grab your copy here.
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